Tuesday, 14 March 2017

The Fed's Forthcoming Rate Hike - Part 4 of 4

The continual flow of funds into German 2 Year Bunds that offer a negative yield near 1%, and into other Eurozone short dated bonds, also at negative yields, and also into UK and US bonds that pay a negative real yield, might be explained by a flight to safety, and whenever some new crisis erupts, increased flows of funds occur into US Treasuries, UK Gilts and German Bunds or JGB's. But, the mass of funds held in these assets cannot all be explained in that way.

UK Gilts are no safer today than they were 7 years ago. Indeed, according to the UK's credit rating, they are less so. UK National Debt has soared in the last 7 years, under the Tory governments. Yet the yield on the 10 year Gilt is half today what it was 7 years ago.

The same is true in the Eurozone. The debt of Spain, Italy, Portugal, Greece and Ireland is no safer today than it was in 2010, and yet the yields on the sovereign bonds of these countries is now, in many cases, lower than on UK or US debt. Even Greek Bonds have yields only a fraction of what they were in 2010.

So, what explains that? The simple answer is that the US Federal Reserve, the Bank of England, and ECB are standing behind this debt. The Federal Reserve has around $4 trillion of this debt on its balance sheet, as a result of asset purchases from its QE programmes. The Bank of England also owns around £450 billion of UK government and corporate bonds, as part of its QE programme. In January 2015, the ECB announced a QE programme amounting to €1.1 trillion to run until September 2016, but in March 2016, increased that programme, so that instead of buying €60 billion of assets each month, they bought €80 billion per month, with no end date fixed for the programme. In fact, the ECB has had to extend the range of assets it will buy, because it started to run out of bonds that could be bought.

The debt has become safer for all those bonds only to the extent that these central banks have bought large chunks of it, and thereby transferred the risk out of the pocket of private speculators, and into the pockets of taxpayers, in the US, UK and Eurozone, who will be expected, once more, to make it good, when the value of that massively inflated debt collapses. The owners of loanable money-capital have foregone the potential of yield/interest and even the potential of profit, were they to use their capital productively, in favour of large, rapid capital gains on their financial assets.

So long as central banks buy up government bonds whenever their prices threaten to drop, speculators can sleep safe in their beds, and continue to buy those bonds themselves, secure in the knowledge that they may be earning no interest on them, but they stand to make a central bank guaranteed 10% capital gain each year. And, if its not from owning government bonds then it will spread out into other financial assets such as commercial bonds, shares and property. With such large guaranteed capital gains, why would you risk your capital advancing it for some actually productive purpose in business?

What causes currency speculators to take fright today, therefore, is not that the central bank might reduce interest rates, cutting their potential yield, and so causing them to withdraw hot money deposits, but the reverse. Speculators today fear that once a central bank can no longer be seen to be standing four-square behind these asset prices, there is a danger of their guaranteed capital gains turning into capital losses. As was seen in Greece, even huge yields on bonds, do not compensate for the size of these capital losses. It is why central banks have had to keep their benchmark rates near zero for the last ten years, and why, when that was not enough to keep those asset prices inflated, they then printed money to buy those assets themselves, to push the prices back up. It has nothing to do with stimulating economic growth – it has the opposite effect, by draining money-capital into unproductive speculation, and away from productive investment – and everything to do with protecting the paper wealth of the owners of fictitious capital.

The consequence of this is that, when, for example, the Federal Reserve has increased its benchmark interest rates, even by the tiniest amounts, money had flowed out of US Bonds, and out of shares. On several occasions, therefore, instead of the Dollar rising, following such a move, it fell, and similar patterns have been seen with the Euro.

The global economy appears to be enjoying a period of stronger growth, as I predicted. That is despite the policies of QE, not because of them. The stronger growth can also be seen in the EU and US. Along with it has also come a rise in inflation, as I again predicted, and this is now putting inevitable strain on central bank policies geared to keeping benchmark interest rates low, as I also predicted.

In the US, the election of Trump, and his proposals for tax cuts on profits and dividends, and his proposals for capital spending projects has fuelled a frenzy of speculation in US shares, in the hope that big profits and payouts to shareholders are on the way. That is likely to be short-lived. In order to undertake many of those projects the government and companies will have to borrow money-capital, which will cause interest rates to rise, particularly as tax cuts reduce government revenues that will have to be replaced by yet more borrowing.

Labour shortages are already appearing in some areas, and as more productive-capital is advanced for these projects, wages will rise, the rate of surplus value will fall, and profits will be squeezed. The mass of profit will rise, as economic activity and capital accumulation rises, but to produce it, firms will have to advance large sums of productive-capital. The demand for capital will rise, but as the rate of profit gets squeezed by rising wages etc., the supply of additional money-capital (from these realised profits) will rise by a smaller amount, causing the rate of interest to rise.

The bond kings, Bill Gross and Jeff Gundlach, have variously argued that a turning point will come when the US 10 year Treasury Yield rises sustainably above 2.6% or 3%. It is currently sitting at 2.58%. At some point, be it 2.6%, or 3%, or some other figure, and when correspondingly the prices of these bonds begin to fall by noticeable amounts, and where it becomes clear the central bank will not, or more likely cannot any longer act as buyer of last resort, so as to again inflate their prices, there will be a rush for the exit, in what is a relatively illiquid market, causing this bond bubble that has been inflating for 30 years, to burst.

Ernest Hemingway, when asked how people go bankrupt answered, “slowly at first, then all at once.” At the point the bubble bursts, it will be all at once, as interest rates spike much higher. As Marx set out in Capital III, the interest rate spikes higher in such a crisis, not because money-capital is demanded for additional investment, but simply to be used as liquidity, to make payments. In this instance, it will be speculators who, as in 2008, find themselves needing to get cash at almost any price to cover their margin calls on trading undertaken with huge amounts of leverage. You cannot have a situation where the total amount of financial assets in the global financial system is $1,000 trillion, or about 14 times annual global income, without that causing severe problems, when its realised that the value of those financial assets has been steadily built up on nothing more than the value of other financial assets. When the speculators run for the door, they will find it is only a window, and the resultant crash will make 2008 look like a mere dress rehearsal.

Whether that happens at 2.6% or 3%, or 3.5% does not matter. Since 2009, the US economy has created an additional 16 million jobs. That is 16 million workers with additional incomes to spend, and thereby create additional aggregate demand. Even at 3%, and with economic activity increasing, as larger numbers of workers, with higher wages begin to demand a larger value of commodities, it will start to become advantageous for money-capital to be put to work productively, in search of profits – and as Marx pointed out in the earlier quote, even lower rates of profit – rather than to be used speculatively to buy financial assets that produce virtually no yield (or even negative yields) and which increasingly produce capital losses.

That very process, reversing what has happened in the last thirty years, will have a significant effect. Share prices and bond prices will fall, and so will property prices. The incentive to use financial resources for speculation in those assets, which also gripped sections of the working-class and middle class. Will then come to an end. The astronomical costs of shelter and pension provision, which the blowing up of those asset price bubbles inflicted over the last thirty years, will be slashed.

Instead of spending half their income on rent, and similar amounts on mortgage payments, where they can even afford to buy a house, workers will have much of that expenditure released to spend on other commodities, which, in turn, will produce a greater spur to aggregate demand, increasing economic activity and employment further. The slashing of land prices will make the cost of house building much cheaper, and more profitable, stimulating a burst in new house building, providing new houses at a fraction of current prices.

The increase in economic activity will provoke additional productive investment, and will require an increase in the issue of additional shares and bonds, which again causes the prices of these assets to fall, and yields to rise. This is why in such periods in the past, when economic activity increases over long periods, the prices of financial assets and property, falls in inflation adjusted terms. No one recognises this trend, because for thirty years, asset prices have been rising, and in the previous period when this occurred, from the 1960's through to the mid-1980's it was disguised by rising inflation.

The mechanism by which this process unfolds is relatively clear, and it has been witnessed before, though not on such a dramatic a scale as that now in prospect. The question of whether this process unfolds is not really in doubt. A look at the UK economy today shows that it is built on froth, with consumer spending driving GDP growth, and that consumer spending is once more financed by levels of private debt, and negative savings rates, back to the level preceding the outbreak of the 2008 financial crisis.

It is not a question of if, but only when this process erupts.

Back To Part 3

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