Fox Capital Management - September 2019
Predicting the inevitable demise of a fiat currency cycle is neither bold nor incendiary. For thousands of years, every fiat currency cycle the world has ever known started and ended the same way. It happened during the Roman Empire with the Denarius, in China during the 11th century with paper “flying money,” in France multiple times beginning with infamous central banker John Law’s Banque General, in the early USA with paper Colonials and Continentals, and perhaps most famously in Weimar Germany with the Mark after WWI. All fiat currencies eventually collapse, and largely for the same reason: the issuing government becomes over-indebted and abuses its privilege by debasing its specie or over-printing its money, which results in a logical collapse of confidence. Timing the ultimate demise is difficult, but having confidence in its inevitability is not.
Cycles are a basic natural phenomenon and are thus unavoidable. For money, the cycle always begins with “hard” currency containing or backed by a physical asset, typically a valuable commodity like gold, copper or silver. Users of the currency have confidence in its value because they know it is or represents a certain amount of something tangible. The medium of exchange is trusted, transactions occur, the system runs smoothly and the economy grows. Eventually, the issuing government becomes over-confident in its success and grows tired of dealing with the constraints this hard-exchange requirement places upon its ability to borrow, spend and expand.
Enter fiat currency.
It is at this point in the cycle that the issuing government decrees by fiat (“let it be done” in Latin) that its currency is no longer exchangeable for any tangible asset or commodity, but is instead backed by a promise that the government is “good for it” via its taxing authority or other means. Thus, the money transitions from hard currency to “legal tender” fiat currency, with no intrinsic value beyond the word of its issuer.
With confidence in the system still high, the issuing government is now free to create and borrow fiat money at will for infrastructure projects, welfare programs, expansionary wars and anything else they deem worthwhile. Without the fetters of a hard currency, money is created and spent seamlessly, with the entire system awash in credit as confidence abounds. The good times roll.
Eventually, however, both the government and its citizens become stretched beyond their means, and the economic demand for fiat money, regardless of how cheap it is to borrow, begins to hit a wall. As the credit cycle falls into a downward spiral, the government printing presses go into overdrive, creating new money out of thin air to pay off debts, meet excessive social requirements, and fund bloated operations.
Once it becomes clear that the government is blatantly abusing its unique privilege of creating fiat money, confidence in the currency and the issuer behind it begins to falter. Purchasing tangible assets requires more and more fiat currency. Inflation infects the system as people scramble to exchange their weakening currency for hard commodities and resources. This happens slowly at first, then all at once. Ultimately, confidence is completely lost, and the once-valuable fiat currency is literally not worth the paper it is printed on. The systemic collapse of the monetary system is complete as the cycle reaches its revolution.
In order to build a new monetary and economic system out of the ashes, the next government must first rebuild confidence in the medium of exchange. Thus, they introduce a new form of hard currency fully exchangeable for a tangible asset like gold, copper or silver. Confidence is restored and the cycle begins anew. Wash, rinse, repeat.
Where We Are in the Cycle
Today, we are in the later stages of this fiat money cycle for the US Dollar and other global reserve currencies, where governments, citizens and corporations are over-indebted and stretched beyond their means. The system has been flooded with easy credit and liquidity for decades, and is now at the point where demand for that credit is finally on the wane.
The chain of events leading to this current stage of the cycle began in 1971 when Richard Nixon halted the US Dollar’s convertibility to gold, ending the Bretton Woods system that had been the global framework since 1944. This historic decree immediately ushered in a fully fiat global currency regime.
Without the constraints of a gold standard and the Bretton Woods system, sovereign treasury departments and global central banks had far more flexibility to create credit and pump liquidity into the financial system at will. But it wasn’t until the 1990’s that central banks unofficially adopted a third mandate of injecting large amounts of liquidity into the system at every sign of financial market volatility, regardless of economic or inflation indicators (most notably after the LTCM failure in 1998 which led to the term “Greenspan Put”). This has been the modus operandi of every major central bank since then, and has directly resulted in asset bubbles, wealth inequality, and unsustainable sovereign debt levels.
The most famous asset bubble in modern history was the housing bubble which drove the global financial system to the brink of collapse in 2008. The Federal Reserve responded by implementing a new zero percent interest rate policy (ZIRP) followed by quantitative easing (QE) in the form of massive mortgage debt and treasury purchases to relieve the strain. This initiative essentially transferred all the toxic debt from the technically insolvent banking sector to the Fed, bailing out the financial system and all responsible parties. While this action almost certainly helped avert a global depression, this “unconventional” monetary policy experiment brought with it many unintended consequences.
Quantitative easing quickly created a large increase in excess reserves in the banking system. This in turn led to excess demand for “risk-free” sovereign debt and investment grade assets. It also ensured market participants that there was a large and persistent buyer regardless of conditions. These unconventional policies (ZIRP and QE) led directly to a universal scramble for yield at any price, artificially low volatility, an abandonment of traditional price discovery mechanisms, and a massive distortion for the pricing of risk. Even more troubling is that the patient became wholly addicted to this “emergency” medicine which was supposed to be just a temporary measure.
With every major central bank following the same playbook post the GFC, global central bank balance sheets swelled from $5 trillion in 2007 to over $19 trillion today. During the last few years, central banks attempted to normalize their bloated balance sheets, but they quickly discovered that financial markets are now fully reliant upon excess liquidity to function properly. All central banks have since abandoned those plans, with the ECB just announcing a new round of open-ended QE after pausing for a scant nine months, and the Fed increasing its balance sheet again via emergency repo operations just last week. The addicted patient has made it clear that any withdrawal of stimulus medication will result in systemic volatility. Of course, central banks view any such turbulence as unacceptable with such a fragile economic backdrop. Rock, meet a hard place.
Another unintended consequence of these unconventional monetary policies is the historic wealth gap, and the polarized social and political environment that accompanies such extreme differences between the rich and the poor. By bailing out the banking system in 2008, and then inflating financial asset prices (stocks & bonds) on every market wobble since then, central banks have demonstrated a clear policy of “socialism for the rich” and “capitalism for the poor.” The vast majority of citizens do not possess large securities accounts, so asset price inflation increasingly benefits fewer and fewer people, widening the skew between the “haves” and “have-nots” (the richest 1% own over 50% of stocks). One might think that the massive amount of monetary and fiscal stimulus would benefit the working class through the corporate channel, but it turns out that corporations just used artificially low interest rates and tax cuts for financial engineering. Instead of investing in their businesses, they simply levered up their balance sheets for stock buybacks and M&A to boost equity option prices. In fact, while corporations have levered up to historic extremes, capital expenditures have languished and worker compensation as a percent of sales has actually declined. So, the rich have gotten a lot richer, while the poor have seen little benefit from these experimental policies, and have actually been punished as savers by artificially low rates. Ironically, the only equality lies in every citizen’s shared obligation for the massive pile of new government debt that’s been created.
This huge chasm between the haves and have-nots has naturally led to extreme social and political polarization, with “populism” on the rise in both factions. Formerly extreme liberal viewpoints in the US have become more mainstream policy, as the have-nots demand socialism for all, not just for the rich. They argue that the monetary and fiscal policy that has served the elites so well should now benefit the masses through deficit monetization, government funding of entitlement programs, loan forgiveness, universal basic income, and hefty taxes on corporations and the rich. In short, they want wealth redistribution and control of the printing presses to get what’s “owed” to them, and they very well might succeed given the current social mood.
With Debt/GDP nearing 110%, trillion-dollar budget deficits, and a Federal Reserve balance sheet of $3.8 trillion (up from just $900 million in 2008), the Unites States has likely passed the point of no return, as has Japan, the Eurozone and probably China too. The burden of excess sovereign debt has curtailed global economic growth as one would expect, with sluggish GDP and low inflation as the norm this decade. It’s also now clear that the massive US tax cuts implemented in 2017 in no way “paid for themselves” as deficits are still exploding. And while the Fed’s balance sheet normalization program was supposed to be like “paint drying” in the background according to Janet Yellen, financial markets proved unable to handle even a 25% reduction before screaming for it to stop (after the balance sheet expanded by 400%). Even with such an extended period of massive stimulus since the GFC, strong economic growth has not been sustainable, and excess cash flow to pay down the debt has not materialized. The medicine has made the patient more comfortable, but it has certainly not been a cure. And it’s clear at this point that the patient can never come off treatment without a severe reaction.
So why can’t this just keep going indefinitely? Why can’t unconventional monetary stimulus and debt monetization just become conventional policy and keep the patient on life support forever? What’s the catalyst to thwart central bank intervention and thrust this fiat currency cycle into its final phase? We believe it’s the boundary of negative interest rates.
There is now currently over $17 trillion of negative yielding debt in the world today, so this has become a mainstream phenomenon. Germany’s entire sovereign debt yield curve is in negative territory, where investors have to pay to park their money in Bunds. And it’s not just “risk free” sovereign debt, as several corporate debt issues in Europe offer negative yields to investors now too! As bizarre as the last decade has been with respect to financial markets, this new development takes us into an entirely new realm which has barely been contemplated by investors, let alone experienced.
Negative rates are antithetical to financial theory and create a perversion of asset and risk pricing models. When using a negative number as your risk-free rate to determine the present value of future cash flows, cash becomes more valuable than any asset. This creates a serious problem for the banking sector. Investors dump bonds for cash, but do not want to pay a fee (negative rate) to park money in the banking system. As depositors withdraw their cash, bank capital becomes compromised, and they are unable to dig out because their business model has been completely destroyed, first by compressed net margins, and finally by negative rates. This “run on the bank” thrusts the fractional reserve money multiplier into reverse, sucking liquidity from a system now fully reliant upon it. European bank executives are pleading daily for the ECB to move off of negative deposit rates, but this is not going to happen, as new ECB chief Christine Lagarde (not coincidentally a debt workout lawyer) has recently hinted at even more negative rates. Ironically, the experimental medicine which saved the banking system (ZIRP & QE) is now actually killing the patient, and there is no way out of this conundrum.
Another problem facing central banks is that negative policy rates paradoxically LOWER inflation expectations as it stokes deflationary psychology, and the lack of income for savers actually increases the savings rate and not consumer spending. Just recently the Federal Reserve of San Francisco published a white paper which concluded that inflation expectations in Japan dropped immediately after the BOJ first took rates negative in 2016 and remain even lower today. In Germany, the personal savings rate has INCREASED significantly since the ECB deposit rate went below zero. Much to the chagrin of PhD central bankers, it’s now very clear that negative rates simply do not have the intended effect.
Finally, for pension and entitlement programs, negative rates destroy the model. Aside from the inability to generate any yield from their fixed income investments to meet obligations, pensions use a discount rate to determine proper funding requirements. Using a negative discount rate would render all pensions technically underfunded. Quite a dilemma to say the least.
In a nutshell, negative rates turn the entire model upside-down. Which is why right now you see investors chasing bonds for capital appreciation and buying stocks for the yield. Truly remarkable phenomena.
Fire and Ice
So how does this all play out? There are obviously many routes and outcomes for all the players and markets involved. That said, we do believe that some results are more likely than others, and that a few are simply unavoidable. From a big picture standpoint, the progression is likely to be led by further debt deflation and economic contraction (Ice), followed by the final act of hyper-inflation as all sovereign debt and fiat currency becomes entirely mistrusted (Fire).
Central banks are the most influential players in this drama, as their own groupthink has played the biggest role in pushing the global monetary system into its current state. What is now very clear is that the major central banks, who have all followed the same strategy, will never be able to normalize rates or their balance sheets, as “unconventional” monetary policy has driven the entire system past the point of no return. They’ve already tried and failed, as evidenced just recently by the ECB restarting QE after only 9 months, and the Fed abandoning its own balance sheet normalization program. There’s no getting off the addictive drug, and those in charge know it, so their plan is to just keep shooting up the dope while hoping that the systemic collapse happens only after they retire.
In the meantime, to stave off the inevitable, we can expect central banks to continue favoring debtors over creditors, as they dogmatically believe that the horrors of deflation far outweigh the perils of inflation. We can also expect them to resume large-scale asset purchases on any market weakness, including equities, because refusing to do so would create too much instability and simultaneously prove that prior asset purchase programs were foolhardy. They will also likely begin to coordinate with their governments to directly fund budgets and social obligations via money printing (Modern Monetary Theory). Any pretense of independence or monetary prudence will be pushed aside as they race to the bottom against their global central banking peers. However, knowing full well that this is a road to ruin, central banks will also continue to build gold reserves (which they have been doing for years) to have on hand as many poker chips as possible when the new post-collapse global monetary regime is established, undeniably with gold as its anchor. By that point, central banks will probably (and correctly) be recognized as the biggest culprits for the systemic failure. Ultimately, they will be abolished and disbanded.
This progression will be aided by populist government policy driven by the “have-nots” who finally get in power and legislate the transition from “socialism for the rich” to socialism for all, with higher spending and crippling taxes on the wealthy. Despite record deficits and government debt/GDP ratios, fiscal spending will go into overdrive, further compromising the credit quality of sovereign issuers. As citizens begin to doubt the value of fiat currency backed solely by over-leveraged sovereigns, and the rich attempt to export their financial assets to safer havens, governments will enact capital controls while outlawing cash, private gold ownership and crypto currencies. Globally, protectionist policies and trade wars will ignite into real wars, as each country scrambles for physical resources while exchanging as much of their eroding fiat paper for hard assets as quickly as possible (Trump’s recent offer to buy Greenland doesn’t seem so funny within this context). Global discord will make cooperation in the face of sovereign debt restructurings extremely difficult at the worst possible time. It will likely require the pain of total collapse before necessity dictates rational compromise among wary nations for a new financial framework.
In the commercial sector, most banks will fail after struggling under the duress of declining loan growth, compressed margins, and finally, negative rates. Depositors will refuse to pay interest for banks to hold their money, and the ensuing run on the banks will generate capital impairments, insolvency, and ultimately nationalization of the commercial banking system.
For the business sector, historically high leverage ratios will become unmanageable and the demise of financial engineering will occur right when recessionary conditions obligate layoffs and spending freezes. Populist policies will increase the tax and regulation burden as the corporate sector faces backlash from decades of elitist treatment, and stock options and buybacks will become outlawed. Worker revolts will be supported by the government, and long overdue bankruptcies of profligate companies will explode. Large industries will become nationalized in an effort to stem the tidal wave of layoffs and unemployment, coinciding with a mass disintegration of stock and bond securities amidst a global depression.
At the end of the day, financial investments and fiat currencies turn to ash while hard assets and tangible resources hold their intrinsic value (but skyrocket in terms of paper money). Initially, however, stocks, corporate debt and sovereign debt will likely be caught in a tug of war between deteriorating fundamentals and relentless central bank buying, making it very difficult for bullish and bearish investors alike. What is certain, though, is that volatility for all financial asset classes will increase substantially in stark contrast to the last decade, and it is only a matter of time before central banks lose all control and credibility. At that point, the game is finally up. Meanwhile, natural resources and hard commodities will be the best stores of value as this chapter reaches its conclusion.
So, while the path ahead is wildly uncertain, the final destination is clear. Decades of excess debt creation financed by the world’s central banks has led us across the Rubicon, and the only valid solution is a coordinated sovereign debt restructuring accord coupled with the creation of a new global monetary system. Given the international discord that will likely accompany and probably lead to this crescendo, any new construct will have to guarantee trust to its participants. Gold, the only reliable monetary constant which spans millennia, is the logical ballast.
As we contemplate this big picture scenario, we are executing trading strategies here at Fox that should serve our investors well in the coming years, favoring commodities over financial assets, while capitalizing on more regular turbulence in global equity, fixed income and foreign exchange markets. At a minimum, we anticipate a new cyclical commodity bull market in the coming years, and in fact see early signs of its development already. But, if this fiat currency cycle actually accelerates toward its conclusion, which is a highly possible black swan event given the circumstances, the ensuing secular bull market in commodities and natural resources will be the investment opportunity of a lifetime. Bring it on.