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2019
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Check-Mate For Central Banks: Negative Rates & Gold
This article dissects the moving parts in this fascinating story. Introduction For some time now, I have maintained the wheels are likely to fall off the global economic wagon by the year-end. Furthermore, for many of my interlocutors, the recent rise in the gold price is just evidence of an impending cyclical crisis, anticipating and discounting the certain inflationary response by central banks. But in this, we are describing only surface evidence, not the underlying market reality. In the combination of trade protectionism and an emerging credit crisis we face a problem upon which almost no formal research has been done, so it is not something that even far-thinking analysts have considered. To my knowledge, no mainstream economist has pointed out the lethal mix these two dynamics together present. Very few even recognise the existence of a credit cycle, traditionally called a trade or business cycle. Not even the great von Mises called it a cycle of credit, having identified and described it with great accuracy in his The Theory of Money and Credit, first published in 1912. But a spade must be called a spade: it is in its fundament a credit cycle. There are many Austrian economists who fully understand the credit cycle. But to it we must add the destructive synergy of American trade policy aimed at China. Much economic research has been conducted on the causes of a credit cycle, trade cycle, business cycle, whatever it may be called. Much research has also been conducted on the economic consequences of trade tariffs. But nowhere is there to be found any research or commentary on the destructive power of combining the two. Yet, these were precisely the conditions in October 1929, when Wall Street awoke to the certainty that Congress would vote in favour of the Smoot-Hawley Tariff Act at the end of that month. The shock of a 35% top to bottom fall in the Dow in October 1929 was only a prelude to an extended collapse following President Hoover signing it into law the following year. The economic research that followed the subsequent depression was conducted almost entirely by inflationists promoting reflation, so the destructive synergy between a credit crisis and trade protectionism has been ignored. We cannot know the future with certainty, but we can point to the empirical evidence following Smoot-Hawley and draw an alarming parallel with today’s events. Thus alerted, we can then develop a convincing theoretical case for its repeat. Every week, reports of the global economy stalling now hit the headlines, drawing the parallel even closer. Yet, with equity markets close to all-time highs, little more than a mild recession, easily batted away with a little more monetary inflation, is the general expectation. But our knowledge tells us there is almost certainly a large unanticipated shock ahead of us, and we should proceed in any analysis with that expectation. This article postulates how early evidence from the rising price of gold suggests the shock is closer than even perennially bearish analysts expect. We shall now take the inflationary consequences of an unexpected slump as a given in order to predict the changes in the relationship between physical gold and fiat dollars; a relationship that has for the last four decades led to a massive expansion of gold derivatives. To understand that relationship, and why it now appears to be reversing requires a working knowledge of time preference, the basis of interest; and more specifically the changing relationship of gold’s time preference to that of dollars. Interest and time preference One’s own bookcase provides the perfect illustration of time preference, which is the greater value of possession over non possession. There will be books bought on a whim which just clutter a bookshelf and have no value. Next time there’s a clear-out, they are destined for the charity shop: there’s no difference in time value, being worthless to the owner today and in the future. Then there are the first editions, which have a commercial value. Books in this category will have a high current value to you compared with their non-possession. But perhaps the books with the highest personal value are the ones that have little value to anyone else: that battered copy of Wren’s Beau Geste, or the translation of Hoffmann’s Struwwelpeter read to you when you were a child. You may have even visited the museum in Frankfurt dedicated to Hoffmann and his famous book of moral tales for children. The value of these books in possession is far greater than their absence, even though you rarely open their pages. This is the basis of time preference: the greater value placed on possession than non-possession. The books with sentimental value will have very little value to anyone else, other booklovers having their own favourites. Everyone’s time preferences are different. In economic terms, we express these varying values in terms of the difference between a current value in possession and the value of non-possession, but the certainty of repossession at a future time. The discounted value of the future possession is normally expressed as an interest rate on the monetary value today. Assuming free market prices, in theory nearly everything of value has a time preference, an interest rate. That is, anything people value more in their immediate possession than the promise of ownership at some stage in the future. A future value, with very few exceptions, is always less than that of current ownership, and it is the difference between the two that is given to a current owner in one form or another to part with possession for a defined period of time. The only examples that go against time preference are special cases. For example, an individual might forgo a decent salary today, in order to study so that he or she can earn more after passing a professional exam. In this case, the value of a current earnings stream is rejected in favour of potentially better prospects later. Or the philanthropist, who lends artworks for free to a public gallery so that a wider audience can appreciate them (but perhaps he does have a reward – to be thought of as a generous philanthropist and pillar of society). The proxy for valuing time preference on goods is money, and the way it is normally expressed is as a money-rate of interest, often termed the originary rate. The originary rate of interest can be specific, assessed and applied in a single transaction such as obtaining the temporary use of a machine for a defined time. It can be a consolidated rate through the application of savings, reflecting the time preferences of the many goods and services whose possession is temporarily deferred by the saver. Time preference is just the core consideration behind an interest rate. There will be other interest elements in addition, such as the trustworthiness and financial record of the borrower. But for the individual who has sacrificed the immediate satisfaction of spending the money put aside as savings, the time preference element will reflect the discounted future values of the goods and services that otherwise would have been purchased. As well as time preferences reflecting baskets of specific goods and services, individuals will personally have different time preferences as well, as illustrated with the example of a personal library. But as is the case with any value, it is the marginal rate which is usually accepted as the market rate of interest, and therefore indicates the overall value of time preference within it. In addition, an interest rate must be greater than the sum of the originary rate and the compensation for all perceived lending risks, in order to create savings flows to feed investment. This being the case, why is it that in financial markets, the forward price of something at a future date is usually higher than the present? The answer is simple: forward prices are not for possession, but for extending non-possession. Instead of being obliged to pay for possession today, a futures or forward price allows an individual to hang on to money for longer, rather than part with it now. And, assuming free markets set interest rates, with money’s time preference being greater than that of the average consumer item (in order to create savings flows referred to above), plus the addition for financial risk compensation, it should always be higher than the pure time preference applied to the underlying commodity, item or even just a title to ownership. Therefore, higher prices for future deliveries of commodities and titles to ownership in financial markets are principally a reflection of money’s time preference, plus the risks associated with change of its ownership. To this should be offset the specific time-preference for individual commodities, but so long as they are in adequate supply, they will not be relatively significant compared with that of money. This means the financial representation of time in a futures or forward contract in a properly functioning market is normally a positive cost. This condition is termed contango. We must also allow for the relative demand and supply characteristics of the underlying security between Date 1 and Date 2, which may temporarily lift a commodity’s time preference above that of money. If demand characteristics are such that the value of an immediate delivery overrides money’s time preference, then we have a backwardation. For example, there may be an acute shortage currently but supplies of the commodity in question are expected to be more plentiful at a future date. Backwardation is a temporary condition, and not the normal situation in financial markets. To summarise so far, time preference tells us, except in a few specific cases, that the underlying or originary interest rate on money, which represents the time preference in all goods and services, must always be positive and include an extra margin to ensure savings flows occur. Furthermore, this is the basis for all pricing in financial markets for deferring delivery or settlement, which is called contango. In normal markets, backwardations are always unnatural and temporary, reflecting an excess of demand over supply for an earlier date over a later, but is never a general condition. Negative interest rates create permanent backwardations The reason it is vital to grasp the meaning and implications of time preference is to show that negative interest rates are unnatural, and do not accord with human action. It might not be obviously disruptive to financial markets when a central bank, whose currency is not the reserve currency, imposes a relatively minor negative rate on its commercial banks’ reserves. After all, a commercial bank will still charge its borrowers a positive rate, even though it may have to be imaginative when it comes to keeping depositors happy. But this is beginning to change, with both governments and large corporates now being able to issue bonds at negative rates. As we have seen from our discourse on time preference, this is a significant distortion from normality, indicating bond markets expect yet deeper negative rates in the currencies concerned. In managing interest rates, the assumption central bankers make is that interest is the price of money. This is wrong for the reasons argued above. But instead of realising that deeper negative rates will not promote economic recovery in accordance with a cost of money approach to economic management, central banks’ economic models predict deeper negative rates are necessary in the event that a significant recession materialises. However, this is new territory for policy makers, and they are naturally cautious about the prospect of deeper negative rates. Deeper negative interest rate policies will almost certainly be preceded or accompanied by quantitative easing, which allows a central bank to anchor term rates and government bond yields at the zero bound or even in negative territory. If the world faces a global recession, monetary expansion is likely to be the only course of action open to central banks, and deeper negative rates will become central to monetary policy if a recession persists. With the expansionary phase of the credit cycle demonstrably running out of steam, history tells us that not only are we overdue a crisis in bank credit, but the tariff war between China and America will probably synergise with the cyclical downturn in the credit cycle to trigger a slump on a scale not seen since the early 1930s. That being the case, under our assumptions for economic prospects, deeper negative rates will become unavoidable. The first to explore this dangerous territory are likely to be the ECB, the Swiss National Bank and the Bank of Japan. So far, lending rates at the Fed and the Bank of England are still in positive territory, but faced with an economic slump, that may not persist. The Fed’s interest rate is particularly important, because international financial markets price everything in dollars. And unless the Fed is prepared to see a dollar being strengthened by deepening negative rates elsewhere, the Fed may have little option but to follow. If the Fed introduces negative dollar rates, then distortions of time preference will take a catastrophic turn. All financial markets will move into backwardation, reflecting negative rates imposed on dollars. Remember, the only conditions where backwardation can theoretically exist in free markets are when there is a shortage of a commodity for earlier settlement than for a later one. Yet here are backwardation conditions being imposed from the money side. It leads us to one conclusion: if negative rates for the dollar are imposed on financial markets, they will almost certainly lead to a flight out of the dollar where deposits become taxed with negative rates, not into other currencies, but into all commodities and future claims upon them. The current situation, where since the 1980s derivatives have inflated commodity supply, thereby suppressing prices, will be reversed. The purchasing power of dollars will be undermined by an attempted flight out of money. And it is unlikely to be long before the difference between negative time preferences between dollars and mildly positive ones for everyday items promotes a similar flight out of retail bank deposits. That is the black and white of it. But there is a grey area of close to zero rates, when they are less than the implied rate of interest on gold, because of its time preference. Here it should be noted that gold’s interest rate when sterling was on the gold standard generally varied between two and four per cent, using the yield on British Consols as proxy. The Fed fund rate is already testing the lower boundary for monetary gold’s historic time preference, and markets are now expecting the FFR to go lower still. Negative dollar interest rates and gold This leads us to consider how a negative dollar interest rate will affect the price of gold. Gold is different from other commodities, because it is also a medium of exchange. And while it may not be commonly used as such in capital markets, it is widely retained by central banks and diverse parties as a monetary store of value. Gold has a monetary time preference of its own, in accordance with time preference theory. And when gold was money, expressed as such through money substitutes, we know from the British experience in the nineteenth century, gold’s time preference usually held above two per cent, and that was still roughly the case reflected in gold’s lease rate since the 1980s. In the 1980s gold was increasingly used as the collateral for a carry trade, leading to an explosion in business for the London bullion market. The underlying position was that central banks had accumulated bullion as part of their monetary reserves, and the gold price was generally falling. As bullish conditions died, gold’s time preference fell. Central banks and government treasury departments added to this trend, being prepared to lease their gold in large quantities to specialist banks in the bullion market. At that time, a bullion bank could lease gold from a central bank and use it as collateral to invest in US Treasury bills. Gold’s time preference was reflected in a lease rate of typically 1.5-2% (though there were some spikes to 3-5%). Lease rates rhymed with evidence of gold’s originary rate established in the nineteenth century. Meanwhile, 6-month UST bills yielded about 6% or more, giving bullion banks a fat profit over the lease rate. While figures were never published, Frank Veneroso, at that time a leading independent gold analyst, gave a speech in Lima in 2002 estimating central bank gold leases and swaps were between 10,000 and 15,000 tonnes. In other words, up to half of all central bank gold was out on lease or swapped. Since those days, the London forward market has continued to grow. Bullion banks extended their operations to offer bullion accounts for wealthier individuals around the world, almost entirely on an unallocated basis. Unallocated accounts allow a bullion bank to own the gold deposited with it and to leverage its use as collateral for carry trades and other opportunities of interest rate arbitrage. This market became so developed that insiders have postulated that for every ounce of physical bullion in the possession of bullion banks there could be a hundred of paper liabilities. We have no way of knowing the true level of paper gold leverage today. A working assumption that actual gearing is closer to between ten or twenty times seems more realistic, given Bank for International Settlements statistics of OTC swaps and forwards and LBMA vaulting statistics, allowing for ETF and other custody holdings, segregated from bullion bank ownership. To this must be added the banks’ unallocated customer account liabilities which go unrecorded. In any event, we can be certain that in recent decades a positive gold lease rate led to a substantial systemic uncovered position, likely to be still institutionalised, given the evidence from the LBMA’s daily clearing statistics. The dollar interest rate that matters today is the wholesale market rate, USD LIBOR of a term that matches a gold lease. At the time of writing, 12-month USD LIBOR shows at 1.949%. The gold 12-month forward rate is roughly the same, implying the lease rate is zero. Clearly, with gold lease rates reflecting no time preference for gold, its supply into wholesale markets is being severely restricted. Look at it from a central bank’s point of view: if a lease is coming due, there is no incentive to renew it, particularly given the unquantifiable counterparty and systemic risks that may arise in the current global economic climate. We can conclude that the basis for highly geared interest rate arbitrage by borrowing gold is running into a brick wall. Not only is there no incentive for lessors but also there is also a diminishing appetite for lessees, because the opportunities are vanishing. Synthetic gold liabilities are being gradually reduced, not only by ceasing the creation of new obligations, but by buying bullion to cover existing ones. This will have been particularly the case when the USD yield curve began to invert in recent months (itself a backwardation of time preference), and was the surface reason, therefore, that the gold price moved rapidly from under $1200 to over $1500. Bullion banks are now faced with the prospect that the Fed will reduce interest rates to zero again, even without a systemic crisis such as Lehman. Traders, who are not often deeply analytical, will almost certainly link gold’s move in the wake of the Lehman crisis, once dollar liquidity concerns subsided, from under $750 to over $1900, with dollar rates being suppressed at the zero bound. If rates return there and LIBOR remains positive, that will be a reflection of systemic risk, not time preference. Meanwhile, gold’s time preference will almost certainly be increasing as markets attempt to discount a new wave of base money expansion when the Fed attempts to stabilise the US economy and manage government finances. Bullion bank traders can see therefore, the day has arrived when gold’s time preference exceeds that of the dollar by an increasing margin. Furthermore, there is the growing threat of negative dollar rates, as economic conditions deteriorate. Putting other considerations aside, the switch in time preferences suggests a bullion bank’s future trading strategy should be the polar opposite of their current position. Instead of holding a small stock of gold to finance a large dollar position, logically they should maintain a small reserve of dollars to finance a larger position in physical gold. It is for this reason that not only is the gold price rising, but is likely to continue to rise, appearing to defy all expectations.It is impossible to quantify the extent to which the gold price will rise as the bullion banks scramble to unwind or even reverse their habitual short positions, but if there is a surprise it is likely to be on the upside. The consequences As well as being modified by its specific supply and demand conditions, Gold’s time preference is essentially for its moneyness, represented by its use as a medium of exchange and store of value. The moneyness aspect links it to its exchange value for all commodities, and it is this aspect of gold’s qualities that should warn us that a backwardation in gold, emanating from negative dollar interest rates, will herald a general backwardation in commodities as well. We must not forget that markets anticipate events where they can, so with a recession threatening to turn into a slump and with a looming credit crisis in the wings the prospect of negative rates will be increasingly priced into the relationship between commodities and fiat dollars. Assuming economic prospects darken because of the coincidence of American tariffs and the emerging crisis stage of the credit cycle, it will be check-mate for central banks. They were never appointed nor are they technically equipped to save the currency at the expense of widespread bankruptcies, not just in the private sector, but of their governments as well. And that is what markets will be faced with. The current situation has striking similarities with the 1930s, and the prospects for the global economy are driven by the same broad factors. With the gold standard then and not now the price effects are already showing differences. Nor was there a bubble of hundreds of trillions of outstanding derivatives then as there are today. This time, the monetary sins since the ending of the Bretton Woods agreement seem set to come home to roost all of a sudden, even if dollar rates are lowered towards zero and only stay there. But if they go negative and the more below zero that they go, the greater the backwardation on the whole commodity complex. The more rapidly commodities will be bought so the dollar, taxed with negative rates can be sold, and the quicker market actors will devalue the currency. With all other fiat currencies referenced to the dollar, it will mark the start of a process that is likely to collapse the entire fiat currency system. Bullion banks which are too slow to recognise the change and have not shut down their gold obligations will be forced to steal their customers allocated gold, or go to the wall, adding to the disruption. All commodity derivatives will face a period of rapid contraction of open interest, in lockstep or one pace behind those of gold. Instead of central banks stabilising the system by monetary easing, the easing itself will guarantee the crisis. The development of a problem in gold markets, driving the gold price rapidly higher while some banks are caught napping, is likely to anticipate a wider financial and systemic crisis. Therefore, with gold’s sudden move higher coupled with its persistent strength we can reasonably certain that we are seeing the start of the dismantling of the dollar-based monetary system, and that gold has much further to go.
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