SNB sign

The Swiss Franc Will Collapse

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.

Swiss Yield Curve Jan23

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%.

Swiss 10-year history

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.


100% of Mainstream Interest Rate Theory is Wrong

An interesting article on MarketWatch today caught my attention. The subhead is the money quote, “Back in April every economist in a survey thought yields would rise. Guess what they did next.”

Every? The article refers to 67 economists polled by Bloomberg, all of whom would seem to believe in the quantity theory of money. This means they believe a rising money supply causes rising prices. That means they think the bond market expects inflation. Which means they expect the interest rate to rise, because investors will somehow demand more.

It didn’t happen because every assumption in that chain is false.

Many people also expect interest rates to rise after the Fed’s bond buying program—quantitative easing—ends. Let’s take a look at the yield on the 10-year US Treasury bond from 1981 through today. This graph is courtesy of Yahoo Finance, though I have labeled it as carefully as I could for the three rounds of QE so far.


By zooming out to capture the entire time period of the bull market in bonds—i.e. the period of the falling interest rate—we can put QE in perspective.

The 10-year US Treasury bond now yields 2.21%. For reference, the 10-year German bund is 0.87% and the 10-year Japanese government bond is 0.48%.

It’s obvious from the chart, that QE is not the cause of today’s interest rate near 2%.

MarketWatch implicitly acknowledges that the conventional theory is 100% wrong. I have published an alternative, The Theory of Interest and Prices in a Paper Currency. It’s a long read in seven parts, but I have tried to keep it accessible to the layman.

Spoiler alert: I think interest rates will keep falling to zero, though of course there can be corrections.

The interest rate is pathological. It’s like an object that gets too close to a black hole. Once it falls below the event horizon, then a crash into the singularity of zero is inevitable.


You are cordially invited to The Gold Standard: Both Good and Necessary, in New York on Nov 1. There hasn’t been a real recovery from the crisis of 2008, and there won’t be until we return to the use of gold as money. Please come to this event to hear Andy Bernstein present the moral case for capitalism, and Keith Weiner present the case for the gold standard as the monetary system of capitalism.

A Monetary Cancer Metastasizes in Europe

The European Central Bank again cut the interest rates it controls. Notably, the deposit rate was moved deeper into negative territory. It is now -0.2% (minus 20 basis points, that is not a typo). The ECB says it’s trying to nudge prices higher, but it’s actually feeding the cancer of falling interest.

The linked article above, like most, is focused on the quantity of euros and the presumed direct relationship to price. The following bit of editorializing from that article is uncontroversial in Frankfurt, London, New York, Mumbai, or Shanghai.

“Inflation weakened to a five-year low in August, just 0.3% in annual terms. That is far below the ECB’s target of a little under 2% over the medium term, raising fears that the region could face a debilitating stretch of weak or falling prices that hampers debt-financing and investment. Those fears intensified as market-based measures of inflation expectations weakened, too.”

Every assumption in this short paragraph is wrong. One, inflation should not be conceived as rising prices. There are many reasons for prices to rise or fall that have nothing to do with the currency. For example, every business is constantly working to cut costs. Without monetary debasement, and a steady stream of onerous new regulations, prices would be falling.

Two, inflation is monetary counterfeiting. Inflation is the fraud of selling a bond into the market, when the debtor lacks the means or intent to repay. The deadly danger is that it seems good to creditors who buy it, often using leverage. Eventually, every fraudulent debt will default.

Three, central banks keep trying to engineer rising prices, in the name of some sort of good, like Stalin and his Five Year Plans. The economic theory that demands this is frivolous at best. There is no there, there. This does not stop the central planners from trying their worst anyway.

Four, it should be obvious by now that central banks do not have control over prices. If they did, we would not still be struggling with prices that stubbornly refuse to rise. How many times has the ECB tried to get prices to rise since the last acute phase of the monetary crisis?

Five, falling prices do not hamper financing or investment. Look at the massive investment in first electronics, then computers, then computer networking, and most recently communications. Prices have been falling, for a long time and by a large amount even in nominal dollars.

Finally, we must distinguish between the prices of consumer goods and the prices of assets that are bought with leverage. The latter is a threat to those who borrow short-term to finance long-term assets. For example, when a real estate developer sells 3-year bonds to buy a large commercial building. Since the developer can’t amortize the debt in three years, it will roll its liabilities—sell new bonds to pay off the old ones. This is a form of counterfeit credit. One way to get in trouble is if the market value of the property falls. Then the bonds cannot be rolled.

These are some of the errors in the conventional, quantity analysis approach. It’s the wrong approach, though it seems intuitive. Suppose we think about wheat. We consider if we had ten huge bags of grain how would we feel if a truck pulled up to attempt to deliver the 11th. Or if we had a basement full of copper bars and contemplated buying more. No one wants to bury himself under a hoard of useless stuff.

Money is not like any commodity. No matter how much money we have, the thought of receiving a big check in the mail is exciting. We don’t think we have too much money already. Even the most die-hard gold bug, is eager to sell you his newsletter in exchange for dollars. No one rolls his eyes or sighs at the prospect of making more money.

We cannot assume that a rise in the money supply translates into a rise in prices. It might or might not. However, there is a danger in focusing too much on prices, and missing the terminal monetary problem. Imagine a doctor obsessing over a patient’s body temperature. He could easily miss the signs of cancer.

I saw a different approach in an article this week. The author suggests that rates on government bonds are now negative, because investors trust they will get their money back. Presumably, this school of thought regards the US government as less trustworthy because the Treasury bond pays a higher yield. This approach is also wrong.

Let’s take a look at the yield curve in Germany.

bund yield curve

There is a reason why the yield on government bonds in Europe is falling to zero and below. Banks have a choice to hold cash or government bonds, with the main factor being liquidity. However, when the ECB lowers the deposit rate for bank cash to below zero, this changes the incentive. The lower the yield on cash, the more the banks will tend to prefer bonds.

I am no European political expert, but perhaps this is the intent of the ECB. Perhaps they would simply like to buy more government bonds, but cannot or dare not due to treaty, law, or politics. But they clearly have the power to create incentives for banks to do it.

The right approach to understanding what’s happening in the euro begins with the observation that a paper currency like the euro is a closed loop system. You may think that you can protest a negative interest rate by getting out of the currency. For example, you can buy antique Ferraris, paintings, real estate, stocks, a foreign currency, or even gold. This may protect you personally, but it does not alter the trajectory of the interest rate.

The former owner of the asset is now the owner of those euros. What will he do with them? Deposit them in a bank. What will the bank do? Buy a bond. At one time, all roads led to Rome. Today, all monetary roads lead to the government bond that backs the currency.

We are all disenfranchised by the regime of irredeemable money. The central bank may have some control. Or, as I argue in my theory of interest and prices, they have little control but set up a positive feedback loop that drives interest to zero. However, the people have no control. The rate has been falling for decades, pushed down by massive forces beyond even the control of central banks. The price of the bond, and hence the interest rate, is set free from constraint.

Consider for a moment, the price of wheat. If the price falls below the cost of growing, then farmers stop planting it. Alternatively, if the price rises above that of other starches, then manufacturers will stop buying wheat. The cost of wheat and every other real thing is dependent on the price of oil, machinery, labor, and many other inputs, it is tied to everything else in the economy.

By contrast, the bond price in a paper currency is not tied to anything. It could collapse and give us an interest rate of 17%. Or it could have a 33-year bull market, and give us an interest rate below 1% (the bond price is inverse to the yield). The rate can keep falling.

There is a cancer metastasizing in the body economic. Zero interest is creeping out from the short-term credit facilities provided by central banks. In Germany, it is now out to the 4-year bonds. Zero interest on overnight deposits is like gangrene in your fingernail. When it hits the 1-year bond, it is spreading to your whole finger. The 2-year bond is like the lower part of the hand. The German 3-year bund now has a negative yield. The all but zero-yield on the 4-year bond is like rot moving up towards your elbow.

What will they do when necrosis spreads up to the shoulder and beyond?

We need a new concept to understand the nature of the problem. The burden of debt is a measure of the pressure on debtors. The net present value of a stream of future payments depends on the interest rate. This is not just the interest rate at the time the asset was purchased. The present value should be recalculated whenever the interest rate changes. Each time the interest rate falls the net present value rises.

This seems good for the bond speculator, who gets a capital gain. However, this is a zero-sum game. His gain comes at the expense of the bond issuer. The bond issuer feels an increase in his burden of debt as rates fall. With each halving of the rate of interest the burden doubles. Of course, the falling rate is also an incentive to borrow more, because the monthly payment is lower. Debtors owe more euros of debt, and the burden of each euro owed is doubling. Here is a graph of the history of the German 10-year bund, a reasonable way to measure burden of debt.

ten yr bunds

In June of 2008, the 10-year bund yielded 4.5%. This is labeled point 1. By August of 2010, point 2, the rate was cut in half to 2.25%. The burden of every debt in Germany—and arguably Europe—doubled. In July of this year, it was lopped in half again to just about 1.13%, at point 3. Now it is 0.94 and well on its way to the next milestone of 0.56%. Not coincidentally, Japan is already there.

This burden of debt is one of the most important concepts, because the entire basis of the system is debt. One man’s debt is another’s asset. The ultimate asset is the debt of the government. If debtors begin to default in earnest and if one default causes others in a cascade, then the system can collapse like dominoes.

The analogy of dominoes is apt because creditors are themselves debtors. They are typically leveraged, so a small loss can cause insolvency.

The financial system must collapse—necessarily so—when the interest on the long bond hits zero. Debtors cannot hold up an infinite burden of debt, and that is what a zero long-term rate means.

Consumer prices in Europe may continue to eke out small gains, especially as the carry trade begins to press down the value of the euro compared to the dollar. Or prices may begin to fall, perhaps slowly.

Either way, who cares? The patient’s arm is turning black.


The Gold Standard Institute Presents The Gold Standard: Both Good and Necessary, in Manhattan on Nov 1. You are cordially invited to join us for a discussion of ideas you won’t get anywhere else. The gold standard is the monetary system of the free market—of capitalism. Dr. Andy Bernstein, a rock star of the liberty movement, shows why capitalism is good. In my talk, I explain why capitalism is impossible with fiat money, and why we have not recovered from 2008, and we won’t without gold.

The Federal Reserve – A Study In Fraud

Guest Post: By Monty Pelerin

In a previous article entitled “Government: ‘A Seedy Circus … Perpetually In Debt’,” government was likened to Larsen E. Whipsnade, the character played by the one-of-a-kind W. C. Fields in the 1939 movie “You Can’t Cheat An Honest Man.” Characterizing Leviathan government as an individual, even one as large as Whipsnade,  was a stretch. Fields’ fans objected because he was reasonably harmless, likeable and entertaining, certainly not adjectives one would apply to our modern-day State.

Ben Bernanke as Larsen E. Whipsnade

If comparing government to Fields’ character is improper, then why not compare individuals in that institution to Whipsnade. Surely there is no shortage of characters (clowns?) that could qualify as circus employees. The commonality between the Fields’ character and most high government officials is that both are out to dupe the people.

Barack Obama doesn’t make the cut, only because he is unlikeable and a genuine fool rather than pretending. Jay Carney is bumbling enough, but only haplessly acting on the orders of others. Eric Holder is too unlikeable and probably too devious to be a carnival barker. His aspirations could not be satisfied in small circus towns. Additionally he is too easy to see through. Timmy Geithner might have qualified, but he’s gone now.That leaves Ben Bernanke.

Mr. Bernanke fits the role quite nicely. He is bumbling, likeable and reasonably harmless, at least as a person. He seems a victim of circumstances, a man out of his comfort zone. But his clinching qualification is his modus operandi which is identical to that of a “carnie.” [For those unfamiliar with the term “carnie,” Wikipedia defines it as follows: “Carny or carnie is a slang term used in North America and, with showie, in Australia for a carnival (funfair) employee, and the language they use, who runs a “joint” (booth), “grab joint” (food stand), game, or ride at a carnival, boardwalk or amusement park.”]

Like a carnie, everything Mr. Bernanke says and does is aimed at deception. A modern day Federal Reserve Chairman must be like a carnie. The primary difference between a carnie and a Fed Chairman is the veneer of sophistication and false omniscience. Gary Dorsch contrasts what the Fed used to do with what it has become:

 It all seems so surreal. After being mesmerized by the Fed’s hallucinogenic “Quantitative Easing,” (QE) drug, and seduced by the Fed’s Zero Interest Rate Policy (ZIRP), and rescued by the Fed’s clandestine intervention in the stock index futures market, for the past 4-½-years, it’s easy to forget that there was once a time when the Fed’s main policy tool was simply adjusting the federal funds rate. It’s even harder to recall that two decades ago, the Fed’s raison d’être was combating inflation, whereas today, the Fed’s main mission is rigging the stock market, and inflating the fortunes of the wealthiest 10% of Americans.

To be Fed Chairman these days, you must be adept at charlatanism.

Like the Wizard of Oz, you must pretend you are in control of things that no one possibly can control. You must, as the Platters sung, be “The Great Pretender.” You must pretend that you know the future and can overcome it if it is not promising.

An entire industry has developed devoted to interpreting Fedspeak. Nothing the Fed says is definitive, despite being said in serious tone. The reason for that is the Fed has no better idea of what is happening in the economy than you or me. All of their messages contain wiggle-words so that they can backtrack without being declared in error. When you don’t know what to say, you say nothing but in a way that it can mean anything.

The pretense of confidence and control are your primary strategic tools, as is the ability to maintain these pretensions despite a series of embarrassing forecasts. Your operating tools — quantitative easing, ZIRP and various market interventions — are all carnie tools, designed to deceive people into doing things they otherwise wouldn’t and shouldn’t.

The Great Coordinating Mechanism

The Fed’s role today is to distort prices, a fraud on the grandest scale. Free markets and free prices are the guidance system that produce the marvelous results that Adam Smith described as an “invisible hand.” Prices encourage cooperation and harmony. They provide guides for tens of millions of economic actors. They signal when to conserve and when to splurge. Prices direct scarce resources to their best uses. They influence career choices. Prices literally provide the signals by which we lead every aspect of our lives. Every decision we make, including the emotional ones such as children, love and marriage, are influenced by prices (see Gary Becker among others).

The modern-day role of the Fed is to distort these prices, effectively to disrupt the economy’s guidance system. The purpose is to fool you into making improper decisions. This deception threatens social harmony and individual well-being. Distorting prices, especially systematically, is the equivalent of drugging a person and then having him make major life or financial decisions. Drugs and price distortions have the same effect on decision-making — the mind is unable to properly receive and process information.

Ben Bernanke is on record hoping to manipulate the following three prices:

  • Interest Rates
  • Housing Prices
  • Financial Assets

Blatant Fraud

Mr. Bernanke deliberately suppresses interest rates in order to raise home prices and stock prices. His stated purpose is to create a “wealth effect.” When people feel wealthier, it is thought they borrow and spend more. Mr. Bernanke’s program is pure deception. It is designed to produce a false and fictitious sense of security (wealth). His policies are the same as those that caused the original bubbles. They will produce another dramatic collapse. Deliberate fraud is being imposed on the American public. The fraud will ultimately end in tragedy and great personal suffering.

The rest of the government supports Bernanke’s scheme by issuing false economic statistics and claims of economic recovery. There is no recovery; nor will there be one until the massive misallocations of resources resulting from the price manipulations are corrected. That cannot happen without a massive recession/depression. As expressed by Zerohedge:

…the American economy faces a long twilight of no growth, rising taxes, and brutally intensifying fiscal conflict. These are the wages of five decades of Keynesian sin – the price of abandoning financial discipline.

That is the most optimistic case. A depression is both necessary, and probably inevitable, to break the legacy of decline that Keynesian economics has created. All government agencies act in concert to postpone this event, ensuring greater calamity when it eventually occurs.

The use of the term “fraud” is no overstatement. Fraud, in a legal sense, is defined in strict terms:

Fraud must be proved by showing that the defendant’s actions involved five separate elements: (1) a false statement of a material fact, (2) knowledge on the part of the defendant that the statement is untrue, (3) intent on the part of the defendant to deceive the alleged victim, (4) justifiable reliance by the alleged victim on the statement, and (5) injury to the alleged victim as a result.

Which one of these conditions does not fit Fed behavior? My opinion is that they meet every condition.

If a private company or individual engaged in similar actions regarding the price or misrepresentation of a single product, fines and jail sentences would be sought. The Fed, however, engages in fraud with impunity. They are encouraged to do so by the political class. Bernie Madoff appears ethical in comparison with government and its agencies. The Fed gets to call their deliberate fraud “economic policy.”  Government supports the fraud by claiming that an economic recovery is underway.

Markets are arguably the greatest “invention” of mankind. They enable social cooperation and harmony while allowing maximum increases in living standards. Markets are the very foundation of modern civilization, allowing many billions of people to survive on our planet. Distorting markets is no small matter. Doing so literally threatens peace and economic well-being.

The Fed’s behavior of distorting prices is deliberate dishonesty calculated for government advantage. The policy is designed to deceive others to behave in a manner which is ultimately harmful to these individuals. It is outright fraud!

Concluding Remarks

In hindsight, apologies are in order. There was no need to insult “carnies” by comparing them to government. Bernie Madoff’s crimes should not be compared to those of the government. He was a small fry and he could not force people to participate in his Ponzi scheme. Government is in a class by itself. The Mafia, in comparison, looks like Mother Theresa.

A government that can only survive via fraud has reached the desperate stage. It can create great harm in its death throes but its survival is unlikely.

The Quantitative Beatings will Continue Until Economy Improves

The Fed’s purpose, when it comes down to it, is to buy bonds. Under their various “Quantitative Easing” (QE) programs, they sure have bought a lot of bonds. This pushes up the price of the bonds. Since the yield is basically the inverse of the bond price, this means the rate of interest falls.

This month, on rumors that QE will be tapered off and despite continued Fed bond buying, the yield on the 10-year Treasury bond has spiked from 1.63% to 2.12%. Will this be the end of the bull market in bonds and the start of rising interest rates in the US in earnest? I rather doubt it, as all of the dynamics that have created this bull market are still in place. And as the other bond markets of the world experience greater trouble (such as Japan today), capital will come pouring into the dollar and the Treasury.


It has been quite a bull market in bonds. Here is a chart of the yield on the 10-year Treasury.


The recent blip is hardly noticeable on this chart, which shows the fall from 16%.

This is all good, right? It’s a bull market, so people are making money. The cost of borrowing to finance a new business is near its all-time low. The deficit to GDP ratio is kept in check by low interest payments too, as any Keynesian will tell you.

Not quite.

In the spirit of the boy who said, “The emperor has no clothes,” let’s ask a question. Where do the profits of the bond speculators come from? Who is on the other side of the trade? Who sold the bond short?

The borrower, who sold the bond, incurs a capital loss as the bond speculator gets his gain. Changes in the bond price are zero-sum: one side loses and one side gains. While they can borrow more money at a cheaper rate tomorrow, they can never make up the loss on the money borrowed at a higher rate yesterday. Their burden of debt rises as the rate of interest falls.

How does this manifest in the economy? A competitor can enter the business more easily. If the interest rate is lower, that means he can borrow the same amount of money and have a lower monthly payment. Or he can borrow more and have the same payment. Either way, he has a sustainable competitive advantage over the established business. If the rate falls again, then another new competitor can enter the market. The established business is pushed into bankruptcy, the first new competitor is on the ropes, and the newest is doing well. That is, until the next decline in the rate. The penalty for borrowing at a too-high rate is harsh.

This is certainly not good for the economy. To the extent that new money goes into the productive sector at all, it may be used to cannibalize existing businesses. The old debt is defaulted, and net debt increases slightly as the new loan is bigger than the old one. Churn is not real activity.

Even more pernicious, our endless non-recovery is not in spite of the Fed’s effort, but because of it. The interest rate is not exclusive to just one business. It is universal, applying to the whole market. Every business can borrow at the prevailing rate. When will they borrow? To oversimplify slightly, they will borrow when they see an opportunity with a net profit greater than the interest rate. This will push down the rate of profit of their market. The actions of a myriad of other businesses will push down the rate of profit in every market.

Let’s pause to consider this for a moment. The rate of interest is falling. This invites businesses to incur more debt. At the same time, their opportunities to profitably deploy the borrowed money are declining due to the very reason of falling interest rates.

The falling interest rate not only sucks capital off their balance sheet and threatens them with death by competitors who wait for a lower rate, but it encourages more leverage and makes them more fragile by lowering their profit margin. Who in their right mind would go deeper into debt for a reduced profit and a longer time to amortize the debt?

The Fed can no more improve the economy by buying bonds than a boss can improve morale by punishing employees. Their low interest rate forces the economy down into the mud and keeps it pinned. The Fed purportedly helps stabilize the economy compared to the gold standard, but it really achieves the exact opposite.

The chief virtue of the gold standard is that it keeps the rate of interest stable. Look at this long-term chart that goes back to 1790. There are spikes due to wars and policy blunders, but it is striking how stable it was prior to 1913 especially in comparison to the era of the Fed.

Interest Long Term

Today, the saver is disenfranchised. If he does not like the rate of interest, he can complain, but there is not much he can do, short of speculating on commodities or stocks. According to many sources I read, pension funds are becoming more underfunded. Why? It is because the net present value of the payout they must make to retirees is rising (as a mathematical function of lower interest), while their ability to earn a yield is falling.

Under gold, if the saver did not like the rate of interest he could sell the bond and take home the gold coin. His preference sets the floor under the rate of interest. No yield, no lending. No lending, no bonds can be sold. So the rate was forced higher. (There was also a ceiling, but the mechanism is only of academic interest today with falling rates.)

Stable rates preserved the saver’s ability to earn a yield, and also protected the capital of borrowers.

How do savers today expect their money to work for them so they can retire comfortably? Those with a defined-benefit pension plan don’t worry about it; they have outsourced the problem of finding a yield to third party money managers behind an opaque structure. As I noted above, most are badly underfunded and the prognosis is that underfunding will become worse.

Everyone else has a choice of believing in one or another myth. The first myth is that everyone can become a great trader, who is nimble, quick, and has superior and timely information. Burt Malkiel wrote a book called A Random Walk Down Wall Street, which debunks this notion. The average investor will not beat the market average. Net of costs and fees, he underperforms.

The other myth is that stocks and other assets will go up and up without limit. So one simply must buy and hold. Then the capital gains will pay for a comfortable retirement. This plan is no more feasible than the first.

The only thing that can pay for retirement is the return on capital put to productive use. This is a serious problem in our era of wholesale capital destruction.

Another reason why rising prices cannot pay for everyone’s retirement is unique to gold. A rising gold price is not a gain. It is just an artifact of using a falling dollar to measure gold’s value. If you have an ounce of gold, and the price doubles to $2800, you have twice as many dollars, but each of those dollars is worth half as much. You still have one ounce of gold. Only if you make a profit by earning more gold do you have a gain. While this was how people made a profit 100 years ago, today few are even thinking about how to do this.

It is high time they started again.

Guest Post: Cyprus – A Stock Market Dies

Author: Pater Tenebrarum

What Happens Usually After Big Bear Markets Conclude?

If we look back at the history of big bear markets in stocks, they normally put in a definitive low either at the height of a panic (a spike low), or after an extended period of disinterest, during which the market usually declines considerably further in percentage terms, but trading volume concurrently dries up.

Two examples for such typical ‘disinterest lows’ following a major bear market are the 1932 low in the DJIA/SPX and the late 2000 lows in the XAU and HUI. In both instances the market suffered considerable additional losses in the final few months of its decline, with trading volume withering away (in the case of US stocks, trading volume was down 90% compared to its height in 1929 – stock prices were down by 90% as well at the low). However, in both instances, after a definitive low had been established, the market very soon embarked on a relentless advance.




The DJIA’s bear market in the 1930’s and the beginning of the subsequent rally. Although this is not immediately obvious on a linear chart, the final decline from February to June 1932 was the biggest wave down in percentage terms – click to enlarge.




The HUI from 1996 to 2002 – again the final wave down was actually the steepest in terms of the percentage loss, but once the low was established, a strong rally ensued – click to enlarge.



So this is the usual manner in which major long term bear markets conclude – once the low is established, the market soon embarks on a sizable rally. So what happens after the biggest crash ever?


You can read the second part of this article at


Charts by: BigCharts, Sharelynx

The Dollar is Going Up

Let’s take a look at a few graphs of the dollar, from Feb 1, 2013 through Friday May 17, 2013. Yes, I said graphs of the dollar. I’ve priced the dollar in gold first (of course), then silver, the euro, and even the yen. The pattern is obvious. The dollar is going up.

dollar Au

dollar Ag

dollar eur

dollar yen

I did not show copper, lumber, or wheat though they show the same trend. These commodities are not money, of course.

My point is simple. It’s not gold that is going anywhere. In past articles, I’ve used the analogy of measuring a steel ruler using rubber bands. Using the dollar to measure gold is like that. In this article I show that it’s not just gold, but silver, other currencies, and commodities. The dollar is rising now matter how we measure it.

The question not to ask is: “how are they manipulating gold?” The question is: “why is the dollar rising?”

To answer that, we first have to understand why the dollar had been going down. Most would say that it’s because the Fed has been “printing” and increasing the quantity of dollars. If that is so, then why would the dollar ever rise, as it has before (e.g. in the 1980’s), and as it is doing now? The Fed cannot and does not “un-print” dollars. This stock explanation is not satisfactory.

In one word, the answer is: arbitrage.

Let’s take a step back and look at the Treasury bond. The government pays for net expenses above tax revenues by borrowing. To borrow money, the Department of the Treasury sells bonds. This is an important aspect of our current form of government, as voters have demanded far more government expenditures than they are willing or able to pay for via taxes. In this aspect, the Treasury bond is a tool of fiscal policy, or spending, and cash flow to pay for it.

There is another aspect to the Treasury bond. It is the key asset of our monetary system. It is the asset on the Fed’s balance sheet (increasingly, post 2008, there are also mortgage bonds) to back its liabilities. The liability of the Fed is the Federal Reserve Note, commonly called the dollar. The Treasury bond is also a significant backing for the liabilities of commercial banks, pension funds, annuities, and insurance funds. Finally, the Treasury bond is used as collateral to enable borrowing.


The monetary system today is entirely based on credit, and the Treasury bond is the base of it. The peculiar characteristic, one could even say the shabby little secret, is that the Treasury bond is payable in dollars but the dollar is the liability of the Fed which is backed by the asset of the Fed which is … the Treasury bond. It’s circular and self-referential.

People often use the shorthand of saying that the Fed is “printing” dollars. It is actually borrowing them into existence and lending them. It is true that there is no actual lender. The Fed has sole discretion to create these dollars, unlike any normal bank, that must persuade a saver to deposit his capital in the bank. The Fed’s expansion of credit involves no saver. The Fed’s credit is counterfeit.[1]

The dollars appear ex nihilo at the Fed, and they use them to buy an asset, basically a bond, or to otherwise lend. Thus the Fed creates both a liability and an asset in this process. If the value of its assets should ever fall significantly, the market will not accept the Fed’s liability—the dollar—at face value. When gold owners refuse to bid on the dollar, the dollar will collapse.

Let’s get back to arbitrage. If a bank borrows money from the Fed, they will use it to buy an asset or lend it to a third party who will. This is an arbitrage. The short leg is the loan from the Fed, and the long leg is the asset purchased. As with all arbitrages, it will act as a force to pull the two values towards one another. Market price is always pulled down by the short leg, and pushed up by the long leg.

In the case of all borrowing from the Fed, the short leg is the dollar itself. I define arbitrage as the act of straddling a spread in the markets.[2] The arbitrager is often trying to profit from the interest rate spread directly, as in borrowing from the Fed at the discount rate and buying a Treasury bond that offers a higher yield.

Another strategy is to try to profit from a change in the spread, as in borrowing dollars to buy gold. In this case, if the dollar price falls, this will be a profitable trade. This is a weaker arbitrage than buying a bond, as gold does not have a yield.

As I noted above, the very act of arbitrage pulls down the price of the short leg and in the case of borrowing from the Fed the short leg is always the dollar. Whether a bank borrows dollars, to buy Euros and from there to buy Greek government bonds; whether it lends to a hedge fund to buy gold; or whether it lends to a consumer to buy a home, the dollar is pulled down. On the other side of the trade, these assets are pushed up.

This, rather than the rising quantity of dollars, explains the falling value of the dollar. And now, recently, the dollar has been rising. The logical explanation is that these trades are being unwound, either voluntarily or under duress. My definition of deflation is a forcible contraction of credit. It is not the shrinking number of dollars (if the number is even shrinking). It is the closing of innumerable positions, by the opposite arbitrage. Previously it was sell dollar / buy asset. Now it is buy dollar / sell asset.

Gold is the most liquid asset. Its bid-ask spread does not widen much when large quantities are sold on the bid or bought at the offer. In contrast, the bid in other assets can drop precipitously in times of crisis. They are hardest to liquidate precisely at the time when one must sell. In some extreme cases, the bid can be withdrawn altogether. Though the spread does not widen in gold, heavy selling does push down the bid on gold. Market makers will then pull down the offer to maintain a consistent spread.

Being the most liquid, gold is the most sensitive. It is the first asset, the “go to” asset to sell when a balance sheet is under stress. Gold therefore has the least lag in response to a change in the monetary system. Compare to real estate, where due diligence alone could take weeks or months. Additional inertia comes from how properties are valued: by looking at recent comparable deals. Real estate would not be the first asset that a bank or fund would want to sell, due to several factors including long closing time, wide bid-ask spread, and high costs to sell such as sales commissions and attorneys. In real estate, there are no market makers. The offer can remain high even with the bid plunging, as the typical holder of real estate is not willing to sell at a loss and holds out for a number that covers all costs and fees and allows an exit at a profit.

Equities are usually liquid, closer to gold than to real estate in this regard. However, for the past few years, there have been many flash crashes. In a flash crash, the bid drops to $0.01 for a brief moment, and typically at least one market sell order is filled far below the “normal” price for the stock. These flash crashes prove that there are serious problems, that there are structural cracks beneath the surface.

An important principle to keep in mind is that in times of stress or crisis, it is always the bid and never the offer that is withdrawn. While there have been a few flash smashes (an amusing term) it is not a coincidence that these are vastly outnumbered by the flash crashes. This is because stress and crisis always come with a need for liquidity to pay debts that cannot be rolled over, margin calls, or to be flexible and agile. In bad times, people prefer to own a more marketable asset compared to one that is less marketable. They especially prefer to own the asset that is the unit of account for their balance sheet.

By definition, there is no risk to holding dollars if your balance sheet is denominated in dollars, and your liabilities are in dollars. This is the reason for the so-called “flight to safety” for the “risk-off asset”. You are not making, nor losing, money when you hold dollars. On gold denominated books, holding dollars is quite risky, of course.

Going back to the falling dollar, as the interest rate falls the discount factor used for an enterprise’s future earnings also falls. The same $1 in earnings in 2023 is worth more at a discount of 3% annually vs. 6% ($0.74 vs. $0.56). The result is rising stock prices.

In addition, the “animal spirits” of John Maynard Keynes have been set loose. Most people hold the false theory about the quantity of money and its impact on the price of everything, and it is quite popular to believe that this means stock prices can only rise. Proponents of this theory should look at Japan. In any case, deprived of other means of obtaining a yield (i.e. in the bond market), they must do something. People know the dollar is falling, though they attempt to measure it by looking at the rate by which consumer prices, measured in dollars, rise. They should be looking at the rate at which the dollar, measured in gold, is falling.

Right now, everyone is on the same side of the trade: long equities. This is dangerous because when it reverses, the market may not find a bid for quite a distance down. In a normal market, it is the short sellers who make the bid. By the indications I can see, those who have attempted to short this market have capitulated by now.



In Part II (free registration required), we consider why stocks are rising in this depressed economy, and look at the abyss we are now rapidly approaching.

[1] My definition of inflation is an expansion of counterfeit credit, discussed in this paper:

[2] I define and discuss in my dissertation: A Free Market for Goods, Services, and Money

The Dollar is Going Up Part II

Meanwhile, the spread between the interest rate and the dividend yield or earnings yield makes an attractive arbitrage. If you are the CFO of a public company and your shares pay a 4% dividend and you can borrow at 2%, it is practically a “no brainer”. The problem is that incurring debt for no productive…

This content is for The Last Contango – Free Membership members only. Please login to view this content. (Register here.)

Guest Post: The Big Picture by Alex Manzara

The big picture over the past few months is that markets are experiencing one large adjustment after another, perhaps analogous to the shifting of tectonic plates that create rolling earthquakes and various aftershocks.  The first large move was the fall in the yen (rise in dollar/yen), and the change in sentiment towards Apple (AAPL) which is down 42% from its high in mid-Sept.  USD/JPY moved 25% in six months from 80 in November to nearly 100 currently as Japan’s Abe vowed to create inflation through Quantitative Easing. Developed equity markets were boosted by this shift, with SPX rallying 18% over the same time frame.

USD/JPY in white and SPX in red


Gold was already moving lower in dollar terms, but precious metals were hit by vicious aftershocks in the past several days, and now copper and, to a lesser extent, crude oil have rolled over.  You can see below that while AAPL took out last summer’s lows in a decisive manner by December, gold had held its low from May 2012, only to be rocked by wholesale selling pressure in the past month, starting April at 1600 and testing 1350 within the space of two weeks.

Chart of AAPL in red and spot gold in white


Both of these investment themes (AAPL and GLD) had caught the speculative fancy of the “investing” public, and latecomers have been washed out.  The damage is shifting from the speculative to the industrial as copper has fallen 18% since February and unlike gold, didn’t have the benefit of even a minor bounce to close out last week.  Crude oil has spent the past three years between 80 and 105 and has fallen in sympathy with other commodities, sinking from $97/bbl in the beginning of April to $88 currently.  Steel rebar traded on the Shanghai exchange has fallen over 30% since 2011 (in yuan terms).

Chart of gold in white, copper in red, oil in yellow


Brazil (IBOV) and the emerging market index (EEM) have been putting in a series of lower highs and lower lows since the apex reached at the beginning of the year.  Now tremors are apparent in developed markets like the German DAX, at a new low for the calendar year, having this month broken an upward sloping trend line which had been in place since last summer.

Chart of IBOV Brazil in red and German DAX in white


It appears that the world is searching for a new equilibrium and markets are currently on unstable footing, spurred by policy makers who are generally oblivious to possible carnage wrought by their actions.  Indeed a loss in confidence of policies, or a market that becomes less certain of follow-through on specific initiatives can lead to rapidly shifting terrain.

Further, the response of one country to another’s change in policy direction must also be figured into the equation, which creates a broader spectrum of possible outcomes.  For example, the G20 has for now refrained from rebuking Japan for competitive devaluation.  But consider the chart below which shows the Japanese yen falling substantially vs the US dollar, and the Chinese renminbi simultaneously strengthening vs the US dollar; is it not fair to assume that China will in some way try to arrest the loss in export competitiveness?

JPY in white, CNY in red


The broad point is that tectonic plates of economic agents have begun to shift, causing disruptions across many asset classes which could easily become more violent in an interconnected world.

Alex Manzara began his career in 1984 at the Chicago Board of Trade and moved to the Chicago Mercantile Exchange in 1990.  He has worked at various Future Commission Merchants including Chase and ABN Amro.  He joined TJM in 2006, specializing in interest rate options and yield curve strategies.  Strong background in structuring trades based on macroeconomic themes.  He received a BA in Economics from Northwestern University and holds Series 3 and 7 licenses.


Don’t Short the Treasury Bond Just Yet

Keith Weiner discusses why interest rates prior to 1933 was set by the marginal saver and how the saver was removed from this process post 1933.