A Financial Repression Authority (FRA) Brief:

What Is The Risk-Mitigated Way To Invest In Gold?

Is it going on the stock market and buying a gold ETF like GLD? Is it buying gold mining stocks? Is it buying some gold coins and burying them in your back yard? Is it buying into a limited partnership where the gold is stored offshore? Is it buying gold coins and gold bullion bars and storing them in a safety deposit box at your bank?

The answer to all of the above is no from a risk-based perspective. What does a risk-based perspective mean and why is it important to invest in gold using a risk-based perspective?

Courtesy of Matterhorn Asset Management GoldSwitzerland

In this brief, we will answer those questions by assessing 15 different risks encompassing market risk, credit risk and operational risk. These risks are tabled below. These risks do not take into account certain risks such as the imposition of a windfall profits tax which may be taken by desperate indebted governments in certain jurisdictions.  Our organization, the Financial Repression Authority (FRA), has assessed how well these risks are mitigated by a wide variety of provider firms buying, selling and storing gold.

But before we get into looking at the risks, let’s consider the big questions about owning and investing in gold – Why does it make sense and why now? Why should anyone invest in an asset that does not pay any yield?  We point out below some of the simple yet powerful answers on why.

As to why now, we point out the trend so far this year has been bullish for gold in U.S. dollar terms, but emphasize how gold has already been bullish in most non-U.S. dollar terms over the past few years already.

In addition, gold is an asset which performs well in extreme inflation and extreme deflation environments[i], and serves as protection in times where there is a loss of confidence in government. There are strong deflationary forces in the world today[ii], and many like Martin Armstrong point out how a loss of confidence in government can lead to hyperinflation.[iii][iv] These trends are very bullish for gold now and we think very likely to persist for the remainder of the decade.

Why Gold?

Courtesy of Matterhorn Asset Management GoldSwitzerland

The quote from Voltaire has proven to be true for thousands of years. Paper money issued by governments eventually either loses its value or is taken out of circulation and existence. Here some long term charts showing this phenomenon[v][vi]:

Courtesy of Bullion Management Group Inc.

Courtesy of Bullion Management Group Inc.

In Roman history, coins were either phased out of existence or were chipped at the corner to reduce their value or were made with successively less gold and/or silver content.[vii][viii]

And since the creation of the Federal Reserve (U.S. central bank) in 1913, the purchasing power of the U.S. dollar has steadily decreased to a fraction of what it once had:

All of these charts and trends emphasize the importance of holding gold as an asset and a currency for wealth preservation – purchasing power protection. Indeed gold is real money as JP Morgan proclaimed:

We can also look at gold as money from the perspective of how the ancient Greek philosopher Aristotle defined money as.  He detailed characteristics of money as follows – gold meets all of these[ix]:

1.) It must be durable. Money must stand the test of time and the elements. It must not fade, corrode, or change through time.

2.) It must be portable. Money holds a high amount of ‘worth’ relative to its weight and size.

3.) It must be divisible. Money should be relatively easy to separate and re-combine without affecting its fundamental characteristics. An extension of this idea is that the item should be ‘fungible’. Dictionary.com describes fungible as:

“(esp. of goods) being of such nature or kind as to be freely exchangeable or replaceable, in whole or in part, for another of like nature or kind.”

4.) It must have intrinsic value. This value of money should be independent of any other object and contained in the money itself.

This is all fine and dandy. But the real reasons why it makes sense to hold gold and to hold it now stem from the current risks in today’s economy, financial system and investment environment. And it is these risks and how to mitigate these risks which really determine how best to hold gold today. Let’s explore these risks and some associated mitigation strategies below.

Risk Management Is The Key To Properly Investing In Gold

FRA has put together a nifty matrix (contact us to get more information on this risk matrix) of the risks stemming from the good-intentioned (macroprudential) central bank policies, government fiscal policies and financial regulations focused on controlling excessive government debt, attempting to stimulate economic growth and minimizing the potential for financial and economic crises. Let’s explore a few of these risks applicable to gold below.

Counterparty Risk

This is the risk relating to the entity or provider of an investment in which the entity or provider:

• does not live up to their contractual agreement
• presents adverse risks caused by changes in the regulations or environment where the entity or provider operates
• presents adverse risks caused by the limitations or vulnerabilities in how or where the investment is held or stored

For gold as an investment, examples are counterparty risks stemming from:

• insecure vaults or volatile environments where the gold is stored,
• a financially stressed or bankrupted limited partnership entity holding the gold as an asset for its partners
• a bank where there is the high potential for theft or confiscation resulting from changing financial regulations relating to gold held in a safety deposit box at that bank
• a provider offering low quality gold

Mitigation of Counterparty Risk: Gold as an investment already represents holding an asset with no liability to any party.

Also, buy the gold from a reputable provider which can deliver the highest quality gold – 999.9 or 99.99% for 1 kilo and 100 gram bars, and for 400oz bars a certification for London Good Delivery.

Additionally counterparty risk needs to be mitigated for storage provider and jurisdictional concerns. For that, invest and store physical gold outside of the banking system and diversify the location of the storage in different jurisdictions. Ensure that the gold is held in an allocated and segregated format with direct ownership (in your name or entity, not that of the provider or a limited partnership). And in the event that the storage providers go out of business, ensure that you still own the gold, and that you can easily and promptly get your gold. Also ensure that the gold is insured by a major international insurance company. And ensure that you can inspect your gold upon request, that you can collect your gold when you request to even in the event of a financial or economic crisis.

Default Risk

This is the risk for an entity or provider of an investment and its associated storage to not meet its payment or debt obligations. For example a gold storage provider is not able to, or does not pay, its loans, debt or bonds, and which provider subsequently goes bankrupt.

Mitigation of Default Risk: Invest and store gold with entities which have financially strong balance sheets, little or no loans or debt, and which are located in secure, stable legal jurisdictions protected through bailment and other laws which will clearly and promptly allow you to get your gold without any legal hassles or potential for confiscation in the event of a default with the entity or provider. And also ensure that the gold is insured by a major international insurance company.

Valuations Risk

This is the risk of entering into an investment when the valuation of that investment is not attractive. An example is like buying a stock at a stock market peak.  For gold, it is difficult to put a valuation to it as it lacks corporate earnings and yield. However, here is a chart showing how little interest there is now in gold as an investment asset class. With such a miniscule interest, it is not likely that its valuation is very high currently.

Courtesy of Dan Popescu

Gold is under owned relative to financial assets at this time. Incrementum has a great chart showing how small gold is relative to other investment asset classes[x]:

Courtesy of Incrementum Liechtenstein

Mitigation of Valuation Risk. At this time investing in gold already mitigates this risk due to the above considerations.

Purchasing Power Loss Risk

This is the risk of an investment not able to preserve how well it, or the proceeds from it after selling it, can be used to purchase the goods and services you need or want. It’s about preserving your wealth when a currency loses purchasing power from inflation or currency depreciation/devaluation.

If this year you have an investment from which you could liquidate to buy 100,000 cups of Starbucks Tall Dark Roast coffee priced at $200,000 but in 5 years from now the same investment only allows you to buy say 50,000 cups of Starbucks Tall Dark Roast cups of coffee, even though the price at that time is say $300,000, what good is the $100,000 gain in that investment?

A key characteristic of gold which has held for thousands of years is the preservation of purchasing power. The old saying of one ounce of gold is equivalent to a fine European cut suit is an illustration of this[xi].

Mitigation of Purchasing Power Loss Risk. Simply keeping a certain allocation of one’s assets in gold is sufficient to mitigate the purchasing power loss risk. The optimal percentage depends upon what assets you hold, what currencies those assets are in, and the correlation of those assets with gold. It is generally recommended to hold more or less 10% of your assets into gold – some say as low as 5% while some say as much as 25%.

Negative Yield Risk

This is the risk that an investment yields a negative yield, such as with many bonds and some bank deposits today around the world as central banks push us into the twilight zone of negative interest rates. For gold, there is no yield, so that there is no issue of negative yield risk.

Mitigation of Negative Yield Risk. Simply owning physical gold entails a yield of 0%, higher than a negative yield.

Liquidity Risk

This is the risk that an investment cannot be sold easily or quickly due to limitations in market participants or to the insufficient volume of a market.  For gold, this means the ability to sell your gold easily and quickly at reasonable market-based rates and to get the proceeds from such a sale easily and quickly as well.

Mitigation of Liquidity Risk. A provider setup to offer and store allocated, segregated and directly owned gold translates into gold that can be easily and quickly sold.

Correlation Risk

This is the risk of linkages and similarities in the performance between investments.  For gold, the historical data indicates an inverse correlation with stocks[xii]. Also many studies have shown that adding gold as an asset in a traditional stocks/bonds portfolio not only adds performance but also reduces overall risk & volatility to the portfolio.

Courtesy of Bullion Management Group Inc.

Mitigation of Correlation Risk. In an environment in which stocks are in a bear market, such as what appears to be in place for this year so far, gold is a great asset to own, given the inverse correlation to stocks. And even if stocks are not bearish, it is nice to have an asset allocation to gold just for purposes of balancing the correlation risks within a portfolio in general. And there is a case to be made for holding gold in a portfolio for asset allocation optimization[xiii].

Negative Interest Rate Risk

This is the risk of negative interest rates, whether they be nominal negative interest rates or real negative interest rates (nominal minus inflation rate), representing a loss of purchasing power over time.  As an asset in a negative interest rate environment, gold performs very well[xiv].

Mitigation of Negative Interest Rate Risk. Simply holding gold as an asset in a negative interest rate environment addresses this risk.

Capital Controls Risk

This is the risk of restrictions placed on the movement of capital and assets, whether physically or via wire transfer across international borders or between different jurisdictions. For gold, this means the ability to transport gold across international borders and also the ability to wire transfer the funds to purchase to buy gold, or to wire transfer the sales proceeds from sold gold holdings.

Mitigation of Capital Controls Risk.  Consider buying and holding gold in jurisdictions which are stable, secure and with strong legal infrastructures, a gold-friendly history and little or no debt, and the ability for capital and assets to freely (through minimal paperwork and restrictions) move across its international borders.  In this regard, we see jurisdictions like Switzerland, Hong Kong and Singapore as being some of the best. The mitigation of this risk is also tied to the mitigation of nationalization risk.

Nationalization Risk

This is the risk of assets, funds or companies or even specific resources being taken over, managed or controlled by the government.  For gold, this could mean a declaration or regulation instituted by the government to take over the ownership of gold within a country or jurisdiction.

Mitigation of Nationalization Risk. Monitor in an on-going basis your investment-related jurisdictions worldwide. Keep abreast of new or changing government regulations, edicts or legislations affecting any aspects of the purchase, sale or storage of gold. The mitigation of this risk is also tied with the mitigation of geographical risk.

Geographical Risk

This is the risk of geo-political events and jurisdictional regulations adversely affecting the valuation, holding or storage of an investment. For gold, this could mean events like war or social unrest affecting the safety and security of the storage of your gold. Or for another example, a regulation stipulating the illegality of investing in, holding or storing gold in a particular jurisdiction – like the U.S. for many years from 1933 referred to in the above under nationalization risk.

Mitigation of Geographical Risk. Diversify internationally where gold is held and how it is held from a country and jurisdictional perspective.  An emphasis on stable and secure political, economic and financial jurisdictions is important. In this regard, we see jurisdictions like Switzerland, Hong Kong and Singapore as being some of the best.

Wealth Confiscation Risk

The risk here is the outright confiscation of assets through bank bailins, wealth taxes or changes in ownership structure. For gold, this could mean bank bailins or bank account dormancy involving the confiscation of safety deposit contents, or the imposition of wealth taxes on gold profits or the valuation of holdings.

Mitigation of Wealth Confiscation Risk.  Consider buying and holding gold in jurisdictions which are stable, secure and with strong legal infrastructures and a gold-friendly history and little or no debt.  In this regard, we see jurisdictions like Switzerland, Hong Kong and Singapore as being some of the best. The mitigation of this risk is also tied to the mitigation of nationalization risk (addressed above).

Regulatory Risk

This is the risk of changes in regulations or legislation affecting the viability or operation of an investment. For gold, it could mean changes in how or where gold is bought or stored, by method, volume, timeframe, or use.

Mitigation of Regulatory Risk. The mitigation of this risk is covered by the mitigation of capital control risk, wealth confiscation risk, nationalization risk and geographical risk – addressed above.

Bank Bailin Risk

This is the risk of banks assigning or confiscating assets from bank depositors, which could extend also to bank safety deposit boxes, in the event of a banking crisis. For gold, it could mean getting your gold simply taken by the bank to shore up the capital adequacy of the bank in the event of a banking crisis.

Mitigation of Bank Bailin Risk. The mitigation of this risk is covered by the mitigation of capital control risk, wealth confiscation risk, nationalization risk and geographical risk – addressed above.

Custodial Risk

This is the risk of loss or theft on assets resulting from events or actions (such as insolvency, lawsuits, or expropriation) of the storage provider, holder, custodian or manager of the assets. For gold, this could mean a bankruptcy in the storage provider, resulting in difficulties or impossibilities on getting your gold, or a long drawn-out entanglement in court with unclear and confiscatory liquidation actions on bank assets, bank buildings and operations, and bank safety deposit boxes.

Mitigation of Custodial Risk. Invest and store physical gold in safe, secure non-bank vaults outside of the banking system and diversify the location of the storage in different stable, secure jurisdictions with little or no debt, minimizing the potential for insolvencies, lawsuits or expropriations. Ensure that the gold is held in allocated, segregated and direct ownership (in your name or entity, not that of the provider) format. And ensure that you still own the gold, and that you can easily and promptly get your gold in the event that the storage provider goes out of business. And also ensure that the gold is insured by a major international insurance company. And ensure that you can inspect your gold upon request, that you can collect your gold when you request to, even in the event of a financial crisis.

Conclusion

Investing in gold makes sense now and very likely for the remainder of the decade. However the way you invest in gold Is very important as there are many market, credit and operational risks which affect gold investing. These risks pose potentially adverse outcomes to vulnerabilities which could mean your investment in gold may not meet your expectations or worse, could translate into capital losses or legal complications.

A Financial Repression Authority (FRA) Brief

See our website for more information – www.financialrepressionauthority.com

FRA Macroprudential Policy Advisors, 200-131 Bloor Street West, Toronto Canada M5S1R8,  tel/fax = +14163525508

[i] http://dailyreckoning.com/how-inflation-could-be-caused-in-15-minutes/

[ii] http://goldsilverworlds.com/economy/jim-rickards-what-will-the-fed-decide-in-2016/

[iii] http://news.goldseek.com/GoldSeek/1437940421.php

[iv] https://www.armstrongeconomics.com/history/ancient-economies/punic-wars-the-economic-confidence-model

[v] https://goldswitzerland.com/why-gold/

[vi] http://bmgbullionbars.com/gold-is-money/

[vii] http://www.armstrongeconomics.com/research/monetary-history-of-the-world/roman-empire/monetary-history-of-imperial-rome/294-360-ad

[viii] http://history.econtrader.com/devaluation_of_the_roman_currency.htm

[ix] http://www.marketoracle.co.uk/Article10370.html

[x] http://www.incrementum.li/research-analysis/in-gold-we-trust-2013/

[xi] http://www.bmgbullion.com/doc_bin/gold_investor_vol_4_infographic.pdf

[xii] http://www.bmgbullion.com/doc_bin/RethinkingAssetAllocation_Jul08.pdf

[xiii] http://www.merkinvestments.com/downloads/2014-03-20-case-for-gold-optimal-portfolio-allocation.pdf

[xiv] http://dollarcollapse.com/gold/gold-in-a-negative-interest-rate-world/

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Charles Hugh Smith* explains why the central bank policy of negative interest rates (NIRP) is communicating that “this sucker is going down” – therefore suggesting it is time to sell everything, hoard your cash & precious metals .. “The last hurrah of central banks is the negative interest rate policy–NIRP. The basic idea of NIRP is to punish savers so severely that households and businesses will be compelled to go blow whatever money they have on something–what the money is squandered on is of no importance to central banks. All that matters is that people and enterprises are forced to spend whatever cash they have rather than ‘hoard’ it, i.e. preserve and conserve their capital. That this is certifiably insane is self-evident. If an economy depends on bringing future spending into the present by destroying savings, that economy is doomed regardless of NIRP, for eventually the cash runs out and spending declines anyway.” .. but the driving reason why NIRP will fail is more fundamental – negative interest rates force us to save even more, not less, meaning we are going to spend even less by saving more .. “If banks start charging savers interest on their cash, savers will have to save even more income to offset the additional costs imposed by central banks on their savings.” .. in any case, the big point is what does it say about the health & stability of the financial system if central banks are saying the only way to save the status quo is to force everyone to empty their piggy banks & spend every last dime of cash? .. “What exactly are we saving by destroying savings and capital? Isn’t capital the foundation of capitalism? What NIRP says about central banks is that they have run out of options and are now in their own end zone, heaving the final desperate Hail Mary pass that has no hope of saving them from complete and total defeat. NIRP also says the economy that needs NIRP is sick unto death and doomed to an implosion of impaired debt, over-leveraged risk-on bets and asset bubbles generated by stock buybacks and central bank purchases of risky assets. The central bankers are delusional if they think NIRP will inspire confidence in investors, punters, households and enterprises. Rather, NIRP signals the failure of central bank policies and the end-game of credit expansion as the solution for all economic ills.”

link here to the article

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Euro Pacific Capital’s John Browne explains the fundamental absurdity of the concept of negative interest rates .. money has a time value, funds available today are worth more to the owner than money available tomorrow .. “Negative interest rates mean that borrowers are paid to borrow. This serves as a powerful inducement for companies to borrow up to the hilt to buy other companies, to pay dividends that are unjustified by earnings levels and to invest in financial assets. Often this includes buying back their own corporate shares thereby increasing earnings per share, the share price and linked executive bonuses. For savers, negative rates discourage savings, stifling future business investment and consumer demand. However, central banks hope that discouraged savers will instead be lured into spending on consumer products and create short-term economic growth albeit at the price of future growth. Negative interest rates mean that lenders have to pay borrowers and that depositors have to pay banks to keep and use their money. One does not require a PhD in economics to recognize this as an unnatural distortion that will create more problems than it solves.” .. Browne sees bank liquidity problems resulting from negative interest rates .. “Should banks with loans to high-yield companies and emerging market nations, especially those hit by falling oil prices, see their loans become non-performing at the same time as deposits are falling, a potentially catastrophic banking crisis could threaten .. We are of the opinion, now echoed by others, that the U.S. will see zero and possibly even negative interest rates before it experiences a one percent Fed rate. This does not bode well for our future.”

LINK HERE to the article

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

FRA Co-founder Gordon T. Long recently interviews Felix Zulauf, Founder and President at Zulauf Asset Management AG. 

FELIX ZULAUF has worked in the financial markets and asset management for almost 40 years. He started his investment career as a trader for a large Swiss Bank and received training in research and portfolio management thereafter with several leading investment banks in New York, Zurich and in Paris. Felix joined Union Bank of Switzerland (UBS), Zurich, in 1977 and held several positions over the years including managing global mutual funds, heading the institutional portfolio management unit and at the same time acting as the global strategist for the UBS Group. After two years with a medium-sized Financial Organization as a member of the executive board, he founded his wholly owned Zulauf Asset Management AG in 1990, allowing him to independently practice his own individual investment philosophy.

Mr. Zulauf focused on macro and strategic issues within the firm. In spring 2009 Zulauf Asset Management was split in two parts and Felix Zulauf fully owns the split-off Zulauf Asset Management AG focusing on some advisory activities to selected family offices and institutions including a US based global macro fund. Felix Zulauf always believed that the world economy and the financial markets move in cycles. That has helped him avoiding all the major casualties in the financial markets since the 1973/74 bear market in equities. He has been a member of Barron’s Roundtable for over 20 years.

QUESTION: How would you define Financial Repression?

FELIX ZULAUF: “Financial Repression is an attempt by the government and central banks to reduce free market forces and the freedom of individuals to do what they would do if they had the free choice.  It is compounded by market manipulations such as money printing, regulations, and distorting the interest rate; which are the best capital allocator there is and much better than any committee or central bank. Government authorities force capital to be allocated wherever they want capital to be allocated and not where the market would allocate it. It is the beginning of an era that will lead to decisive decline of prosperity and individual freedom.”

QUESTION: What type of economist would you consider yourself?

FELIX ZULAUF: “I am closer to the Austrian School. It is important to know that economies and financial markets do not progress in a linear way. They are cyclical; there are expansions and contractions and recessions have the job to remove the excessive build up in expansions. Bear markets have the same job, to reduce excess in boom markets. This is a very natural action and reaction process.”

QUESTION: You wrote the following – could you elaborate on it:

FELIX ZULAUF: “At some point in time we have to get rid of the debt that we have. Obviously central banks are trying to do that by financial repression. The consensus among the investment community is that financial repression will work. I’m not so sure. Financial repression means that they put interest rates below the inflation rate, and by doing that the debt-to-GDP level of the different segments in an economy, the households, governments, etc., drops down over time. I’m not sure that policy will be successful, but for some more years they will try that. If it doesn’t work, then we will go into other things such as currency reforms, confiscation .. It’s very hard to imagine the world will solve its problems in a conventional way. More likely we will see more government controls on capital flows as things get out of control over time.”

Central banks have used mechanisms to reduce the level of debt ration within the economy. They have tried these mechanisms for many years and it hasn’t worked. You have seen some deleveraging in parts of the world economy, but in total the world economy has leveraged more.  Debt to GDP is the highest level it has been in modern history and therefore this route the central banks have taken has failed.

QUESTION: Where are we in the possible outcomes you warned us of?

FELIX ZULAUF: If it unfolds in a free market mechanism fashion then it would lead to massive bankruptcies but I doubt the authorities will allow this to play out be cause it can lead to a systemic collapse. I think eventually there will be another burden on taxpayers and there will be attempts to confiscate some of the wealth out there through whatever means they can think of to bring down and finance the debt. The bottom line is in the future we will be less wealthy.

QUESTION: How will the leverage failure unfold?

FELIX ZULAUF: I don’t know if there is a way to escape. Even if you made all the right decisions and came out a winner and were able to preserve your capital, they would most likely tax you on whatever gains you make. Ideologically, we are in a very highly socialist environment.  You have to have a certain diversification as an investor and you have to make sure you’re in the right jurisdiction.

QUESTION: How can the fed raise rates into a economy where broad fires are burning especially in credit markets?

FELIX ZULAUF: Quantitative easing does not work. You cannot fix the problems rampant in today’s economies by printing mass amount of money. You have to solve problems from a political and economic angle but not by printing money. I don’t expect any further rate hike by the Fed, they are attempting normalize but it won’t work because the economy is soft. They have tried and I think it is becoming more and more apparent to them that money printing does not work. Rather than money printing I think they have adopted a bond yield target. Central banks are tired of QE, they realize they have to leave some pressure on the economy, politicians, and entrepreneurs move forward and make the necessary decisions. I don’t think this is a good message to the financial markets, because it means the financial markets have to suffer more pain until the central banks come in and attempt to fix the system again.

QUESTION: What does the BOJ’s recent announcement of NIRP signal?

FELIX ZULAUF: With the world economy growing at such low rates, we have a risk of running into systemic growth again. I suspect the Chinese will eventually let the currency go and then you have another deflation hit the world economy, this is when you run into another systemic crisis.

Letting the currency go and letting the currency find its own equilibrium will lead to a central bank crisis. This affects pricing power and when pricing power is affected it trickles down to profit margins, and therefore corporate earnings are going to decline.

Abstract written by, Karan Singh

Karan1.snigh@ryerson.ca

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

GoldMoney’s John Butler describes what is money & how gold & silver serve as sound money .. he highlights why he thinks gold & silver prices will keep rising in the current environment of financial repression: “The spread of negative interest rate policies around the world, heralded by economic officials as the answer to the disappointing results of zero-rate policies and quantitative easing, is in fact nothing of the sort. By degrading the nature of money, negative interest rates will have commensurately negative consequences. As savers and investors seek non-negative yielding monetary substitutes, gold and silver prices are likely to continue rising .. If the store of value function of all major currencies is substantially undermined, as indeed it is by negative interest rates, then investors are going to have to look for a non-national currency alternative. Historically, gold and silver have most frequently served as reliable, stable international stores of value, protecting against devaluations and default generally.” .. he makes a key point about gold as a 0% yielding asset: “Which brings us to an important point: If currencies in general are offering negative rates of interest, then what, exactly, is the opportunity cost of diversifying into zero-yielding commodities? Zero! And if commodities offer greater diversification benefits than a basket of negative-yielding currencies, which should you overweight in a low-risk, defensive portfolio designed primarily to function as a store of value? Diversification is held, rightly, to be the only “free lunch” in economics. Not Keynesian pump-priming; not central bank interest rate manipulation; not holding an asset for the long-term just because history has been kind (eg equities, housing). No, diversification is the only exception to this other Iron Law of economics. And in a world of negative rates the benefits of diversification into gold and silver are available at a favorable, non-negative yield. This is having the effect of shifting the demand function for gold and silver. With supply for both gold and silver growing only slowly and steadily over time as a result of costly mining production, however, negative interest rates thus imply potentially far higher prices in future.”

LINK HERE to the PDF

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Margin Rules Changes Force New Private Funding Of Public Debt

by Daniel R. Amerman, CFA

Originally Published at danielamerman.com

The Federal Reserve and other regulators around the world (including all members of the G-20) have recently agreed to alter margin rules, which will allow them to claim new powers over lending and leverage. In the United States these developing regulatory changes will not be restricted to the Fed’s legal oversight over banks alone, but will affect all financial companies.

The new margin rules will impact about $4.4 trillion in investments in the US. In combination with new rules for $2.7 trillion in money funds, the regulations are changing for about $7 trillion in investments. And the combined effect of these changes may be to drive up to $2.5 trillion out of the private investment markets and into purchasing the debts of a heavily indebted US government, thereby providing a very low cost source of funds.

In a matter of a few months and with almost no notice, changes in obscure regulations are being used to create a new captive market for US Treasuries and agencies that is approximately equal to the total amount of federal debt purchased by the Federal Reserve over the course of many years of quantitative easing.

The headlines are that the United States is starting to slowly release its control over interest rates, and return them to private market control. The reality is that the government is doing just the opposite, and is capturing formerly free and private money at a fantastic rate. Which brings up the question: just why is the government quietly deploying two massive financial stabilizers for the federal debt in 2016?

The effects are likely to persist far beyond 2016, and could help depress interest rates for all investors for potentially years and decades to come. Yet, because these trillions of dollars of major changes are hidden inside of obscure financial regulations, the general public is completely unaware of what is happening, or how it could change their investment results, their lifestyle in retirement, or even their ability to retire at all.

Margin Rules & The New Regulations

A detailed overview of the new rules in process can be found in a Wall Street Journal article published on January 11th. 2016 and linked here. As of November 12th, 2015, the US and the other member nations and organizations of the Financial Stability Board agreed to implement margin rules changes (although there was almost no notice at the time). The intent of so many nations doing so simultaneously is to keep investors from dodging the regulations by moving their assets offshore.

Traditionally, stock purchases were the primary focus of margin rules. The Federal Reserve’s Regulation T requires a minimum of a 50% margin on new stock purchases. This means that if an investor purchases $200,000 in stock, no more than $100,000 of that can be with borrowed money.

Increasing margin requirements requires investors to either come up with more cash or to very quickly sell their assets – at a time when the market is potentially being flooded with other sellers who are also forced to sell at almost any price because of their own unexpected margin calls. Because of this power to push prices downwards, it is considered to be a textbook means of dampening speculative bubbles. Of course, the regulatory power of margin rule changes to rapidly change prices can also be used for other purposes and with other instruments, such as futures and options.

Perhaps the most infamous series of margin rules changes in recent years occurred in 2011, when the Chicago Mercantile Exchange repeatedly and sharply raised margin requirements for silver futures contracts, with most increases occurring in late April and early May of that year.

In the spring of 2011, silver prices were soaring above $45 an ounce, but were rapidly sent to below $35 an ounce as repeated margin increases forced investors to either come up with large sums of cash overnight, or liquidate into a plunging market as everyone around them faced the same dilemma. Prices then slowly rebuilt to above $40 an ounce, until a new margin increase in September inflicted another round of pain and quickly knocked the price of silver below $30 per ounce.

The new Federal Reserve regulations will vastly expand the reach of margins rules because it is proposed that they will apply to securities financing transactions, such as repurchase agreements. In this market, which the US Office of Financial Research estimates to be approximately $4.4 trillion in size, high quality collateral is provided to secure a very short term and very low interest rate loan. The value of the collateral provided is somewhat more than the amount of loan, with the excess collateral (the margin) securing the lender against a reduction in the value of the collateral.

Under the still developing new regulations, the Federal Reserve will be able to set a minimum margin, rather than the market. The theory then is that by raising margin requirements, the Fed will be able to reduce leverage in the system at will. And because the margin rules will apply to all financial companies and not just the banks, the Fed will have new powers to control the behavior of the entire financial system.

Now some might portray this extraordinary expansion of powers via regulatory fiat to be a good thing. After all, there is a lot of risk in the system, highly leveraged systems are generally riskier, and it is said to be in all of our interests for the government to have additional new powers to reduce that leverage and pull risk from the system as needed. Or at least that seems to be the publicly presented justification for this change.

Interestingly enough however, there happens to be a rather major loophole, whereby if the private sector more closely aligns its behavior with what the government wants it to do, then market participants no longer have to worry about this new generation of regulation induced financing risks.

The Danger & The Loophole

The key loophole is that when US Treasury obligations and agency securities are used as the collateral, the borrower will be immune from the new margin regulations. This then creates a split market, with two kinds of secured financings.

For those who own Treasuries and agencies and use them as collateral, they are not subject to the planned new rules. According to the US Office of Financial Research, about two thirds of the collateral currently being used is Treasuries and agencies, so this will be true for most of the current market borrowers.

For the remaining one third of borrowers, however, there is a potentially substantial increase in risk. The dangers are those of liquidity and market risk. If the Fed increases margin requirements in order to pull leverage from the system, then more or less by definition, that action creates a liquidity crunch for borrowers who were not invested in Treasuries and agencies.

For that is what reducing leverage is all about – short term loans cannot be rolled over, as they usually are, but have to be actually paid off. Which means a scramble to come up with the cash to pay down the borrowings. Which likely means forced asset sales as well, because that is the essence of what financial companies do – they purchase assets with borrowed money. And to pay back the money, they need to sell the assets.

These asset sales and borrowing reductions may potentially occur on a massive scale, because that is more or less the point of the Fed expanding the reach of its powers – to be able to make the entire financial system, and not just the banking system, quickly and simultaneously reduce their borrowings.

Because these asset sales are occurring on a system wide basis, this then sets up the possibility of a feedback loop. Too many companies simultaneously selling the same type of assets drops the price of those assets. Which reduces their value as collateral. Which means that still more loans must be paid down, as the existing collateral will not go as far. Which forces still more asset sales, which then further reduces the market value of the assets, and requires the payback of still more loans – and so forth.

The alternative is to sell the other collateral up front, use the proceeds to buy Treasuries and agencies as replacement collateral, and thereby escape any exposure to increases in margin requirements and the abrupt need to reduce borrowings.

The Stick & The Carrot

Viewed from the perspective of market participants, what the Federal Reserve is really doing is creating a “stick” and a “carrot”.

The stick applies to all financial companies who refuse to buy US Treasuries and agencies, and use them as collateral for their secured borrowings. Once the new rules take effect, then these participants can be forced into a liquidity crunch and/or asset losses at will, as they are made to reduce their borrowings and sell assets. It should also be noted that liquidity crunches, i.e. not being able to come up with the cash to pay off overnight or other borrowings, are an existential risk for financial companies, as they can take down what previously appeared to be a healthy company in a matter of days.

So the stick of margin rules changes is potent indeed in general, as silver market participants found out in 2011, and there are particularly powerful aspects when it comes to highly leveraged financial companies.

And then there is the carrot, which is the safe harbor of buying US Treasuries and agencies to use as collateral for secured financings. For the financial companies willing to do their part in helping to finance the national debt – then all these newly created problems go away. Just sell the other collateral, buy the debt of the government to use instead, and the risk of margin rules changes, the risk of the potential associated liquidity crunch and the risk of the potential associated forced rapid sale of assets are all no longer a concern.

Because the total market is about $4.4 trillion, and about a third of the market uses non-exempt collateral, that means that roughly $1.5 trillion dollars of investments are stake. An enormous incentive is being created for financial companies to sell about $1.5 trillion in other types of investments which are currently being used as collateral, and to purchase Treasuries and agencies instead.

Is This Really About Controlling Leverage At All?

The other fascinating implication is that so long as most market participants act rationally – the power of the new margin rules disappear, as does the ability to pull leverage from the system. Two thirds of the market is already exempt from the margin rules changes. If the market reacts rationally to both the new rules and the safe harbor, and changes to the place where 90% to 95%+ of the collateral is Treasuries and agencies, then the Fed has very little power to pull leverage from the system.

The new margin rules therefore make no sense when it comes to their stated purpose, which is giving the Federal Reserve the power to reduce risk by mandating a reduction in leverage. Why create a rule to control market conduct, if a wide open loophole is simultaneously created such almost all of the market can be expected to be exempt from the rule?

Crucially, there is no difference in systemic risk from leverage if Treasuries are used as collateral rather than high quality private instruments. The issue is the borrowing level in the system, and not the credit quality of the collateral.

The new rules are likely to be of little use when it comes to the stated purpose of reducing leverage – but are likely to be very useful indeed in motivating investors to seek safety in the loophole, and thereby increase the funding of the national debt by private investors for potentially many years to come.

Textbook Financial Repression

The regulatory changes planned by the Federal Reserve are a textbook example of what economists refer to as Financial Repression. For those who are not familiar with the term, or are unsure about exactly what it means, I have written an understandable tutorial on the subject whichcan be read here.

Financial Repression is one of the four core tools available for heavily indebted governments to manage and reduce their debts, along with austerity, high rates of inflation and outright default. While the least known by the general public, Financial Repression has an extensive history in the United States and other nations.

What most people don’t realize is that the United States has been here before, in terms of a national debt approximately equaling the size of the national economy. This was the situation after World War II. And as shown below, that debt steadily came down over a period of decades, when measured as a percent of the economy.

Financial Repression is exactly how it was done, from the 1940s until the early 1970s. Indeed, the previously linked Wall Street Journal article does point to the not at all coincidental timing, even though the words “Financial Repression” are never used:

“The Fed’s return to margin requirements is symbolically significant, a kind of throwback to an earlier era of empowering regulators to try to steer markets. Until 1974, the Fed regularly tinkered with the amount of margin, or collateral…”

The very high levels of debt are back – and increasingly, so are new variants of the old tools.

In  general terms, Financial Repression can be used to refer to one half of a long term cycle between free market-dominated economies (Financial Liberalization), and more government-dominated economies (Financial Repression).

The heavily indebted US government moved to Financial Repression in the 1940s. The cycle changed to Financial Liberalization in the 1970s and 1980s as the national debt dropped to about 30% of the size of the economy. And the cycle then swiftly moved back to Financial Repression as the national debt surged in the aftermath of the financial crisis of 2008.

There is much more specific meaning for Financial Repression as well, which involves governments forcing negative real (inflation-adjusted) returns on savers over a period of decades.  The idea is that unmanageable national debts are held down or reduced while economic growth continues, so that the economy gradually pulls away from the level of national debt, until a now manageable level of debts allows a return to the alternating cycle of Financial Liberalization (in theory anyway, many other issues are at play in this current round that were not there in the 1940s).

As part of that process, there is an effective checklist for how governments can accomplish this, as covered in the linked tutorial.

The first principle is that financial institutions will be made to participate through regulatory means, and because the institutions are really just intermediaries, that means the public is being forced to participate, without realizing that is happening.

Margin Rules Changes – Check.

A second principle is that a combination of sticks and carrots will be used to compel participation, and create a captive audience for government debt.

Margin Rules Changes – Check.

A third principle is that the regulatory changes which compel the purchase of government debt will be described as being done in the name of public safety.

Margin Rules Changes – Check.

A fourth principle is that this be done in a manner where history shows that most voters won’t understand what is happening, and there will therefore be few if any political consequences.

Margin Rules Changes – Check.

A fifth principle is that for the few people who are aware of what is happening, they will be prevented from leaving a rigged playing field by the use of capital controls.

Margin Rules Changes – Check. This is why the entire G-20 simultaneously said (via the Financial Stability Board) that they would be doing this, so that wherever the financial companies go, they can’t get away (at least not in the major markets).

The Federal Reserve’s plan to change margin rules checks all five of those boxes. The rules changes may be a poor and strange way to attempt to control financial system leverage, but they are likely to be highly effective as a straight out of the textbook example of Financial Repression.

An Extraordinary & Almost Unnoticed Combination

Some regular readers may be feeling a bit of deja vu – didn’t they just read an analysis on a very similar subject a few months ago?

I know that I personally felt a strong sense of deja vu when I first learned about the new margin rules, and identified on a checkpoint by checkpoint basis how they were an almost perfect example of Financial Repression.

But the interesting and remarkable part – and perhaps the greatest source of information value – is that the two analyses address entirely different regulatory changes, in different markets. Changes that are nonetheless occurring at about the same time.

As analyzed here, the regulations are being changed for money funds as well. And what is happening with money funds is quite similar, as 1) there is the stick of more stringent regulatory treatment of investments for an entire multitrillion dollar industry; 2) there is the carrot of a safe harbor exemption from those expensive new regulations when Treasury and agency securities are owned; 3) the official reason offered is that of increasing safety for the public; and 4) the general public has no idea that anything is going on at all.

In the case of money fund regulation, the industry is about $2.7 trillion in size, and about $1 trillion was previously not invested in Treasuries and agencies. In the case of the particular type of secured financings addressed by the Fed, the industry is about $4.4 trillion in size, and about $1.4 to $1.5 trillion is not currently invested in Treasuries and agencies.

(There is some overlap, as money funds do invest in repurchase agreements. In this case, the two rules changes are cumulative for those using non-government collateral, as the new money fund rules penalize the investor and the new margin rules penalize the borrower.)

So in combination (and before any overlap), the government is increasing the demand for Treasuries and agencies by up to about $2.4 to $2.5 trillion – which is a serious amount of money. Not all of that money may initially change, but there are powerful incentives to do so.

By way of comparison, the US Treasury securities held by the Federal Reserve primarily as the result of quantitative easing (QE) are about the same amount, in the $2.4 to $2.5 trillion year range.

One of the differences is that QE was intensely controversial, and it took about five years to reach that level, with screaming headlines each step of the way, at least in the financial media.

Yet, the combined regulatory changes for money funds and secured lending may reach close to that same level in a matter of months, or perhaps a year, but with almost no notice, and very few headlines even in the financial media.

The Short-Term Question For 2016

Effectively, what the US government is doing is deploying two massive stabilizers simultaneously, when it comes to sources of funding for the national debt. They may be doing it silently – but it is also happening very quickly.

And the question has to be – why now?

As covered in the linked tutorial, most of the initial round of bringing back Financial Repression occurred in a relatively short time period in 2010. The policies have been maintained continuously since that time, to the devastation of savers, but there haven’t been regular increases since then.

And yes, there has been extensive quantitative easing since that time, but the level stabilized more than a year ago. Indeed, we are supposed to be attempting to begin a bit of Financial Liberalization, or so the Fed would have us believe is its intent, at least when it comes to interest rates.

If there were just one major change, that would be very interesting – but not necessarily fascinating. For two such events to happen at almost the same time – after all this time – and on such a large scale… now that is fascinating.

Coincidence seems unlikely. The decision-makers and economists involved are not amateurs, there is nothing accidental or inadvertent about the creation of the stick of onerous new regulatory controls, or the simultaneous creation of the carrot of the safe harbors for escaping the regulations, or the effect on market participants, or the resulting increased demand for Treasuries and agencies.

So… why both changes now? And on so large of scale?

Investors & The Long-Term Conflict Of Interest

On a longer term basis, the implications seem (unfortunately) to be more clear.

As explored here, there is a powerful conflict of interest between investors and the United States government. Low interest rates are required for Financial Repression. Any substantial and sustained increase in interest rates could send the deficits and the national debt spiraling upwards and out of control.

Simultaneously, investors very badly need higher interest rates, and this is particularly true in retirement.

There is talk of increasing interest rates, which would increase investor returns and lifestyle in retirement.

Yet, when it comes to action, instead of incipient Financial Liberalization we are seeing a massive structural reinforcement of the tools of Financial Repression in 2016.

Now, a small increase in interest rates is not incompatible with Financial Repression. Near zero interest rates are unusual, and an increase to 1% or even 2% short-term interest rates can work for governments, so long as the real rate of inflation is still significantly higher.

But what tens of millions of Boomers and other investors badly need is interest rates that are a good bit higher than that, and as soon as possible.

What we know from history is that the last time the US government was this heavily indebted (as a percent of the economy), it kept interest rates low for another 25 years as one critical aspect of effectively lowering those government debt levels.

And we also know that as of 2016 – new and major Financial Repression tools are being deployed.

When we put that information together, then it would seem that the most reasonable long-term interpretation of the money fund and margin rules changes is that the government is concretely showing through its actions that it will be attempting to keep interest rates in the lower end of the historical range for at least many years to come, and possibly even decades.

Which then means that a generation of Boomer retirement investors and other retirees may never get the relief they are hoping for when it comes to substantially higher interest payment cash flows. If that is, the government has its way and is able to maintain both stability and control over interest rates.

What you have just read is an “eye-opener” about one aspect of the often hidden redistributions of wealth that go on all around us, every day.

A personal retirement “eye-opener” linked here shows how the government’s actions to reduce interest payments on the national debt can reduce retirement investment wealth accumulation by 95% over thirty years, and how the government is reducing standards of living for those already retired by almost 50%.

National debts have been reduced many times in many nations ─ and each time the lives of the citizens have changed. The “eye-opener”linked here reviews four traditional methods that can each change your daily life, and explores how governments use your personal savings to pay down their debts in a manner which is invisible to almost all voters.

The stakes are high for the government when it comes to the national debt – and that is also true of Social Security. And once again, the numbers don’t quite work the way many people think. The government strongly encourages people to wait as long as possible before collecting their retirement benefits – but as explored here, is that truly in your best interest, or are a few factors being left out?

If you find these “eye-openers” to be interesting and useful, there is an entire free book of them available here, including many that are only in the book. The advantage to the book is that the tutorials can build on each other, so that in combination we can find ways of defending ourselves, and even learn how to position ourselves to benefit from the hidden redistributions of wealth.

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Lars Schall speaks with Incrementum AG’s Ronald-Peter Stoeferle about this year’s prospects for gold, silver & mining shares; the still increasing gold demand in China; & a book that Stoeferle co-authored, Austrian School for Investors – Austrian Investing Between Inflation and Deflation. .. an update on trends in negative interest rates, money printing, capital controls .. Stoeferle also discusses his new book on investing using the principles of the Austrian School of Economics .. 31 minutes

LINK HERE to our webpage on the Investing using the Principles of the Austrian School of Economics

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

John Charalambakis is the Managing Director of Black Summit Financial Group, a boutique style asset and wealth management firm, which focuses on risk mitigation, capital preservation and growth through strategies that are rule based. Dr. Charalambakis has been teaching economics and finance in the US for the last twenty years. Currently he teaches economics at the Patterson School of Diplomacy & International Commerce at the University of Kentucky.

FINANCIAL REPRESSION

“The outcome of financial repression is when the role of the markets is diminished because of the actions of central authorities, such as central banks.”

Fed: Central banks of the United States, ECB: European central bank, and BoJ Bank of Japan

Assets under management have skyrocketed from about 7% in 2007 for the U.S Fed, to over 20% as of the end of 2015, increasing 3 times. Over this time, the GDP did not equally increase 3 times. This increase eventually leads to a greater role of central authorities. Looking at Japan in 2007, they had about 20% of their GDP in their balance sheet, currently they have over 90%, meaning the role of the markets is diminishing and the role of central authorities is increasing, creating financial repression.

Gord asks John what assets people should invest in, in this era of financial repression that would create a store of value, which may not bring in a yield, but would preserve their money.

GOLD – INTRINSIC VALUE ASSETS

“I think the goal of any pension fund, institutional or private investor should be capital preservation. Assets should have intrinsic value.”

“Assets that have intrinsic value such as gold or silver, historically have retained their value especially in times of crisis.”

John mentions how the price of gold in 2009 rose from about $500-$500 to $1900 because investors were seeking a safe haven of intrinsic value assets. “There is not enough gold for everyone. Only 1/3 of 1%, a miniscule number, is invested in precious metals.” Hypothetically if every manager by the end 2016 would invest just 3% of their wealth into precious metals, the price of gold would rise to an estimated $2700. Growing demand and financial stress can, and likely eventually will, create a financial crisis.

KEY PRINCIPLES OF THE AUSTRIAN SCHOOL OF THOUGHT

• Uncertainty is endogenous in the markets, and therefore investments should be based on rules. “Regardless of where the market temporarily may be moving, the investor, whether individual or institutional, should be guided by rules.”

• Investors, whether fortunately or unfortunately, are emotional beings, therefore there are psychological deficiencies caused through emotions, effecting investments. Due to these emotional deficiencies, investors must be disciplined, and once again be guided by rules

• The conventional methodology of 60/40, stock and bond rule is not adequate. It ignores the risk parity considerations. Investors should shift their portfolio based on the macro environment of risk, in order to take advantage of the more promising and safe investment at the time being. John mentions that in 2009-2011 bonds gave a much better return, because money had left stock and shifted to bonds. It also ignores the potential black swan phenomenon. A black swan phenomenon is likely to happen again and in greater frequency than we’ve seen before, we need to be prepared and eventually hedge our portfolios in such a way, that we are able to sacrifice some return for the sake of stability and preservation.

• Portfolios need to structure in such a way to survive in a macro and business cycle, as well as the credit cycle.

• Markets cannot escape realities of wealth creation. Nations do not become wealthy by printing money. Rather, wealth is created through free markets, when the entrepreneur is allowed to take risks, because risk liberates. “When there is excess regulation suffocating the entrepreneur, wealth cannot be created.” Investing in entrepreneurs and innovators, with proper risk analysis, can result in great returns.

“Unfortunately risks and stresses are being built up and portfolios are suffering the consequences. People think because they have wealth on a financial statement, that wealth can be preserve. When the markets collide, that wealth is destroyed because it is paper wealth, not real wealth.”

INFRASTRUCTURE INVESTMENT

“Infrastructure investment needs to be financed, usually countries finance infrastructure through deficit spending, and that cannot happen due to big holes in their budgets.” John questions whether or not the internal rate of return justifies infrastructure. He doesn’t believe the environment is mature enough currently, due to the possibility of a looming crisis in the next couple years. This would push back infrastructure spending.

PREPARING FOR A POSSIBLE CRISIS

• Analyzing risk, and understand where the risk is coming from.
• Anchor the portfolios. (Most usually used in hard assets)
• If applicable; hedge the portfolio either by selling covered calls, and collect premium by doing so, as well as mitigating risks. Individuals may also consider buying puts.

“Since we are in an era of financial repression you cannot expect the income from treasuries or CDs, explore all sources of income”

Kamilla Guliveva

kamillaguliyeva@hotmail.ca

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

McAlvany Financial weekly commentary .. discussion on how financial repression is intensifying – the war on cash .. Employing behavioral psychology to force you to spend .. Swedish Riksbank: Charge penalties those who use cash .. The bosses are liquidating: High volume Insider selling .. 46 minutes

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Courtesy of Deutsche Bank and Cumberland Advisors/Camp Kotok:

INTEREST RATE PASSTHROUGH AND THE DEMAND FOR CASH AT NEGATIVE INTEREST RATES

http://www.nationalbanken.dk/en/publications/Documents/2015/06/Interest%20Rate%20Rass-through%20and%20the%20Demand%20for%20Cash%20at%20Negative%20Interest%20Rates.pdf

We find that negative interest rates have not weakened the pass-through from Danmarks Nationalbank’s interest rates to money market rates.

Riksbank: How far can the repo rate be cut?

http://www.riksbank.se/Documents/Rapporter/Ekonomiska_kommentarer/2015/rap_ek_kom_nr11_150929_eng.pdf

The lower limit ultimately depends on costs associated with holding cash. Before this happens, however, it is possible that frictions will occur which reduce the impact of cutting the repo rate further. In addition, risks to the financial system will increase the lower the rate goes. One important factor that is difficult to assess is also whether negative policy rates change the behavior of households and companies.

Rogoff: Costs and benefits to phasing out paper currency

http://scholar.harvard.edu/files/rogoff/files/c13431.pdf

This paper explores the costs and benefits to phasing out paper currency, beginning with large-denomination notes, later extending to all but small coins and bills, and eventually those as well. It is hardly a simple issue; paper currency is deeply ingrained in the public’s image of government and country, and any attempt to change long-standing monetary conventions raises a host of complex issues.

Fed (New York): If Interest Rates Go Negative . . . Or, Be Careful What You Wish For

http://libertystreeteconomics.newyorkfed.org/2012/08/if-interest-rates-go-negative-or-be-careful-what-you-wish-for.html#.VrOKDU2FNdO

We suggest that significantly negative rates—that is, rates below -50 basis points—may spawn a variety of financial innovations, such as special-purpose banks and the use of certified bank checks in large-value transactions, and novel preferences, such as a preference for making early and/or excess payments to creditworthy counterparties and a preference for receiving payments in forms that facilitate deferred collection.

Fed (Richmond): Overcoming the Zero Bound on Interest Rate Policy

https://www.richmondfed.org/~/media/richmondfedorg/publications/research/working_papers/2000/pdf/wp00-3.pdf

The paper proposes three options for overcoming the zero bound on interest rate policy: a carry tax on money, open market operations in long bonds, and monetary transfers. A variable carry tax on electronic bank reserves could enable a central bank to target negative nominal interest rates. A carry tax could be imposed on currency to create more leeway to make interest rates negative. Quantitative policy–monetary transfers and open market purchases of long bonds–could stimulate the economy by creating liquidity broadly defined. A central bank needs more fiscal support than usual from the Treasury to pursue quantitative policy at the interest rate floor.

BoE: How low can you go?

http://www.bankofengland.co.uk/publications/Documents/speeches/2015/speech840.pdf

…central banks may then need to think imaginatively about how to deal on a more durable basis with the technological constraint imposed by the zero lower bound on interest rates. That may require a rethink, a fairly fundamental one, of a number of current central bank practices.

What Lower Bound? Monetary Policy with Negative Interest Rates

http://www.mit.edu/~mrognlie/rognlie_jmp.pdf

…gains from negative rates depend inversely on the level and elasticity of currency demand. Credible commitment by the central bank is essential to implementing optimal policy, which backloads the most negative rates. My results imply that the option to set negative nominal rates lowers the optimal long-run inflation target, and that abolishing paper currency is only optimal when currency demand is highly elastic.

BoC: The International Experience with Negative Policy Rates

http://www.bankofcanada.ca/wp-content/uploads/2015/11/dp2015-13.pdf

A key issue in the renewal of the inflation-control agreement is the question of the appropriate level of the inflation target. Many observers have raised concerns that with the reduction in the neutral rate, and the experience of the recent financial crisis, the effective lower bound (ELB) is more likely to be binding in the future if inflation targets remain at 2 per cent. This has led some to argue that the inflation target should be raised to reduce the incidence of ELB episodes. Much of this debate has assumed that the ELB is close to, but not below, zero. Recently, however, a number of central banks have introduced negative policy interest rates. This paper outlines the concerns associated with negative interest rates, provides an overview of the international experience so far with negative policy rates and sets out some general observations based on this experience. It then discusses how low policy interest rates might be able to go in these economies, and offers some considerations for the renewal of the inflation-control agreement.

OVERCOMING THE ZERO BOUND WITH NEGATIVE INTEREST RATE POLICY

http://www.cepr.org/sites/default/files/Goodfriend%20slides.pdf

The Malady of Low Global Interest Rates

http://www.levyinstitute.org/pubs/wp_852.pdf

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

“Central banks all seem to believe that there is an interest rate SO LOW that resultant financial market wealth will ultimately spill over into the real economy. I have long argued against that logic and won’t reiterate the negative aspects of low yields and financial repression in this Outlook. What I will commonsensically ask is ‘How successful have they been so far?’ Why after several decades of 0% rates has the Japanese economy failed to respond? Why has the U.S. only averaged 2% real growth since the end of the Great Recession? ‘How’s it workin’ for ya?’ – would be a curt, logical summary of the impotency of low interest rates to generate acceptable economic growth worldwide. The fact is that global markets and individual economies are increasingly ‘addled’ and distorted ..  What I do know is that our finance-based global economy is transitioning due to the impotence of monetary policy which has always, and is now increasingly focused on the elixir of low/negative interest rates.”

LINK HERE to the essay

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Chief Executive of CREATE-Research, Amin Rajan discusses investing in the age of financial repression as well as key points for risk mitigation with FRA Co-founder Gordon T. Long. CREATE-Research is a a network of prominent researchers undertaking high level advisory assignments for governments, global banks, fund managers, multinational companies and international bodies such as the EU, OECD and ILO. In 1998 Amin was awarded the Aspen Institute’s Prize in leadership. It is a subject on which he has done extensive research involving some of today’s outstanding business leaders. In two resulting publications, he has developed a close link between leadership and the emerging business models.

As well as appearing on radio and television regularly, he has contributed feature articles to The Financial Times, The Guardian, The Sunday Times, and The London Evening Standard and IPE. He has published reports and articles on leadership, business cultures, strategic change, globalisation, new technologies, and new business models. He has presented the results of his work at over 100 major events in the USA, UK and Asia-Pacific in the last five years. His expertise covers, amongst others, leadership and new business models in financial services. As an economist, he has held significant positions, including, Secretary; Economic Group, Cabinet Office, providing weekly briefs to the Prime Minister. And as a Forecaster; UK Treasury’s Econometric Model, producing forecasts of key macro indicators.

“Financial repression results from a combination of low interest rates and rising inflation. Authorities are keeping interest rates low so they can manage their huge debt and furthermore they’re attempting to spike up inflation as a means to eliminate this debt. This combination of low interest rates and rising inflation results in an arbitrary redistribution of wealth from investors to borrowers.”

PENSION PLANS AND SMARTER ASSET ALLOCATION

Risk in equity markets are currently at their all time high. We have a lot of conviction-less trade which means people are taking high amounts of risk because they have no other choice. Under this new approach to asset allocation, a number of things are happening:

1. They are taking much more risk in order to get higher return.
2. Trying to look for uncorrelated assets
3. Having a very broad diversification which covers different geographies, different asset classes etc…
4. Practising dynamic investing

In today’s markets lucrative opportunities do appear but they vanish as soon as they appear which results in a tendency to capture value as soon as value appears. Pensioners have been pushed up the risk curve and as a result their main view is they ought to be as opportunistic as possible and get out at the first sign of concern. What they are essentially doing is rebalancing their portfolios much more now than they have ever done before.

Dynamic investing has become the norm in that you have to be very vigilant from where your returns are coming from, how quickly they’re materializing and how nimble can you be in ensuring you are capitalizing on those returns. As a result of difficulties in seeking non-correlated assets, institutional investors are moving towards risk factor diversification. They are identifying various risks and are identifying various assets which allows them to compensate for that risk.

“Authorities are looking at all the factors which contribute to portfolio risk and undoubtedly the biggest risk at the moment is policy errors on the part of the Federal Reserve.”

There are many risks lurking in the background, risks such as QE. The challenge is to construct a portfolio which factors in such risks. In the past there was tendency to go for stop-loss mechanisms or to go for options contracts, in order to protect the downsides. What we are finding now is there has been so much volatility in the market that many of these stop-loss mechanisms get activated from the wrong information.

IDIOSYNCRATIC RISK

“Idiosyncratic risk Deals with the fact correlation between asset classes is very difficult to avoid which essentially makes diversification seemingly ineffective.”

We find that all asset classes are highly inflated in values simply because of central bank action. We find that the real returns come from finding individual opportunities at the most micro level. Idiosyncratic risk is about looking at very specific investment opportunities, assessing their risk parameters and making a decion to act upon it or not. These broad brush approach ways in investing just do not work; you have to be much more specific. It is about understanding the risk parameters about specific investment opportunities and understanding what are the inherent risk and opportunities and figuring out how to minimize the risks while maximizing the returns.

“Growth is what everybody is looking for and it is truly what keeps people awake at night.”

In regards to figure 4.1, what we try to do before asking investors about their asset allocation approaches, we try to find out what they think will be driving the markets over the next 3 or so years. The most common response we got was growth in global outlook and growth in the European economy. There are worries about currency wars, since the beginning of last year we have had 25 nations around the world that have devalued their currencies. Things like aging demographics are having major effects on pension plans because due to the baby boomer generation a mass influx of people will be coming into retirement, and this will dramatically change the asset allocation of pension plans or of individuals who are managing their own funds.

QE programs inflated asset values for both equities and bonds and that saved the day. Now we are in a situation where these asset values are not sustainable in light of economic performance from the last two years or so. We hope that growth will resume, we hope that the situation in China and Japan improves and so on. But if these conditions do not happen we will be in a situation where the current valuation will be very hard to sustain and we could be looking at another major correction.

“Growth has slowed down everywhere. In Europe and Japan we are talking about another round of QE. The biggest worry in all this is that this drug of QE worked in the beginning but for it to work again we have to come out with bigger and bigger doses.”

THE GOALS OF PENSION PLANS

“They key is to try and be a smart investor, don’t continue old trends because that is a recipe for disaster.”

Four key ideas that pension plans have is:

1. Don’t follow the herd: Have an intelligent asset allocation. Engage in asset allocation which firmly addresses your long term liabilities.
2. In so far as long as good returns will come from idiosyncratic forces try to engage in dynamic investing. Identify opportunities, identify value traps, know the difference between the two and take advantage whenever opportunities arise.
3. Go for consistent returns and capital protection: If pension plans experience big losses now, it will take a very long time to reconcile those losses. Because of the fact we are in a low return environment you cannot afford to take big hits.
4. Healthy funding levels: At the moment the funding levels are not good in any part of the world except for Canada. In the US every funding level in the private sector is about 78 and numbers do not vary much in the UK, Japan and other markets.

MACRO RISKS TO IDIOSYNCRATIC RISKS

What we did was analyze amongst these asset classes which ones are people most likely to fear. And sure enough at the top came out global equities and real estate. Secondly, within these asset classes are people going to use them the same way they have in the past? For example, to think that as long as you’re invested in global equities you will be okay or are you going to be much more selective? We concluded that being selective is definitely the way to go, to be very selective in the way we invest in global equities, real estate etc.

It used to be a belief that fixed asset allocation in numbers would follow as well as that 90% of returns come from doing the right asset allocation. Now this is outdated and nobody holds on to those beliefs anymore. If we believe in this we will only think that some 50% of returns come from correct asset allocation and the other 50% comes from making the right choices of specific securities.

THE AIMS OF ASSET MANAGERS

“There is a rampant feeling that we are entering a long period of low returns. QE isn’t going to work second time around in the way that it worked the first time. It has lost its potency.”

What asset managers need to do is having their business models change in four fundamental ways:

1. Asset managers need to get much closer to their clients. Understand their clients risk profiles, identify if clients are being provided service that they need and so on. Client focus is paramount.
2. Investment Capabilities: What makes an investment professional at a time when markets are so distorted? It is a tough question to answer but I believe an investment professional should know the difference between value traps and value opportunities. The fact that markets are falling in emerging markets does not necessarily mean that it is a great buying opportunity. A smart investor knows that emerging markets have very strong price momentum. Prices in these markets have tendency to be falling for much longer.
3. Understanding correlations under different phases of market cycles: Yes, correlations are rising but what we also find is that there are different regimes emerging. Under certain regimes correlations are higher and under others they are lower. Learn to understand what those different regimes are and then devise your portfolio accordingly.
4. Alignment of interest: Asset managers need to have a strong financial alignment of interest. It can be from having things such as performance related fees or making sure they are not a part of a structure which basically says, heads I win and tails you lose. Innovation processes that asset managers have need to be rethought. Products need to be tested and tried before being released.

A link to Amin Rajans’ full report, Investing in the Age of Financial Repression can be downloaded at

DOWNLOAD

http://www.create-research-uk.com/?p=dlreport&t=report&r=37

Abstract written by, Karan Singh

Karan1.snigh@ryerson.ca

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

The rise of index ETFs and mutual funds which all depend on the FANTAsy stocks, has never accounted for this much of the market before.  The rapid emergence of Index ETFs accounted for nearly 30 percent of the trading in the U.S. equities market last summer.  FANTAsy weakness will magnify, or even potentially cause flash crashes if they break critical support levels. This is an untested $1 trillion stock bubble problem! The FRA examines the problems and where FANTAsy may be headed.

FANG & NOSH

As we entered Q4 earnings season and the economic news continued to deteriorate, it was clearly evident that we had eight stocks called “FANG & NOSH” holding up the US equity markets. Market breadth had collapsed but not the indexes – yet!

“FANG” STOCKS

• Facebook,
• Amazon,
• Netflix and
• Google

THESE EIGHT BECAME THE “NIFTY NINE”

While the S&P languishes unchanged in 2015, these small groups of overwhelmingly propagandized stocks were up on average over 60%, but with a collective P/E of 45, they were not cheap.

Ned Davis Research identified the NIFTY NINE in December, which added the following to the four FANGs:

• Priceline,
• Ebay,
• Starbucks,
• Microsoft and
• Salesforce. (Note that Apple appears on neither list which until recently was THE MARKET and accounted for 20% of the underlying Margin Expansion since 2010.)

WE HAD FALSE EUPHORIA CENTERED ON 9 STOCKS

This was very similar to what we have witnessed at all bubble tops.

Only the names change (the 4 Horsemen in the Dotcom Bubble run-up: Cisco, Intel, Microsoft & Qualcomm) and the rationalization hype (2000: “new economic paradigm”)

“NIFTY9” HID THE FACT THAT INSTITUTIONS HAD LEFT THE PARTY

Institutions were seeing the following Sales Growth was no longer there,

Earnings were steadily falling,

Companies were spending more on Buybacks and Dividends than they were actaully earning:

Almost 60 percent of the 3,297 publicly traded non-financial U.S. have bought back their shares since 2010.

In fiscal 2014, spending on buybacks and dividends surpassed the companies’ combined net income for the first time outside of a recessionary period, and continued to climb for the 613 companies that have already reported for fiscal 2015.

In the most recent reporting year, share purchases reached a record $520 billion. Throw in the most recent year’s $365 billion in dividends, and the total amount returned to shareholders reaches $885 billion, more than the companies’ combined net income of $847 billion.

Spending on buybacks and dividends has surged relative to investment in the business. Among the 1,900 companies that have repurchased their shares since 2010, buybacks and dividends amounted to 113 percent of their capital spending, compared with 60 percent in 2000 and 38 percent in 1990.

Among approximately 1,000 firms that buy back shares and report R&D spending, the proportion of net income spent on innovation has averaged less than 50 percent since 2009, increasing to 56 percent only in the most recent year as net income fell. It had been over 60 percent during the 1990s.

FANTAsy – FAN + Tesla + Alphabet

At the end just before the markets began collapsing at year beginning 2016, we had the FANTAsy stocks. This included the core FAN plus Tesla and Alphabet (Google).

By considering an Equal-Weighted Stock Index which removes the FANTAsy distortions from the market many technicians  were able to identify clearly what was occurring.

“FAN” HAS BROKEN DOWN – Possible Near Term Support and Then Another Drop??

CONCLUSIONS

A technical view of the equal-weighted US stock index may help resolve the support question.

It appears to suggest the market has further to fall in Q1 2016!

Caution is advised, as it has been since we first identified the FANGs in the market,

which could really bite the unsuspecting!

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Commentary on Japan’s decision to join countries such as Denmark, Switzerland, Sweden & others on imposing negative interest rates .. more than a 1/5th of the world’s GDP is now covered by a central bank with negative interest rates .. the BBC writes: “The country is desperate to increase spending and investment.” .. commentary: “Japan has been desperate to boost consumer spending for years. At one point it even issued shopping vouchers to stimulate demand.” .. The New York Times writes: “Moving to negative rates reflects a measure of desperation on the part of central banks. Their traditional tools have been largely exhausted, as most countries’ interest rates have been pushed to almost nothing.” .. commentary: Negative rates will eventually come to America. Central bankers are implementing negative interest rates to force savers to buy assets … so as to artificially stimulate the economy.”

link here to the article & links

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Dr. Lacy Hunt joins FRA Co-Founder Gordon T. Long in an in-depth discussion on the current debt dilemma and the decisions of the Federal Reserve. Dr. Lacy H. Hunt, an internationally known economist, is Executive Vice President of Hoisington Investment Management Company, a firm that manages over $5 billion for pension funds, endowments, insurance companies and others. He is the author of two books, and numerous articles in leading magazines, periodicals and scholarly journals.  Included among the publishers of his articles are. Barron’s, The Wall Street Journal, The New York Times, The Christian Science Monitor, the Journal of Finance, the Financial Analysts Journal and the Journal of Portfolio Management.

Previously, he was Chief U.S. Economist for the HSBC Group, one of the world’s largest banks, Executive Vice President and Chief Economist at Fidelity Bank and Vice President for Monetary Economics at Chase Econometrics Associates, Inc.  A native of Texas, Dr. Hunt has served as Senior Economist for the Federal Reserve Bank of Dallas. Dr. Hunt received his Ph.D. in Economics from the Fox School of Business and Management of Temple University. Furthermore Dr. Hunt served on the Board of Trustees of Temple University from 1987 to 2010 and is now an honorary life trustee. He received the Abramson Award from the National Association for Business Economics for “outstanding contributions in the field of business economics.” He is a life member of the American Finance Association.  He was a member of the Economic Advisory Board of the American Bankers Association and Chairman of the Economic Advisory Board of the Pennsylvania Bankers Association.  He served on the Monetary and Fiscal Policy Affairs Committee of the National Chamber of Commerce.

TACTICS OF THE FED

“Debt only works if it generates an income to repay principle and interest.”

Research indicates that when public and private debt rises above 250% of GDP it has very serious effects on economic growth. There is no bit of evidence that indicates an indebtedness problem can be solved by taking on further debt.

One of the objectives of QE was to boost the stock market, on theory that an improved stock market will increase wealth and ultimately consumer spending. The other mechanism was that somehow by buying Government securities the Fed was in a position to cause the stock market to rise. But when the Fed buys government securities the process ends there. They can buy government securities and cause the banks to surrender one type of government asset for another government asset. There was no mechanism to explain why QE should boost the stock market, yet we saw that it did. The Fed gave a signal to decision makers that they were going to protect financial assets, in other words they incentivized decision makers to view financial assets as more valuable than real assets. So effectively these decision makers transferred funds that would have gone into the real economy into the financial economy, as a result the rate of growth was considerably smaller than expected.

“In essence the way in which it worked was by signaling that real assets were inferior to financial assets. The Fed, by going into an untested program of QE effectively ended up making things worse off.”

THE FLATTENING YIELD CURVE

“Monetary policies currently are asymmetric. If the Fed tried to do another round of QE and/or negative interest rates, the evidence is overwhelming that will not make things better. However if the Fed wishes to constrain economic activity, to tighten monetary conditions as they did in December; those mechanisms are still in place.”

They are more effective because the domestic and global economy is more heavily indebted than normal. The fact we are carrying abnormally high debt levels is the reason why small increases in interest rate channels through the economy more quickly.

If the Fed wishes to tighten which they did in December then sticking to the old traditional and tested methods is best. They contracted the monetary base which ultimately puts downward pressure on money and credit growth. As the Fed was telegraphing that they were going to raise the federal funds rate it had the effect of raising the intermediate yield but not the long term yields which caused the yield curve to flatten. It is a signal from the market place that the market believes the outlook is lower growth and lower inflation. When the Fed tightens it has a quick impact and when the Fed eases it has a negative impact.

The critical factor for the long bond is the inflationary environment. Last year was a disappointing year for the economy, moreover the economy ended on a very low note. There are outward manifestations of the weakening in economy activity.  One impartial measure is what happened to commodity prices, which are of course influenced by supply and demand factors. But when there are broad declines in all the major indices it is an indication of a lack of demand. The Fed tightened monetary conditions into a weakening domestic global economy, in other words they hit it when it was already receding, which tends to further weaken the almost non-existent inflationary forces and for an investor increases the value.

FAILURE OF QUANTITATIVE EASING

“If you do not have pricing power, it is an indication of rough times which is exactly what we have.”

The fact that the Fed made an ill-conceived move in December should not be surprising to economists. A detailed study was done of the Fed’s 4 yearly forecasts which they have been making since 2007. They have missed every single year.

The Fed begins the year with the high forecast and ts declines each forecast after that and by December it isn’t much of a forecast because you already have 11 months of data. An empirical indication that QE has failed is the fact that their models have relied on them to be indications and the models were wrong which means the policies have also been a failure.

CRIPPLING NEGATIVES

“Another risk which may very well lead to a worse result is the Fed going to negative interest rates. First we must consider if the Fed can engineer negative interest rates and it is very likely they do have that capability. There will be severe consequences which we will not even be able to anticipate.”

There is a trend that in weak economic times the fed will continue untested experiments. Even though QE 1, 2 and 3 have failed, in dire times they will implement QE 4. But if the Fed resorted to negative interest rates it will have an adverse impact on bank earnings, particularly small banks and greatly harm savers who have already been hurt. Negative interest rates will simply penalize people to a far greater degree. It will have devastating consequences to the money market mutual funds; difficult to see how they would operate at all.

Pushing interest rates in a negative territory will greatly increase the unfunded liabilities of the corporate pension plans. Pension plans will either be dropped or for those already covered it will explode the liabilities causing them to cut expenditures in the real economy to fund the pension liabilities.

“If the Fed went into negative interest rates they would ultimately be required to call in the currency and force people to use their bank deposits.”

We are no closer to solving our indebtedness problem in 2016 as we were in 2009.

Q4 2015 REPORT  – PDF DOWNLOAD

Abstract written by, Karan Singh

Karan1.singh@ryerson.ca

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

 

“The BoJ actions should lead to further intensification of global currency wars with central banks around the world trying to engineer sustained competitive devaluation against the background of slowing global trade and growth as well as persistent commodity price disinflation. With its latest measures the BoJ will allow Japan to borrow more growth from its trading partners and limit the severity of the imported disinflation .. Almost 60% of the households’ financial assets are held in deposits. If indeed, the Japanese banks pass on some of the costs from the BoJ’s penalty rate to their depositors, this will result in a negative wealth effect, reducing the purchasing power of the Japanese consumers. Domestic demand should suffer and Japan’s contribution to global growth could decrease further. The BoJ’s measures thus should result in more currency wars and continuing slowdown in global trade and growth.” – Credit Agricole’s Valentin Marinov

LINK HERE to the article

LINK HERE to commentary

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Mises Institute’s Dr. Joseph Salerno highlights the developments in Norway in the war on cash .. Norway’s largest bank, DNB, has joined the campaign by governments & big banks the world over to abolish cash .. the first step the bank suggests is to get rid of the 1000 kroner note – “The aim of progressively withdrawing larger denomination notes from circulation is, of course, to make cash payments less convenient and to habituate the public to paying for even small transactions electronically.” .. Salerno asks what is the real reason for this war on cash – he quotes Zero Hedge: “The answer appears to be that the banks and government authorities are anticipating bail-ins, steeply negative interest rates and hefty fees on cash, and they want to close any opening regular depositors might have to escape .. The escape mechanism from bail-ins and fees on cash deposits is physical cash, and hence the sudden flurry of calls to eliminate cash as a relic of a bygone age — that is, an age when commoners had some way to safeguard their money from bail-ins and bankers’ control.”

link here to the article

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.