Listen for the silence

Author: Tony Bell (Head: International and Retail)

One thing financial markets reflect over time is that there is value in listening for the silence. Consensus forecasts are mostly wrong, but most use them as there is little else to go on. Last week initial jobless claims in the US came in at 1.8m, yet economists had forecast 7m. Does this make economists bad at what they do? No. It’s just that forecasting is very difficult to do in almost any field of endeavour. Equally puzzling is why equity markets are rising sharply while the global economy is in the dumpster. Nearly all the commentators are talking about the disconnect between the economy (bad – very bad) and equity markets. But equity markets are not alone in providing a sense of direction. The trade-weighted dollar is advancing slightly, but with very much lower volatility, bond yields have stabilised, and bond volatility has dropped quite a bit while credit spreads – particularly on low-grade credit, has narrowed. So, I ask myself the question: may we be witnessing the re-engineering of the financial system while everyone focuses on the latest CoVid stats? This could be the biggest re-engineer without mention since Bretton Woods in 1947. How and why?

The how part is simple – print lots and lots of new money. The why is a bit more complicated – debt monetisation. Without going into a long story consider the following: Approximately 730 delegates representing 44 countries met in Bretton Woods in July 1944 with the principal goals of creating an efficient foreign exchange system, preventing competitive devaluations of currencies, and promoting international economic growth. The Bretton Woods Agreement and System were central to these goals. The Bretton Woods Agreement also created two essential organisations—the International Monetary Fund (IMF) and the World Bank. While the Bretton Woods System was dissolved in the 1970s, both the IMF and World Bank have remained strong pillars for the exchange of international currencies. Though the Bretton Woods conference itself took place over just three weeks, the preparations for it had been going on for several years. The primary designers of the Bretton Woods System were the famous British economist John Maynard Keynes and American Chief International Economist of the U.S. Treasury Department, Harry Dexter White. Keynes’ hope was to establish a powerful global central bank to be called the Clearing Union and issue a new international reserve currency called the bancor. White’s plan envisioned a more modest lending fund and a greater role for the U.S. dollar, rather than the creation of a new currency. In the end, the adopted plan took ideas from both, leaning more toward White’s plan. It was not until 1958 that the Bretton Woods System became fully functional. Once implemented, its provisions called for the U.S. dollar to be pegged to the value of gold. Moreover, all other currencies in the system were then pegged to the U.S. dollar’s value. The exchange rate applied at the time set the price of gold at $35 an ounce.

the race may be on as to who controls the base currency of the future…

In 1974 Kennedy took the US off the gold standard with the result that the dollar no longer had a physical base. Slowly those currencies that were pegged to the dollar began to strain where productivity did not equal currency gain. Pressure mounted for the pegs to break and currencies to float – which they did. Following the GFC of 2008, central banks around the world printed money. But something else happened – interest rates were artificially suppressed leading to lots of borrowing and leverage. We started to see liquidity shortages developing in the interbank market in October last year – you may recall the US interbank rate spiked to over 5% towards the end of the year. The equity crisis, in my view, started because of a liquidity crisis in the interbank markets and not CoVid. The latter added a dimension akin to the great depression but equity markets have headed higher – why? The short answer is because the primary reason for the decline in the first place was a brewing liquidity / credit crisis – similar to almost all other bear markets. The difference this time round may be the quantum of money being spent by central banks to underpin liquidity. How does the system get re-engineered? By printing money, the insoluble problem of how to pay back the huge debt pile amassed since 2008 is solved. And, not surprisingly the IMF and World Bank (backed increasingly by the ECB it seems) starts to talk of SDR’s (special drawing rights) to assist countries (SA included) in their recovery. SDR’s are like the dollar – a form of money. So, the race may be on as to who controls the base currency of the future – will it be the dollar or could something like Facebook’s lunar crypto start to undermine central banks?

Allied to the monetisation of debt lies another objective. By printing to monetise debt, central banks have a second objective – import inflation and devalue the currency. Japan has, after all, been doing this for the past 20 years. Asset allocation implications abound as do the assumptions that go into calibrating excess returns for each asset class.