By Paul Mylchreest of ADM International
Can you arbitrage time? Central banks made the whole world “buy time”. There are signs that we’re beginning to sell it
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Can you buy and sell time? We think that you can from the perspective of time horizons. In our view, financial markets are operating on the wrong time horizon – one that is too long (thanks to central banks ZIRP/NIRP and credit creation) - although there are signs that this is beginning to change.
We are in a global debt bubble and debt has a “time function” given its ability to bring forward consumption from the future into the present. Debt essentially “buys time” and the world has bought a (hell of a) lot of time. The “present” is inexorably catching up with what was the “future.”
Time preference reflects the relative valuation placed on goods at an earlier date versus a later date. While current goods (including cash) should always have a higher valuation than future goods, time preference declines as an economy becomes wealthier, i.e. the proportion of income devoted to current consumption falls versus that devoted to saving/capital accumulation.
Since the crisis, central banks have sought to address “under-consumption” (how many people do you know who voluntarily under-consume?) by distorting time preferences in the real economy and financial markets via zero interest rates and excessive credit creation. Negative interest rates are another step in this direction. At the heart of their policy, however, is a fundamental contradiction.
- On one hand, their policies seek to increase current consumption, at the expense of long-term saving & capital accumulation, in an over-leveraged world. This increases time preference and would normally equate with higher interest rates, shortening time horizons and diminution in wealth.
- However, by forcing down interest rates, the substitution of savings (real wealth) by cheap credit and by supporting financial markets, they have created an impression that time preference is lower than it really is. This lengthens time horizons, implies that current/rising consumption levels are more easily sustainable and induces incorrect spending decisions.
While artificially increasing time preference fundamentally weakens an economy, there is no immediate concern unless there is evidence that businesses, consumers and investors are recognising that time preference is too high and are responding accordingly.
We detect signs that time horizons are shortening in both the “real” economy and financial markets.
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Time, Debt and Central Banks
We are in a global debt bubble and debt brings forward consumption into the present from a more distant point in the future – since it removes the need to save the loan value out of disposable income.
Consequently, the accumulation of debt has a time function.
Debt essentially “buys time”, so borrowers are literally “long” time and short the currency/credit which they must return to the lender at a later date. While lenders lend money, they are also “lending” or “selling” time to the borrowers.
While it has a geared effect on economic growth, “buying” more and more time becomes problematic.
As time progresses, what is “the present” begins to catch up with what was “the future.”
In the US, total credit market debt outstanding is US$58.0 trillion, or $62.4 trillion if you include the Fed’s balance sheet. At 331.7% of GDP, it is significantly higher than the 275% reached at the peak of the Great Depression.
It’s noticeable how central bankers almost never mention that TOO MUCH DEBT is the key factor holding back growth in what is a credit-driven global economy. This is the sleight of hand to deflect guilt. In fact, their strategy has been to address the fallacy (think about it) of under-consumption by an all-out attempt to make it cheaper to borrow so that the world accumulates even more debt.
And the US is only a part of the story.
The total amount of debt accumulated on a global basis is approximately US$200 trillion according to a recent report from the management consulting firm, McKinsey.
The world is “long” (a hell of) a lot of time.
Looked at in another way, central banks have artificially lengthened time horizons in the real economy and financial markets by distorting time preference. They have created an illusion at the heart of which is a fundamental contradiction.
Time preference is the relative valuation placed on goods (including money) at an earlier date versus a later date. It almost goes without saying that, in general, people would rather fulfil their desires today than tomorrow. Who wouldn’t? People value present goods more highly than future goods. This concept is obviously used in DCF calculations to value financial assets/projects, i.e. cash flows at an earlier date have a higher valuation than cash flows at a more distant date.
In an economy, the way that time preference alters the balance between consumption today versus saving/investment for the future - and how debt accumulation interacts with this process – has major implications for growth. As an economy becomes wealthier, time preference declines.
Time preference plays a key role in the formation of interest rates along with diminishing marginal utility (e.g. if you were on a desert island with nothing but 2 bananas, it probably makes sense to eat the other one tomorrow).
Implicit in time preference is that interest rates should be positive. Borrowers have to compensate lenders for the use of cash now if they don’t want to (or can’t) save it out of disposable income. Lenders require positive interest rates to defer consumption over and above some level of precautionary cash reserve.
Negative interest rates violate the normal concept of time preference, implying the premium of present goods to future goods is reversed. A person who saves SFr100 and gets SFr 99 back in a year’s time must judge that the value of SFr 99 for consumption in a year’s time is more than SFr100 now.
Switzerland was the first country to see its 10-year yield slip into negative territory.
More than 15% of all developed market sovereign bonds are now trading on a negative yield. Swiss yields are currently negative out to nine years, German yields out to six, Danish out to five and Swedish out to four.
This strikes us as an extraordinary market signal. How could things have become so distorted and why is the consensus view so complacent? It seems that as long as stock markets are buoyant and sovereign bond yields of major nations remain very low, the majority will bask in the status quo.
Many suggestions are being put forward to explain negative yields so far out on the curve.
- Rising deflation risk;
- SNB’s negative policy rate (reduced from 0.00% to -0.75% since December 2014);
- A shift towards “safe” assets as some investors question the future stability of the current financial architecture;
- Limited guarantees on bank deposits and risks to the banking system;
- A view that Swiss government bond prices will continue rising, so there will be an opportunity to sell them at a higher price to someone else;
- Supply shortages of specific assets relative to the massive liquidity injections from central banks;
- The financial system has been so distorted by central banks that it’s almost impossible to value anything even with a degree of objectivity any more; and
- Asset prices are increasingly driven by flows of capital as markets try to front-run changes in central bank policy.
All might be contributing, to a greater or lesser extent, but most are reflecting economic weakness and/or risk aversion on one hand and extreme policies of central banks on the other.
In contrast to the Fed, BoJ, BoE and (now) the ECB, the Swiss National Bank has never bought its own sovereign bonds. Nor should we forget that there are still alternative sovereign bonds with respectable credit ratings and much higher (it’s all relative) yields, e.g. US Treasuries. Yet the yield differential has not been arbitraged away, or at least not yet. And if it was, which way would it go?
What’s happening made us think about time preference and the way in which it is being distorted.
An increase in time preference implies that a higher ratio of income is devoted to consumption versus saving/investment for the future.
It should be obvious that this is precisely the aim of central bank policies to “correct” what they view as under-consumption. At its heart is a cynical inducement for businesses and consumers to make what are, in some cases, incorrect or risky spending decisions. Increasing consumption when savings ratios are low and debt is high suggests that central banks are trying to create the illusion that time preference is lower/falling when it’s actually higher/rising.
If we look at the US, for example, while debt is at an all-time high, the savings ratio is at a very low level by historical standards.
The problem becomes clear when you think more deeply about rising time preference in an economy. An increase in time preference means a corresponding reduction in saving. Saving/investment, in case we forget these days, is the basis of wealth creation, i.e. the creation and productive application of surplus. An economy with a time preference of 100% would spend all of its income on consumption and would never have any surplus for capital investment in order to increase its standard of living. Indeed, in no way is it an exaggeration to say that it was only by lowering time preference that civilisation was possible.
In normal circumstances, the more that time preference is raised, the more people live a hand-tomouth (or “paycheck to paycheck”) existence. Current levels of consumption become harder to sustain, there is less confidence in the future and time horizons shorten. In this environment, capital investment, which is the basis for wealth creation, suffers. All things being equal, high time preference would normally equate with higher interest rates as borrowers compete for scarce funds and need to offer high rates to induce people into saving.
Time preference tends to be higher for the very old, the very young, people living in less developed societies and for individuals and entities which are heavily indebted (which increasingly includes governments).
In extreme cases, it can be associated with a rise in central planning, “big government”, the subversion of property rights and rule of law and when a system starts decaying towards socialism.
Venezuela is an example of this. In such circumstances, governments “kill” productive investment, there is hoarding/shortages and capital flight emerges. What about the opposite situation?
When time preference is low or declining, a smaller ratio of income is devoted to consumption versus savings and investment. This implies a comfortable level of financial “surplus”. Current levels of consumption should be sustainable and time horizons lengthen due to greater confidence in the future. Abundant savings implies lower interest rates for borrowers. Businesses and entrepreneurs react to the higher savings/confidence with new capital investment, particularly in higher orders of production which are more distant from the final consumer. This includes natural resources, like oil & gas and metals and mining, and capital goods projects.
In a big picture sense, time preference tends to decline when a society experiences a broadly-based rise in wealth/capital accumulation. It is often associated with other factors such as technological progress, free-market capitalism, “small” government, the respect for property rights and the rule of law.
This was Douglas French writing in “High Rises and High Time Preferences”.
“The lower the time preference rate, the earlier the onset of the process of capital formation, and the faster the roundabout structure of production will be lengthened. Civilization is set in motion by individual saving, investment, and the accumulation of durable consumer goods and capital goods.”
It should be clear how central banks are attempting to distort time preference and how their policies contain a fundamental contradiction in terms of time horizons and wealth creation. In essence, they are creating an illusion.
While aggressively seeking to increase time preference, with all its negative implications, on the one hand, they are trying to give the impression that time preference is lower than it really is by making current levels of consumption seem more sustainable by forcing down interest rates and replacing savings with cheap credit. This artificially extends time horizons and increases confidence. But, lest we forget, a rising time preference is indicative of a weakening economy, not a strengthening one, and one which is more vulnerable than it looks.
It doesn’t take a genius to realise that the end result of trying to artificially lower time preference is to exacerbate the volatility of the business cycle and financial markets.
We know the result.
Each bubble is bigger than the last because the recovery from the previous bubble requires even lower interest rates and more credit creation…which induces some businesses and consumers to make a new round of risky spending decisions…and eventually…investment decisions.
There comes a point when the illusion should start to fade. The average person will start to realise that, in spite of historically low interest rates and all around central bank largesse, their time preference is not that low. In fact, it’s been rising and increasing it further would be irresponsible. Time horizons will shorten and risk increases.
The focal point of the last bubble was US house prices and associated securitised loans. House prices, which (according to Bernanke) were never supposed to fall, but were already falling more than a year and a half before Lehman collapsed.
This got us thinking about what signs we should we look for to tell if the central banks’ time preference illusion is running out of road.
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Much more in the full report found below: