‘China June inflation eases further, more policy stimulus anticipated…’
— Reuters 9 July 2016
‘Korea quickly proposed a supplementary budget, Taiwan cut rates by 12.5 basis point, and China has let the CNY weaken…’
— French investment and bullion bank Natixis
‘[Japan PM] Abe to give order for new stimulus package…’
— Nikkei Asia Review headline, 10 July 2016
‘Global stocks rally, markets look for more stimulus’
Stimulus everywhere and anywhere is driving share markets higher, and gold lower.
The prospect of more easy money, and even lower rates, has investors rushing to the share market.
The CNN analyst I was watching the other day explained away the US market’s new high with this: ‘Interest rates are so low investors are chasing anything with a yield…price does not matter.’
The disconnect between markets and the economy continues. The reason more stimulus is needed is because the underlying economy is weak — and getting weaker. Why on Earth would you pay higher prices for companies trading in an economy with softening demand?
In recent weeks we’ve been to London, New York and Rome. Every retailer has a sale. Some more than others.
‘Saldi — 50% riduzione’ signs are a ‘dime a dozen’ in Rome.
Are the retailers clearing old stock? Moving on winter stock? Or are they trying to tempt reluctant customers to spend?
Hard to tell what the truth is. My Italian is on a par with my Russian.
However, the level of ‘sale’ activity is definitely more noticeable this year compared to last year, and the year before that. Is it the Italian banking crisis that’s sapping confidence? Is it the backlash against entrenched political and corporate corruption? Is it the tax burden being paid by Italian citizens to fund the cost of a decade-long intake of refugees?
Lots of questions, but my very limited language skills make it difficult to source qualified answers.
My feeling is the proliferation of ‘Saldi’ signs is a sign of the deflationary forces at play in Italy.
Italy’s economy has shrunk by 10% since 2007. It has suffered not one, not two, but three recessions. In the aftermath of the Brexit vote, there’s concern over whether the current Italian government — led by PM Matteo Renzi — will last long enough to oversee the October referendum on constitutional reform…a vote to essentially streamline Italy’s bloated bureaucracy.
The economic contraction has taken its toll on the Italian banking system. Italian banks are considered to be the weakest in Europe. The level of non-performing (a nice way of saying delinquent) loans is in excess of US$400 billion. For a little perspective on that bad debt number, Italy’s GDP is around US$2 trillion. The value of the security backing these loans is either negligible or overvalued. The true extent of the bad debt losses on the bank’s books has not been disclosed.
Italy is Europe’s fourth largest economy, and the world’s eighth largest. Unlike Greece, Italy matters.
Negative Interest Rates
The debt and deflation disease is gradually working its way through the economic body…moving from the extremities to the vital organs.
What are the financial doctors prescribing? A massive injection of negative interest rates…in the hope of creating more debt. Brilliant!!!
But will the injection of negative rates achieve the desired objective?
To answer that question we have to understand the mechanism of negative rates.
Quantitative easing (money creation) and negative interest rates are the central bankers’ stimulus tag team.
‘The European Central Bank has unleashed a bigger than expected package of measures to stimulate the eurozone economy, with expanded quantitative easing [QE], incentives to banks to increase lending and further [negative] interest rate cuts.’
— Financial Times 10 March 2016
Firstly, central banks release excessive levels of QE into the system. At present, the European Central Bank (ECB) is printing €80 billion a month to buy government and corporate bonds from the private sector.
What do the private sector banks do with that money? It ends up in their cash reserves.
Under the complex rules of banking, solvent banks must satisfy minimum cash reserve requirements…a percentage of depositor funds to be held with the central bank. For example, a bank with deposits on its books totalling $100 billion might be required to have a 10% cash reserve requirement ($10 billion) lodged with the central bank.
When there is excessive QE (money creation), a bank’s cash reserve level can easily exceed the minimum reserve requirement…this is a deliberate ploy by central bankers.
The excess cash reserves (manufactured by QE) are then penalised under the negative interest rate regime.
In the above example, if the bank’s cash reserves ballooned to $30 billion, the central bank negative rate would apply to $20 billion (the amount in excess of the 10% cash reserve requirement).
The ECB interest rate is MINUS 0.4%.
Therefore, based on having $20 billion in excess reserves, a European bank would be charged $80 million to deposit the surplus requirement with the ECB. Not an insignificant amount of money.
Here’s the simple version: Central banks create the money, out of thin air, to give to the banks. The banks then give it back to the central bank and are penalised for doing so. In theory, the name of the game is to lend, lend, and lend that excess cash. But theory and practice do not always align.
What are the options available to the banks to minimise the central bankers’ punitive strategy?
- Wear the cost. Take a hit to the bottom line.
- Move deposit rates into negative territory. Effectively offsetting the central bank costs by penalising depositors (even harder) with negative interest rates.
- Increase lending to reduce the level of excess reserves.
At present, banks have not passed on the costs of negative rates to deposit holders via negative interest on bank accounts and term deposits.
However, if central bank holding rates go much lower — let’s say to MINUS 1% — the banks may well be to forced pass on this cost to savers.
This would have a disastrous effect on the psychology of savers…making them tighten their belts even further in a deflationary economy.
Another unintended consequence could be that banks find savers deciding to close their account/s…preferring to hold physical cash in personal safes or safety deposit boxes at the bank.
Alternatively, savers could say ‘what the heck’ and, in their desperate search for yield, they could decide to buy into a UK commercial property fund. In doing so, they’d find the redemption facility temporarily suspended, and the fund’s assets devalued by 30%.
Oops, I almost forgot, this is what’s already happened to investors chasing yield. While chasing a few extra percentage points of returns, their capital is cut-off at the knees.
A rush to hold cash could see central banks ban the withdrawal of physical tender above a certain limit…say a few thousand dollars. We then move to a cashless, electronic system…of course, this will be done for our protection against crime bosses and terrorists.
Or we could have the last option, where banks are flooded with demands from people keen to borrow money, embarking on yet another decade-long spending spree.
Possible, but highly unlikely.
There are no good outcomes with negative interest rates. The lower rates go, the greater the risk of unintended and potentially disastrous consequences coming into play.
Negative rates are like taxes. People start looking for creative ways to avoid them.
Central bankers cannot possibly know how investors will react when faced with the prospect of losing their savings. We’ll lurch from one crisis to another.
Blind ignorance is no impediment to central bankers.
‘Crash or crash through’ appears to be their reckless creed.
In due course, their actions will see asset markets looking like the shop windows in Rome:
‘Saldi — 50% OR MORE riduzione’.
For The Daily Reckoning