March 19, 2015 Could Negative Rates Be On The Way To America? By Ric Panzera First Financial Equity Corporation, Member FINRA/SIPC Ask people on the street what caused “The Great Depression” in 1929 and most likely you’ll hear an answer like: “Well, the stock market collapsed.” While that statement is true, I believe the stock market may have been reacting then to what it foresaw in the near future, i.e., a rapidly slowing US and world economy. Arguably our nation’s economy never fully recovered until World War II. I believe the seeds for the Great Depression were sowed some years earlier in another depression in 1920-1921. In his recent book The Forgotten Depression (1921: The Crash That Cured Itself) author James Grant (founder of the eponymous Grant’s Interest Rate Observer) lays forth his overview of this bleak period in the American economy’s history. After World War I, the economies most of the world were in severe recession. A deflationary wave swept over the world. “No stock-market crash announced bad times. The depression rather made its presence felt with the serial crashes of dozens of commodity markets.”1 Grant’s thesis in the book was that this was the last depression in America that was left “untreated” by the Federal Reserve and it ended in little more than a year. Also in the 1920’s and 1930’s there were a number of currency devaluations, best described by Hoisington Investment Management Company’s Quarterly Review and Outlook, Fourth Quarter 2014.2 “In the aftermath of the French devaluation (1926), between late 1927 and mid-1929, economic conditions began to deteriorate in other countries. Australia, which had become extremely indebted during the 1920s, exhibited increasingly serious economic problems by late 1927. Similar signs of economic distress shortly appeared in the Dutch East Indies (now Indonesia), Finland, Brazil, Poland, Canada and Argentina. By the James Grant, The Forgotten Depression (1921: The Crash That Cured Itself), November, 2014, Simon & Schuster, p. 99 2 Hoisington Investment Management Company, Quarterly Review and Outlook, Fourth Quarter 2014 (http://www.hoisingtonmgt.com/) 1 fall of 1929, economic conditions had begun to erode in the United States, and the stock market crashed in late October. Additionally, in 1929 Uruguay, Argentina and Brazil devalued their currencies and left the gold standard. Australia, New Zealand and Venezuela followed in 1930. Throughout the turmoil of the late 1920s and early 1930s, the U.S. stayed on the gold standard. As a result, the dollar’s value was rising, and the trade account was serving to depress economic activity and transmit deflationary forces from the global economy into the United States. By 1930 the pain in the U.S. had become so great that a de facto devaluation of the dollar occurred in the form of the Smoot-Hawley Tariff of 1930, even as the United States remained on the gold standard. By shrinking imports to the U.S., this tariff had the same effect as the earlier currency devaluations. Over this period, other countries raised tariffs and/or imposed import quotas. This is effectively equivalent to currency depreciation. These events had consequences. In 1931, 17 countries left the gold standard and/or substantially devalued their currencies. The most important of these was the United Kingdom (September 19, 1931). Germany did not devalue, but they did default on their debt and they imposed severe currency controls, both of which served to contract imports while impairing the finances of other countries. The German action was undeniably more harmful than if they had devalued significantly. In 1932 and early 1933, eleven more countries followed. From April 1933 to January 1934, the U.S. finally devalued the dollar by 59%. This, along with a reversal of the inventory cycle, led to a recovery of the U.S. economy but at the expense of trade losses and less economic growth for others. One of the first casualties of this action was China. China, on a silver standard, was forced to exit that link in September 1934, which resulted in a sharp depreciation of the Yuan. Then in March 1935, Belgium, a member of the gold bloc countries, devalued. In 1936, France, due to massive trade deficits and a large gold outflow, was forced to once again devalue the franc. This was a tough blow for the French because of the draconian anti-growth measures they had taken to support their currency. Later that year, Italy, another gold bloc member, devalued the gold content of the lira by the identical amount of the U.S. devaluation. Benito Mussolini’s long forgotten finance minister said that the U.S. devaluation was economic warfare. This was a highly accurate statement. By late 1936, Holland and Switzerland, also members of the gold bloc, had devalued. Those were just as bitter since the Dutch and Swiss used strong antigrowth measures to try to reverse trade deficits and the resultant gold outflow. The process came to an end, when Germany invaded Poland in September 1939, as WWII began.” To be sure, times are different today in America. In 1920, America was a powerhouse in agriculture and industry. Our economy is much different today, but we are much more interconnected with the world’s economies. But note that global commodity prices have been in a serious correction since 2011, just like they were in the period from 1919 to 1921. And currencies are being “revalued” against the dollar, just as they were in the late 1920’s and early 1930’s. As you can see in the above charts, the value of the dollar is increasing while the other currencies of the world are dropping along with commodity prices. “Two economists who warned of a looming credit crunch in 2007 are now warning about the onset of competitive devaluations driven by central bank policies. Before Davos, William White, a senior OECD official and a former chief economist to the Bank for International Settlements (BIS), told the Daily Telegraph: “We’re seeing true currency wars and everybody is doing it, and I have no idea where this is going to end.” In the Guardian before Christmas, Nouriel Roubini, the economist known as Dr Doom for his prescient predictions of calamity, warned that while it was possible for one or two small nations to quietly devalue, a look around the world revealed almost every country devaluing against the dollar and each other.”3 What does this mean for you? It means that money was and is flooding into the US to purchase US Securities. David Kotok of Cumberland Advisors put it succinctly: “Think about future decision-making in sovereign debt allocation jurisdictions outside of the G7. Put yourself in charge of the sovereign wealth fund in a Caribbean nation, the Persian Gulf, or an Asian country. You have an allocation to high-grade government debt. No matter how large or small it is, it is large in terms of presence. A piece of your total fund will be in the highest-credit-quality sovereign debt. In Europe, you will favor Germany but will not go near a credit like Greece. You will also favor the Japanese yen, the US dollar, and the British pound. When you have to select among them, where will you apply your heaviest weight? You’ll overweight the US dollar and holdings of US government obligations at the expense of all others.”4 Now that we have identified the trend, where will it end? Paul Kupiec recently penned this in the Wall Street Journal: “Banks are now charging their big institutional customers to keep money on deposit—and these so-called negative interest rated are forcing liquidity out of the banking system. The irony is that this is the result of post crisis financial regulations that are supposed to ensure that banks remain liquid. J. P. Morgan Chase recently announced it may charge institutional accounts as much as 5.5% on certain deposits, in an effort to push as much as $100 billion out the door. Other U.S. banks already charge institutions negative interest rates to hold euro deposits.”5 If you were the treasurer of a company in Europe and looking at the chart below, what would you do with your company’s money? 3 “Devaluation And Discord As The World’s Currencies Quietly Go To War”, The Guardian [UK], Jan 24, 2015 (http://www.theguardian.com/business/2015/jan/25/devaluationdiscord-currencies-war-quantitative-easing) 4 David Kotok, Cumberland Advisors, “NIRP, ZIRP, PIRP & Paris”, http://www.cumber.com/commentary.aspx?file=031015.asp Paul H. Kupiec, “Negative Interest Rates Threaten The Banking System,” Wall Street Journal, March 6, 2015, http://www.wsj.com/articles/paul-h-kupiec-negative-interest-ratesthreaten-the-banking-system-1425600889 5 By the way, while German bund yields at the 10 year maturity still have a plus sign in front of them, anything shorter than 7 years has a minus sign. Do you have a game plan to deal with negative rates for your entity’s funds? If you don’t, may I respectfully submit that it might be a good time to start thinking about one instead of waiting for the banker’s (or the pool’s) call. What will you tell your City Council, Board or Commissioners? I would be happy to have a discussion with you about some possible alternatives that are legal investments for public entities in Texas. Best Regards, Ric A. R. (Ric) Panzera Senior Vice President-Investments Corporate & Institutional Services ERISA 408(g) Certified Fiduciary Advisor First Financial Equity Corporation Member FINRA and SIPC 5005 LBJ Freeway, Suite 1410 Dallas, Texas 75244 214.545-3322 direct 214.505.0884 cell [email protected] e-mail P.S. The finest compliment we can ever receive is a referral from our clients and friends. Thank you.
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