June 15, 2016

Vinnie the Face

How do you know macroeconomists have a sense of humor?  They use decimal points.

While you ponder, it’s that time again when the Federal Reserve meets to wring its figurative hands over decimal points, VIX expirations hit as volatility explodes anew, and Brits consider telling Europe to pound sand.  Wait, that last part is new.

And by the way, what’s with these negative interest rates everywhere?

I’d prefer to tell you how computerized high-speed market-makers have made “the rapid and frequent amending or withdrawing of orders…an essential feature of a common earnings model known as market making,” according to Dutch regulators studying fast trading (that nugget courtesy of Sal Arnuk at Themis Trading). If you as a human do that, they throw you in jail for spoofing. If it’s a machine programmed by humans, all’s well.

We’ll instead talk macro factors today because they’re dominating. Negative interest rates, the Brexit, currencies, stocks, share a seamless narrative.

First, the Brexit looms like a hailstorm in Limon, Colorado, not because the UK and Europe are terminating trade. No, nerves are rattled because it represents a fracture in the “we’re all in this together” narrative underpinning global monetary policy. All that’s needed – infinitely – if everybody lives within their means are currencies that don’t lose value over time. There’s not a single one like that right now.

Suppose on your street some neighbors were prosperous and others deep in financial trouble, and block leaders built a coalition around a mantra: The only way for us all to prosper is if the neighbors with money give some to the neighbors without.

It altruistic. It’s also untrue.  That will ensure nobody prospers. The EU strategy has been to get countries like the UK to agree to principles that let wastrel nations offload their profligacy on responsible ones.  It doesn’t matter how one views it ideologically. What matters is the math and the math doesn’t work.

The UK is threatening to quit the block coalition on a belief that the best way to ensure that the UK prospers is to stop taking responsibility for others.

Negative interest rates tie to the EU strategy. Contrary to what you hear from droning economists and central bankers, low interest rates aren’t driven by low growth prospects. If growth prospects are low and therefore risky, capital costs should be high.  Low growth is a product of lost purchasing power, defined as “what your money buys.” If what your money buys diminishes, you’ll be buying less, which leads to low growth.

The reason money buys less is because governments are filching from their citizens by trading money for debt, and falling behind on their payments.

I’ll explain in simple terms.  If you miss a credit card payment, your creditor doesn’t receive money it’s owed. Driving interest rates to zero is tantamount to skipping payments because it reduces the amount owed.  Interest is money owed.

Suppose you told your credit card company, “I will pay you only 1% interest.” That would be nice but generally debtors don’t get to set the terms.

The world’s largest debtors are governments, and they do get to control the terms.  What’s more, they alone create money. Heard of the California Gold Rush, the Alaska Gold Rush?  Why none now?  Governments outlawed the use of gold as money. Gold is valuable, yes. But it’s not legal tender. So you can’t mine for legal tender anymore.

It’s a great gig if you can get it, spending all you want and borrowing and telling creditors what you’ll pay, and then whipping up a batch of cash to buy out your own debt.

Except even governments can’t just prestidigitate cash like a single item in a double-entry ledger. It used to be central banks offset created cash with things like gold.  Now, the entire global monetary system including the dollar, euro, UK pound, Japanese yen, Chinese yuan, etc., is backed by debt.

What does that mean?  To create money, central banks manufacture it and trade it for debt. Why? Because much of what is measured as growth today is really just rising prices. So if prices stop rising, growth stalls, and economies slip into recession and then governments have an even harder time funding bloated budgets.

More money chasing goods drives up prices. So central banks attempt to encourage spending and borrowing by creating money to buy the debts of their governments and now private companies too. The idea is to relieve banks and businesses of debts, thus enabling them to borrow and spend more, which, the thinking goes, will produce growth.

This cycle creates extreme demand for debt, which becomes so valuable that the interest rates on it turn negative.  What happens to ordinary people who borrow and spend beyond their means is the opposite. The cost of debt keeps rising until you’re paying Vinnie the Face the 20% weekly vig in an alley as he smacks a baseball bat in a hand.

So you see, it’s all related. The strangest part is that all financial crises are products of overspending.  Yet governments and central banks cannot manufacture money to save us from our largess unless we rack up debts they can buy with manufactured money.

It’s like an episode of CNBC’s American Greed in which people engage in bizarre and irrational behavior to perpetuate fraud. The world’s money is entirely dependent on more debt. It manifests for you and me in how little our money buys now.  That’s stealing as sure as someone reached in your wallet and took money out. I was just commiserating with a client about the cost of NIRI National.  Our money doesn’t go as far as it did.

What’s it mean for the equity market? It fills up with arbitragers, who see uncertainty as opportunity rather than threat.  They’re not trading fundamentals but fluctuations. They can sustain stocks for a while. But sooner or later Vinnie the Face shows up with a bat.

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