Submitted by Russell Napier of ERI-C
The Solid Ground fortnightly - Destroying Dollars - in a world with more growth and inflation?
"At a meeting in Washington in spring 1995, former Federal Reserve chairman Paul Volcker, who had used all the Fed’s tools to control the “monetary aggregates” in the late 1970s and early 1980s, asked current chairman Alan Greenspan, “Whatever became of M-1?” Greenspan nodded thoughtfully and said, “It was once the name of a pretty good rifle.”
-The Bankers - The Next Generation: The New Worlds of Money, Credit and Banking In an Electronic Age, Martin Mayer, E.P. Dutton & Co Inc, 1997
There is always a reason (some might say excuse) for the delay in the production of The Solid Ground Fortnightly. Your analyst has excelled himself in search of extenuating circumstances this time, with a trip to Ghana sadly interrupting the scribbling process. Subscribers will know that 10% of the revenue from the sale of The Solid Ground goes to finance scholarships for people who could not otherwise afford to attend university. Over the seventeen years of donations many of our recipients have come from Ghana and it was great to meet many of them and hear of their successes. Many thanks to all those subscribers who have contributed to their education and prosperity.
Meanwhile, far from the real world, in the world of money and credit, things continue to go from bad to worse. Sometimes it just seems perverse to be negative about a world where our scientists and technologists are making tremendous progress. However, for this analyst, the negativity stems not from their efforts but from the shockingly bad job that financiers/investors are doing in producing the stable financial system against which such progress can be sustained.
Too much debt and not enough money remain a diagnosis for deflation and not inflation. In particular, we need to discuss why fears of inflation persist in a world where the US central bank and the US commercial banking system are now both destroying money. When both these key engines of the reserve currency creation act to destroy money, there will ultimately be a contraction in broad money growth, the first since the 1930s, if nothing changes. This analyst thinks that matters, but few, if any, agree. At this stage the interesting evidence is that this dramatic tightening of monetary policy seems to matter more outside the USA than within.
From its peak in November 2017 the level of US bank credit, when we adjust for the systems acquisition of non-banks, has posted no growth. When a commercial banking system posts no growth in bank credit over four months, it creates no money over that period. It just so happens that this is the same four months during which the Federal Reserve has been contracting its balance sheet. Sticking to the Policy Normalisation Principles (PNP) and their addendum of June 2017, the Fed has been destroying money by shrinking its balance sheet. In the period from August 2017 to February 2018 there has been a shrinkage of US$105.2bn in commercial bank reserve balances: the high-powered money. Based on the PNP, a further US$20bn will have been destroyed in March 2018.
So with a commercial banking system creating no money, and a central bank destroying money, we are looking at one of the tightest monetary policies ever pursued by a central bank. To disagree with that statement is to believe that monetary policy is judged solely by the price of money, without reference to the quantity of money. Such was the belief that led to the Great Depression. At this stage the distress associated with this policy seems to be falling primarily upon non-US companies that have borrowed USD. This has huge consequences for investors.
Regular readers will know that your analyst has long expected a de facto default by Turkey, enforced by an imposition of capital controls by President Erdogan. No such imposition was likely until the pain of foreign borrowing and of defending the Lira exchange rate produced bankruptcy in Turkey. That time has come. Otas, which owns 55% of Turk Telecom, has ceased paying interest on a USD denominated loan of US$4.75bn. Yildiz Holdings is seeking to restructure US$7bn of debt, which would be the largest restructuring in the history of Turkey. Bloomberg reports that in Turkey, ‘banks have been extensively restructuring loans’. Such is the pain for those who borrow USD when interest rates rise by just 150bp and their exchange rate devalues.
The Turkish President, following a tried and trusted political stratagem, is determined to distract the populace from the pain with foreign adventures. Those foreign adventures include menacing Italian ships in the Mediterranean, threats to attack France and now coming increasingly close to attacking US troops in the city of Manbij. Your analyst remains baffled by those financiers, attracted by the yield on the Turkish lira, who refuse to see themselves as legitimate foreign targets in the President’s war on foreigners.
Of course, it is not just in Turkey that the borrowers of USD are in distress. In China Anbang Insurance Group’s excessive USD debt burden has forced it into the warm and welcoming embrace of the Chinese government. HNA Group of China is ditching assets and sacking a quarter of its workforce in a desperate attempt to meet its USD debt obligations. Meanwhile, in Europe, the US LIBOR-OIS spread and the TED Spread have reached levels not seen since the beginning of the great financial crisis in 2007. There has been much analysis of these measures in recent days that argues they do not reflect growing credit distress. Well, perhaps, but they do coincide with a period of observable credit distress for key USD borrowers in Turkey and beyond.
Whatever the cause of this rise in the price of Eurodollars, somebody is paying up to borrow USD in a way they have not had to do since September 2007, when Northern Rock folded. As a key borrower at the short end of the Eurodollar market, banks with large USD loan books, but lacking a sufficiently large USD deposit base, are likely paying more to fund their USD lending. The likelihood is that these higher costs will have to be passed on to borrowers.
In 1Q 2015 (“Why Deflation Means Default”) The Solid Ground analysed the offshore USD loan market and concluded that the combined non-US bank USD loan book to the non-financial sector amounted to US$3.7trn. This accounts for 43% of offshore total USD credit (including bonds). That’s US$4.3trn in credit, extended by banks that have limited, if indeed any, access to USD deposits. A rise in the cost of their funding, at a time when the quality of some of their assets is deteriorating, is not a pleasant combination. What may be even more unpleasant is that the US Federal Reserve may not be minded to pay any attention to their distress.
At a recent investment conference your analyst attended, Larry Lindsey was asked what he would now do had he accepted the recent offer to become Vice Chairman of The Federal Reserve. He replied, “ exactly what we said we will do.” Those who have read this far will know that the Fed has provided a very clear roadmap as to the scale and timing of its balance sheet reduction. The Fed has told us that it will destroy US$380bn of high-powered money in this calendar year. Almost nobody in the financial markets takes that pledge seriously, distracted as they are by the party game that involves guessing the number of interest rate rises in any given twelve-month period.
It is once again forgotten that monetary policy is determined by the quantity of money, as well as the price. While everyone agrees that the Fed’s creation of high-powered money prompted asset price inflation, nobody, it would seem, thinks the destruction of that money matters. We shall see. We shall see if this Federal Reserve chairman does exactly what he says he will do, or if he blinks like his predecessor did, if faced with similar episodes as a taper tantrum or the offer of the so-called ‘Shanghai Accord’.
The Solid Ground believes that Jay Powell is likely made of stronger stuff than the two academics and the Ayn Rand ideologue who preceded him. This is particularly bad news as the pain of higher US interest rates raises credit quality issues for both financial and non-financial corporations far from US shores. While any central banker has to react to changes likely to impact economic data, the era has likely passed when the Federal Reserve, like Pavlov’s salivating dogs, reacted to the ringing of the bell by financial market participants. In short, there may be a ‘Powell Put’ for the US economy, but this is not the same thing as a ‘ Powell Put’ for the US financial markets.
Subscribers who have read the latest Quarterly will know why higher US interest rates do not signal higher inflation. They will know why we enter a new era, the like of which your analyst, with almost thirty years in the investment industry, has only read about in the history books. What everyone needs to know is that the USD remains the world’s reserve currency, and they have stopped making more of it.
This will be very painful for the over-leveraged, and currently the most over-leveraged, already suffering, seem to be non-US corporations. The mystery remains why this rise in real rates has not been positive for the USD exchange rate given that the BOJ and the ECB continue to create money while the Fed destroys money.
The best answer your analyst can provide for the weakness of the USD is that the consensus still believes, based primarily upon the tightness in the US labour market, that inflation is coming. When it doesn’t, only then will the very high and attractive level of US real rates of interest become apparent. Then the USD will react and move higher on the international exchanges, further exacerbating the pressure on those non-US companies, particularly those in emerging markets, who are financing their USD debt burdens with non-USD cash flows.
It has now been just over thirty years since the US central bank was run by a central banker unwilling to fill up the punch bowl for the more leverage/more liquidity crowd that has destroyed the stability of the global financial system. The last time they had one of those central bankers, the USD soared. It did so despite large fiscal and current account deficits, and commodity prices collapsed triggering a major emerging market debt crisis in 1982.
Seasonally-adjusted USD M1 just fell by US$33.8bn from January to February and has very likely fallen by a similar amount from February to March. The contraction of the Fed’s balance sheet, begun in November 2017, is beginning to spread through the monetary aggregates. Today the answer to Volcker’s 1995 question, “Whatever became of M-1?” is likely to be: “It was once the fuel for the biggest asset bubble ever created by a central bank”.
Your analyst continues to believe that money matters and, in a world of record high debt to GDP, money matters more than at most other times. The fact that USD M0 and M1 are both shrinking also matters. After nine years of extreme monetary policy USD M2 growth, at 4% year on year, is at a level recorded in only 14% of the quarters since 1960; that too matters. As the Fed’s balance sheet continues to shrink and credit creation by the commercial banks has ended, further slowing in broad money growth is coming. This slowdown in money growth combined with the likelihood of a credit event in the offshore USD credit market will mean that inflation fears can disappear rapidly. That is when the scale and attractiveness of US real rates of interest will become apparent and the USD will begin its rise.
Remember those good old days when the markets asked for more ammunition, and the Fed provided as much M0/M1 as anyone demanded? Well, the ammunition just ran out.