The “R” Word Is Rearing Its Ugly Head
It’s here, or at least nearly here. “It,” in this case, is another recession.
We can debate the causes – an escalating trade war between the US and China, too much dodgy debt, the end of the longest bull market in history, or perhaps all three.
But all the economic indicators tell us the recession we’ve anticipated for so long is finally here:
The most obvious consequence of a recession is increased stock market volatility. We’ve seen a lot of that lately, with the Dow Jones Industrials index falling nearly 3% on August 5.
A less visible, but equally important result of a recession will be a big fall-off in the value of bonds rated BBB-. If a sizable chunk of that $3 trillion market is downgraded to junk status, institutional investors like pension funds that are legally required to hold only investment-grade bonds will have to sell their holdings all at once. That rush to the exits could lead to enormous losses, which could happen in a matter of hours.
We’ll also see further interest rates cuts by the Federal Reserve and other central banks. On July 31, the Fed cut short-term rates by 0.25%. But investors anticipate much larger cuts. Indeed, the prices for bond futures indicate traders have priced in an additional 0.25% rate cut the next time the Fed’s Board of Governors meets.
As the world’s largest economy, the US doesn’t exist in a vacuum. And one innovation we witnessed in the last recession was that central banks started imposing negative interest rates. The European Central Bank has had negative interest rates in effect since June 2014. These rates apply to the “deposit facility rate,” which is the rate on “excess reserves” banks maintain at the ECB. If you’re a bank in the eurozone, your “reserves” gradually dwindle in value if you don’t lend them out. For instance, after one year at a -0.1% rate, €1 million of your reserves would only be worth €999,000.
The Danish and Swiss national banks went even further, with negative interest rates as low as -0.75%. After a year, 1 million Danish krone or Swiss francs would be worth only DKK/CHF992,500.
Today, 17 countries in the eurozone have negative interest rates at -0.4% on central bank deposits. At least 11 countries now have yields on their 10-year Treasury debt, including Germany, Europe’s largest economy. In at least one country (Denmark), homeowners can take out negative interest rate mortgages.
While bond yields in the US remain positive, if the Fed cuts rates low enough, they could easily become negative. That’s especially true if the Fed resumes creating money out of thin air and injecting it directly into the economy through the process of quantitative easing (QE). In a QE scenario, a central bank buys government bonds or other financial assets. In the last recession, the Fed purchased about $4.25 trillion of Treasury securities and mortgage-backed securities to prop up the economy.
I get dizzy when I think about paying someone for the privilege of holding my money, but there’s an easy, albeit inconvenient, way to deal with the problem. And that’s to hold assets in cash. After all, 100 Swiss francs in a floor safe will still be worth CHF100 in 12 months, not CHF99.25.
Banks and governments don’t like that option one bit. In 2015, Citigroup Chief Economist Willem Buiter proposed abolishing cash to allow banks to impose negative interest rates. He suggested negative interest rates as low as -6.0% be imposed in financial crises to force banks to lend and consumers to spend.
That hasn’t happened in the US, but other countries are trying desperately to prevent their citizens from holding large quantities of cash.
Similar restrictions are in place in Belgium, Bulgaria, Greece, Mexico, Russia, Uruguay, and a handful of other countries.
Naturally, restrictions on cash transactions are justified by the need to fight “tax evasion” and “terrorism.” But I think the real reason is to force savers to help prop up the tottering banking system. And don’t forget that the global “bail-in” model applies to these deposits. If a bank goes bust, depositors must share in the losses, as I discussed in this essay.
Will these extraordinary efforts stave off a recession and reflate the economy? I doubt it, if the last recession is an indicator. In the US, Japan, the UK, and the eurozone, interest rates actually fell as governments debt rose. That’s not what’s supposed to happen; the traditional economic view is that big deficits inevitably lead to inflation.
But why not? One reason is that the levels of debt are now so high that additional debt won’t have a stimulating effect. And make no mistake: global debt levels are at nosebleed levels and increasing fast. At the end of the first quarter of this year, global debt rose to $246.5 trillion, nearly 320% of global economic output.
And as the impact of debt falls, it slows down the velocity of money – a measure of how quickly money passes from one person or company to another. The fact is, in a recession, there’s a lower demand for money to borrow. That leads to lower velocity, and by extension, lower interest rates. Indeed, the velocity of money has fallen by one-third since 1998.
Simply put, it’s time to get defensive. Here are some measures to consider:
My larger concern, though, is that a bear market could turn into a systemic financial collapse. This is the term economists use for the collapse of an entire financial system. In that event, a loss in the value of your portfolio will be the least of your concerns. A more pressing issue could be that someone else has a superior claim to the assets you thought you owned.
For instance, you don’t own the assets in your bank account. The bank does. You have only a debt claim on those assets. Your legal status becomes that of an unsecured creditor holding an IOU. If the bank fails, and deposit insurance doesn’t pay up, you’re left holding the bag.
The only way to defend yourself from systemic risk is to make sure your assets are held by the safest and most liquid brokers or banks and to use strategies that put you at the front of the creditor line if they do fail.
I discussed these strategies recently in a three-part series of articles I shared with members of our Nestmann Inner Circle (NIC). To try a risk-free subscription the NIC and learn more ways to protect yourself from the next financial crisis, click here.
Protecting your assets (and yourself) against any threat - from the government, the IRS or a frivolous lawsuit - is something The Nestmann Group has helped more than 15,000 Americans do over the last 30 years.
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