I have worked to keep this piece readable, and as brief as possible.
My grave diagnosis demands the evidence and reasoning to support it. One
cannot explain the collapse of this currency with the conventional view.
“They will print money to infinity,” may be popular but it’s not accurate.
The coming destruction has nothing to do with the quantity of money. It is a
story of what happens when interest rates fall into a black hole.
Yields Have Fallen Beyond Zero
The Swiss yield curve looks like nothing so much as a sinking ship. All
but the 20- and 30-year bonds are now below the water line.
Look at how much it’s submerged in just one week. The top line (yellow) is
January 16, and the one below it was taken just a week later on January 23.
It’s terrifying how fast the whole interest rate structure sank. Here is a
graph of the 10-year bond since September. For comparison, the 10-year
Treasury bond would not fit on this chart. The US bond currently pays 1.8%.
The Swiss 10-year yield was as high as 37 basis points on Friday January
2. By the next Monday, it had plunged to 28, or -25%. By January 15—the day
the Swiss National Bank (SNB) announced it was removing the peg to the
euro—the yield had plunged to just 7 basis points. It has been nonstop freefall
since then, currently to -26 basis points.
What can explain this epic collapse? Why is the entire Swiss bond market
drowning?
Drowning is a fitting metaphor. In my dissertation,
I describe several harbingers of financial and monetary collapse. The first
is when the interest interest rate on the long bond goes to zero. I discuss
the fact that a falling rate destroys capital, and that lower rates mean a
higher burden of debt. If the long bond rate is zero then the net present
value of all debt (which is effectively perpetual) is infinite. Debtors
cannot carry an infinite burden. As we’ll see, any monetary system that
depends on debtors servicing their debt must collapse when the rate goes to
zero.
I think the franc has reached the end. With negative
rates out to 15 years, and a scant 33 basis points on the 30-year, it is all
over but the shouting.
Not Printing, Borrowing
Let’s take a step back for a moment, and look at how the recent chapter
unfolded. It began with the SNB borrowing mass quantities of francs. Most
people say printed, but it’s impossible to understand this
unprecedented disaster with such an approximate understanding. It’s not
printing, but borrowing.
Think of a homebuyer borrowing $100,000 to buy a house. He never gets the
cash in his bank account. He signs a bunch of paperwork, and then at the end
of the day he has a debt obligation to repay, plus the title to the house.
The former owner has the cash.
It works the same with any central bank that wants to buy an asset. At the
end of the day, the bank owns the asset, and the former owner of the asset
now holds the cash. This cash is the debt of the central bank. It is on the
bank’s balance sheet as a liability. The bank owes it.
This is vitally important to understand, and it can be quite
counterintuitive. If one thinks of the franc (or dollar, euro, etc.) as money,
and if one thinks that the central banks print money, then one will
come to precisely the wrong conclusion: that there is nothing owed, and
indeed there is no debtor. In this view, the holder of francs has cash, which
is a current asset. End of story.
This conclusion could not be more wrong.
Certainly, the idea of the central bank repaying its debt is absurd. By
law, payment is deemed made when the debtor pays in currency—i.e. francs in
Switzerland. However, the franc is the very liability of the SNB that we’re
discussing. How can the SNB pay off its franc liabilities using its own franc
liabilities as means of payment?
It can’t. This is a contradiction in terms. Thus it’s critical to
understand that there is no extinguisher of debt in the regime of
irredeemable paper currency. You may get yourself out of the debt loop by
paying in currency, but that merely shifts the debt. The debt does not go out
of existence, because paying a debt with an IOU cannot extinguish it. Unlike
you, the central bank cannot get itself out of debt.
However, it can service its debt. For example, the Federal Reserve
in the U.S. pays interest on reserves. Indeed, the bank must service its
debts. It would be a calamity if a payment is missed, if the central bank
ever defaulted.
The central bank must also maintain its liabilities, which is what it uses
to fund its assets. If the commercial banks withdraw their deposits—and they
do generally have a choice—the central bank would be forced to sell its
assets. That would be contrary to its policy intent, not to mention quite a
shock to brittle economies.
Make no mistake, a central bank can go bankrupt. This may seem tricky to
understand, as the law makes its liability legal tender for all
debts public and private. A central bank is also allowed to commit acts of
accounting (and leverage) that would not be tolerated in a private company.
Regardless, it can present misleading financial statements, but even if the
law lets it get away with that, reality will have its revenge in the end. The
emperor may claim to be wearing magnificent royal robes, but he’s still
naked.
If liabilities exceed assets, then a bank—even a central bank—is insolvent
and the consequences will come soon enough. The cash flow from the assets
will sooner or later become insufficient to pay the interest on the
liabilities. No central bank wants to be in a position where it is obliged to
borrow, not to purchase asset but to service a negative cash flow. That is a
rapid death spiral. It must somehow push down the interest rate on its
liabilities (which are typically short term) to keep the cost of financing
its portfolio below the revenue generated on the assets.
This becomes increasingly tricky when two things happen. One, the yield on
the asset goes negative. Thus, the even-more-negative (and even more absurd)
one-day rate of -400 basis points in Switzerland. Two, the issuance of more
currency drives down yields even further (described in detail, below).
Events force the hand of the central bank. It goes down a path where it
has fewer and fewer choices. That brings us back to negative interest rates
out to the 15-year bond so far.
The Visible Hand of the Swiss National Bank
So the SNB issued francs to fund its purchase of euros. Next, it spent the
euros on whatever Eurozone assets it wished to buy, such as German bunds.
It’s well known that the SNB put on a lot of this trade to keep the franc
down to €0.83 (the inverse of keeping the euro down to CHF1.2) l. It also
helped push down interest rates in Europe. The SNB was a relentless buyer of
European bonds.
That leads to the question of what it did in Switzerland. The SNB was
trading new francs for euros. That means the former owner of those euros then
owned francs. These francs have to stay in the franc-denominated domain. What
asset will this new franc owner buy?
I frame the question this way deliberately. If you have a 100-franc note,
you can put it in your pocket. If you have CHF100,000, you can deposit it in
a bank. If you have CHF100,000,000 (or billions) then you are going to buy a
bond or other asset (depositing cash in a bank just pushes it to the bank,
who buys the asset).
The seller of the asset is selling on an uptick. He gives up the bond,
because at its higher price (and hence lower yield) he now finds another
asset more attractive on a risk-adjusted basis. Risk includes his own
liquidity risk (which of course rises as his leverage increases).
As the SNB (and many others) relentlessly push up the bond price, and
hence push down the yield, the sellers of the ever-lower yielding bonds have
fresh new franc cash balances.
The Quantity Theory of Money holds that the demand for money
falls as the quantity rises. If demand for money falls, then by this
definition the prices of all other things—including consumer goods—rises. It
is commonly held that people tradeoff between saving money vs. spending money
(i.e. consumption). The prediction is rising consumer prices.
I emphatically disagree. A wealthy investor does unload his assets to go
on an extra vacation if he doesn’t like the bond yield. A bank with a
trillion dollar balance sheet does not dole out bigger salaries if its
margins are compressed.
So what does trade off with government bonds? If an investor doesn’t want
to own a government bond, what else might he want to own? He buys corporate
bonds, stocks, or rental real estate, thus pushing up their prices and yields
down.
And then, in a dysfunctional monetary system, you can add antique cars,
paintings, a second and third home, etc. These things serve as surrogates for
investment. When investing cannot produce an adequate yield, people turn to
non-yielding non-investment assets.
The addition of a new franc at the margin perturbs the previous
equilibrium of risk-adjusted yields across all asset classes. Every time the
bond price goes up, every owner of every franc-denominated asset must
recalculate his preferences.
The problem is that the SNB does not create any more productive investment
opportunities when it spills more francs into the Swiss financial system.
Those new francs have to chase after the existing assets.
Yields are falling. They necessarily had to fall.
An Increasing Money Supply and Decreasing Interest Rate
The above discussion describes the picture in every developed economy.
Interest rates have been falling for 34 years in the U.S., for example.
In a free market, the expansion of credit would be driven by a market
spread: available yield – cost of borrowing. If that spread is too small (or
negative) there will be no more borrowing to buy assets. If it gets wider,
then banks can spring into action.
However, central banks distort this. Instead of the cost of borrowing
being a market-determined price, it is fixed by the central bank. This
perverts the business model of a bank into what is euphemistically known as maturity
transformation—borrowing short to lend long. It’s not possible for a
bank to borrow money from depositors with 5-year time deposit accounts in
order to buy 5-year bonds. The bank has to borrow a shorter duration and buy
a longer, in order to make a reasonable profit margin.
If the central bank sets the borrowing cost lower and lower, then the
banks can bid up the price of government bonds higher and higher (which
causes a lower and lower yield on the long bond). This is not capitalism at
all, but a centrally planned kabuki theater. All of the rules are set by a
non-market actor, who can change them for political expediency.
The net result is issuance of credit far beyond what could ever happen in
a free market. This problem is compounded by the fact that the central bank
cannot control what assets get bought when it buys bonds. It hands the cash
over to the former bond holders. It’s trying to accomplish something—such as
keeping the franc down in the case of the SNB, or preventing bankruptcies, in
the case of the Fed—and it has no choice but to keep flooding the market
until it achieves its goal. In the US, the rising tide eventually lifted all
ships, even the leaky old tubs. The result is a steeper credit gradient,
and the bank can eventually force liquidity out to its target debtors.
The situation in Switzerland makes the Fed’s problems look small by
comparison. Unlike the Fed, which had a relatively well-defined goal, the SNB
put itself at the mercy of the currency market. It had no particular goal,
and therefore no particular budget or cost. The SNB was fighting to hold a
line against the world. While it kept the franc peg, the SNB put pressure on
both Swiss and European interest rates.
Something changed with the start of the year. We can understand it in
light of the arbitrage between the Swiss bond, and other Swiss assets. The
risk-adjusted rate of return on other assets always has to be greater than
that of the Swiss government bond (except perhaps at the peak of a bubble).
Otherwise why would anyone own the higher-risk and lower-yield asset?
Therefore, there are three possible causes for the utter collapse in
interest rates in Switzerland beginning 10 days prior to the abandonment of
the peg:
1. the rate of return of other assets has been leading the drop in yields
2. buying pressure on the franc obliged the SNB to borrow more francs into
existence, fueling more bond buying
3. the risk of other assets has been rising (including liquidity risk to
their leveraged owners)
#1 is doubtful. It’s surely the other way around. It’s not falling yields
on real estate driving falling yields on bonds. Bond holders are induced to
part with their bonds on a SNB-subsidized uptick. Then they use the proceeds
to buy something else, and drive its yield down.
One fact supports conclusion #2. Something forced the SNB to remove the
peg. Buying pressure is the only thing that makes any sense. The
SNB hit its stop-loss.
The rate of interest continued to fall even after the SNB abandoned its
peg. Why? Reason #3, rising risks. Think of a bank which borrowed in Swiss
francs to buy Eurozone assets. This trade seemed safe with the franc pegged
to the euro. When the peg was lifted, suddenly the firm was faced with a
staggering loss incurred in a very short time.
The overreaction of the franc in the minutes following the SNB’s policy
change had to be the urgent closing of Eurozone positions by many of these
players. The franc went from €0.83 to €1.15 in 10 minutes, before settling
down near €0.96. For those balance sheets denominated in francs, this looked
like the euro moved from CHF1.20 to CHF0.87, a loss of 28%. What would you
do, if your positions instantly lost so much? Most people would try to close
their positions.
Closing means selling Eurozone assets to get francs. Then you need to buy
a franc-denominated asset, such as the Swiss government bond. That clearly
happened big-time, as we see in the incredible drop in the interest rate in
Switzerland. Francs which had formerly been used to fund Eurozone assets must
now be used to fund assets exclusively in the much-smaller Swiss realm.
In other words, a great deal of franc credit was used to finance Eurozone
assets. This is a big world, and hence the franc carry trade didn’t dominate
it. When those francs had to go home and finance Swiss assets only, it
capsized the market.
And the entire yield curve is now sinking into a sea of negative rates.
The Consequences of Falling Interest
Meanwhile, unnaturally low interest is offering perverse incentives to
corporations who can issue franc-denominated liabilities. They are being
forced-fed with credit, like ducks being fatted for foie gras. This surely must
be fueling all manner of malinvestment, including overbuilding of unnecessary
capacity. The hurdle to build a business case has never been lower, because
the cost of borrowing has never been lower. The consequence is to push down
the rate of profit, as competitors expand production to chase smaller
returns. All thanks to ever-cheaper credit.
Artificially low interest in Switzerland is causing rising risk and, at
the same time, falling returns.
The Swiss situation is truly amazing. One has to go out to 20 years to see
a positive number for yield—if one can call 21 basis points much of a yield.
It’s not only pathological, but terminal. This is the end.
In Switzerland, there is hardly any incentive remaining to do the right
things, such as save and invest for the long term. However, there’s no lack
of perverse incentives to borrow more and speculate on asset prices detaching
even further from reality.
Speculation is in its own class of perversity. Speculation is a process
that converts
one man’s capital into another man’s income. The owner of capital,
as I noted earlier, does not want to squander it. The recipient of income, on
the other hand, is happy to spend some of it.
We should think of a falling interest rate (i.e. rising bond market and
hence rising asset markets) as sucking the juice (capital) out of the system.
While the juice is flowing, asset owners can spend, and lots of people are
employed (especially in the service sector).
For example, picture a homeowner in a housing bubble. Every year, the
market price of his house is up 20%. Many homeowners might consider borrowing
money against their houses. They spend this money freely. Suppose a house
goes up in price from $100,000 to $1,000,000 in a little over a decade.
Unfortunately, the debt owed on the house goes up proportionally.
With financial assets, they typically change hands many times on the way
up. In each case, the sellers may spend some of their gains. Certainly, the
brokers, advisors, custodians, and other professionals all get a cut—and the
tax man too. At the end of the day, you have higher prices but not higher
equity. In other words, the capital ratio in the market collapses.
To understand the devastating significance of this, consider two business
owners. Both have small print shops. Both have $1,000,000 worth of presses,
cutters, binding machines, etc. One owns everything outright; he paid cash
when he bought it. The other used every penny of financing he could get, and
has a monthly payment of about $18,000. Both shops have the same cost of
doing business, say $6,000. If sales revenues are $27,000 then both owners
may feel they are doing well. What happens if revenues drop by $3,500? The all-equity
owner is fine. He can reduce the dividend a bit. The leveraged owner is
forced to default. The more your leverage, the more vulnerable you are to a
drop in revenues or asset values.
Falling interest, and its attendant rising asset prices, juices up the
economy. People feel richer (especially if their estimation of their wealth
is portfolio value divided by consumer prices) and spend freely.
Unfortunately, it becomes harder and harder to extract smaller and smaller
drops of juice. The
marginal productivity of debt falls.
Think about it from the other side, the borrower. The very capacity to pay
interest has been falling for decades. A declining rate of profit goes
hand-in-hand with a falling rate of interest. Lower profit is both caused by
lower interest, and also the cause of it. A business with less profit is less
able to pay interest expense. Who could afford to pay rates that were considered
to be normal just a few decades ago? It is capital that makes profit, and
hence capacity to pay interest, possible. And it is capital that’s eroded by falling rates.
The stream of endless bubbles is just the flip side of the endless
consumption of capital. Except, there is an end. There is no way of avoiding
it now, for Switzerland.
How About Just Shrinking the Money Supply?
Monetarists often tell us that the central bank can shrink the money supply
as well as grow it, and the reason why it’s never happened is, well… the
wrong people were in charge.
I disagree.
To see why, let’s look at the mechanism for how a central bank expands the
money supply. It issues cash to an asset owner, and the asset changes hands.
Now the bank owns the asset and the seller owns the cash (which he will
promptly use to buy the next best asset). A relentlessly rising bond price is
lots of fun. It’s called a bull market, and everyone is making profits
as they reckon them (actually consuming
capital, as we said above).
How would a contraction of the money supply work? It seems simple, at
first. The central bank just sells an asset and gets back the cash. The cash
is actually its own liability, so it can just retire it. And voila. The money
supply shrinks.
Not so fast.
There is an old saying among traders. Markets take the escalator up, but
the elevator down. Central bank buying slowly but relentlessly bid up the
price of bonds. Tick by tick, the bank forced it up. What would central bank
selling do? What would even a rumor of massive central bank selling do?
Bond prices would fall sharply.
The problem is that few can tolerate falling bond prices, because everyone
is leveraged. Think about what it means for everyone to borrow and buy
assets, for sellers to consume some profits and reinvest the proceeds into
other assets. There is increasingly scant capital base supporting an
increasingly inflated—as in puffed-up with air, without much substance—asset
market. A small decline in prices across all asset classes would wipe out the
financial system.
Market participants have to be leveraged. Dirt cheap credit not only makes
leverage possible, but also necessary. How else to keep the doors open,
without using leverage? Spreads are too thin to support anyone, unlevered.
Banks are also maturity mismatched, borrowing short to lend long. The
consequences of a rate hike will be devastating, crushing banks on both sides
of the balance sheet. On the liabilities side, the cost of funding rises with
each uptick in the interest rate. On the asset side, long bonds fall in value
at the same time. If short-term rates rise enough, banks will have a negative
cash flow.
For example, imagine owning a 10-year bond that pays 250 basis points. To
finance it, you borrow at 25 basis points. Well, now imagine your financing
cost rises to 400 basis points. For every dollar worth of bonds you own, you
lose 1.5 cents per year. This problem can also afflict
the central bank itself.
You have a cash flow problem. You are also bust.
The Bottom Line
The problem of falling rates is crushing everyone, but raising the rate
cannot fix the problem. It should not be surprising that, after decades of
capital destruction—caused by falling rates—the ruins of a once-great
accumulation of wealth cannot be repaired by raising the interest rate.
I do not see any way out for the Swiss National Bank and the franc, within
the system of irredeemable paper money. However, unless the SNB can get out
of this jam, the franc is doomed. I can’t predict the timing, but I believe
the fuse is lit and the powder keg could go off at any time.
One day, a bankruptcy will happen. Soothing voices will assure us it was
unexpected. Then another will happen, perhaps triggered by the first or
perhaps not. Then the cascading begins. One party’s liabilities are another’s
assets. ABC’s bankruptcy wipes out DEF’s asset. Since DEF is leveraged, it
cannot absorb much loss until it, too, is dragged under.
Somewhere in the midst of this, people will turn against the franc. Today,
it’s arguably the most loved paper currency. However, I don’t think it will
take too many capital losses in Switzerland, before there is a selling
stampede. The currency will fall to zero, in a repeat of a pattern that the
world has seen many times before.
People will call it hyperinflation (I don’t prefer that term).
Call it what you will, it will be the death of the franc. It will have
nothing to do with the quantity of money.
Two factors can delay the inevitable. One, the SNB may unwind its euro
position. As this will involve selling euros to buy francs, the result will
be to put a firm bid under the franc. Two, speculators will of course know
this is happening and eagerly front-run the SNB. After all, the SNB is not an
arbitrager buying when it can make a spread. It is a buyer by mandate (in
this scenario) and must pay the ask price. Even if the SNB does not unwind,
speculators may buy the franc and wait for it to happen. And of course, they
could also buy based on a poor understanding of what’s happening, or due to
other perverse incentives in their own countries.
Bankruptcies aside, the franc is already set on a hair-trigger. Something
else could trip it and begin the process of collapse. There is little reason
for holding Swiss francs in preference to dollars. The interest rate
differential is huge. The 10-year US Treasury pays 1.8%. Compare that to the
Swiss bond which charges you 26 basis points, and the
difference is over 208 points in favor of the US Treasury. Once the risk of a
rising franc is taken out of the market (by time or price action) this trade
will commence. A falling franc against the dollar will add further kick to
this trade. A trickle could become a torrent very quickly.
I would not be surprised if the process of collapse of the franc began
next week, nor if it lingered all year. This kind of event is not susceptible
to a precise prediction of when.
What is clear is that, once the process begins in earnest, it will be
explosive, highly non-linear, and over quickly (I would guess a matter
weeks).
I plan to publish a separate paper revisiting my Gold
Bonds to Avert Financial Armageddon thesis in light of the Swiss crisis.
I will save for that paper my assessment of whether or how gold bonds can
provide a way out for the Swiss people trapped in the terminal phase of
irredeemable paper money.
