Trapped inside the zero bound: What it means now that we’ve crossed the economic event horizon

A friend of mine, a very successful tech CEO who is also profoundly astute in matters of finance, once asked his economics prof during a lecture on interest rates in his university days “could interest rates ever go negative?”.

The professor, gazing over his glasses and down his nose at what obviously had to be an imbecile in his lecture hall calmly set aside a second of his podium time to shoot the idea down: “No.”, he said quite simply, as if he couldn’t believe he had to be explaining this to university level students, “it has to be a positive number….”.

My colleague believed him. After all, being in technology he was familiar with the computer code analogy of a negative interest rate, that being the dreaded divide by zero error. Coders take great pains to avoid these because if it actually happens, the currently running program basically “shits the bed” and all bets are off.

If the currently running program was generating a balance sheet, it may set the line printer on fire instead. If it’s deploying an airplane’s landing gear it may jettison everything in the cargo bay. It’s impossible to guess what will happen. So when people who viscerally understand the kind of consequences the ERR:DIV0 can cause extrapolate it out to an entire economy, they’re the ones that end up “shitting the bed”. It’s really bad.

I always knew that ZIRP was bad, but I just thought it would be normal, run-of-the-mill bad. You know, where most normal people get screwed for a long time, and then “suddenly” everything comes unglued and the financial system implodes, followed by a government intervention while the usual suspects (free markets and capitalism) get hung from telephone poles.

…and then everything would mean revert and overshoot. In this case, interest rates north of 15% (a la 1980), massive debt default, another economic depression, followed by a grand new government intervention, and the blame would be placed squarely at the feet of runaway free markets and capitalism.

In other words, I have long thought we have been existing at a cyclical extreme on the spectrum of financial repression, which would eventually become untenable and then we’d swing up to the other extreme (of financial repression).

However lately I have been hearing and reading things that put this scenario, this comfortable (in it’s familiarity) expectation of central bankster boots stomping on my face forever, into doubt. It might end up being a lot worse than that.

People who are lot smarter than I think that rates can not be normalized in our lifetimes. Ever, in fact.

It’s could be that once a financial market hits the zero bound in interest rates, it’s like crossing the event horizon of a black hole – there is no going back, not even light can escape it.

For years I blogged that ZIRP was grossly unfair to savers, especially seniors and that it would introduce all sorts of distortions into the economy that would render it dysfunctional.

When I looked at the chart of the Fed funds rate, I was struck with the foreboding flatline pattern that is ZIRP:

Looking at Japan (who’s been trying to suppress interest rates and inflate their way out of this for 30+ years) it looks the same (just longer):

And for artistic symmetry, here’s an echo-cardiogram of a patient who died on the operating table (He was a computer programmer that realized he’d coded a divide-by-zero error into the firmware for a nuclear reactor near his home town).

Notice the similarities?  The “financial pulse” of the economy (that being the price of money) has flatlined. Notwithstanding the faux-rate-hike of December, since the market reactions since then make it clear:

• The Fed cannot undertake four more rate hikes this year
• As Zerohedge reported, odds are favouring a rate cut at the next meeting on Jan 27th are currently implied at 8% – with the accompanying odds of another hike come at …zero.

We’ve been at the zero-bound for 7 years and all indications are we can’t break free of it stateside. Europe (and possibly Canada) are headed down the rabbit hole of negative rates – and after the attempt at rate hikes in the US fail, they will likely follow (at least one FOMC member already predicted as much before the December hike).

Now it’s time to examine how these policies go beyond being mere economic abstractions and impact us in the real world:

#1 Financialization Trumps Real Economic Activity

Yield is dead. Long live yield. Alas the only way to get it these days is to simulate it through speculation. Make no mistake, the objective by policy makers is to punish savers and chase their evil savings into discretionary spending (yachts, flat screens and facelifts) or better, the stock market. This “pent up demand” becomes “green shoots” and when you get enough of them it achieves “escape velocity” which then benevolently alchemies into “trickle down” and then everybody should enjoy above average “wealth effect”. Get it?

The reality is all gains are made through financialization and thus the participants in those gains are confined to those who are in a position to play that game: well connected banksters, hedge funds, private equity funds and VC’s.

The ostensible reason to own a publicly traded equity historically was to participate in a share of the profits, traditionally distributed via dividends.

Here we see the dividend yield in a downtrend since 1880. The effect of dividends on total returns has been in secular decline since about the 1980’s (around the time the great bull market of 1982-2000 got underway)

According to somebody I once studied under (not the same prof who scolded my colleague above), the dividend yield itself is at historic lows: 1.6% from 2000 thru 2014 compared to 130 year historical average of 4.4%

This begs the question then, with the stock market at or near ALL TIME HIGHS then where are all the gains coming from? Is it because businesses are that much more profitable?

Not really – today most of the gains are coming from stock buybacks – and many of those are leveraged, paid for with borrowed money at (you guessed it), artificially low interest rates.

Where I live, in tech-land, financialization plays out amongst pre-IPO unicorn pageant contestants and  800lb gorillas, leaving independent, non-financialized businesses in a vice. I always used to joke “we do business the old fashioned way …at a profit”, however as we get further past the event horizon and deeper down the rabbit hole, this actually puts us at a competitive disadvantage to “New Economy” ventures .

Such companies aren’t in business to actually earn anything. They create value for their backers and shareholders via serial funding rounds, doing whatever it takes to gobble up market share, including operating at a loss for extended periods, if not their entire lifespans.

In other words, if you’re operating an independent tech business along old school business rules (earn profits or die, don’t run out of cash or die, satisfy your customers, or die), you find yourself today competing against financialized zombie companies on a suicide mission: burning cash and cannibilizing the entire market so that they can be ingested by the nearest unicorn with the deepest pockets.

Speaking from personal experience, my company’s largest head-to-head competitor loses between 200 to 300 million a year and has never earned a profit. But they have 35% of the domain name market and they recently went public with nearly all the funds raised going to pay off loans to the private equity firms who backed it (and who also floated their shares in the IPO).

Then last year, both Amazon and Google entered our market as direct competitors as well. Do I feel massively outgunned? I do. So does everybody. Everybody that is, who isn’t relying on hot money and participating in the manic game of liquidity-events-as-a-business-model.

Which brings us to:

#2 Absolute Dependence on Intervention

It seems patently absurd that people spend a lot of energy blaming “free market capitalism” for the world’s ills when every possible market is so heavily manipulated that price discovery is completely broken and asset allocation decisions are inherently foundationless.

Now it’s all about “The Fed Put” and the utterances of central bankers. Entire media frenzies erupt over the slightest shift in timbre of the wording of an FOMC statement.

Market participants don’t do fundamental analysis anymore. Why bother? It doesn’t matter what the fundamentals are because if a microscopic number of appointed committee members (a few dozen worldwide?) decide that the fundamentals (a.k.a “reality”) won’t suit the agenda, they’ll simply issue some policy to override it. That’s why we’re here in the rabbit hole.

#3 War on Cash

By this I not only mean paper currency we carry around with us, but after the current round of central bank initiatives fail, the next logical step will be to target money velocity and discourage any uninvested bank balances. This would imply that negative rates won’t just be a matter between the money center banks and the Fed window, it’ll creep into depositor accounts (which has already started happening in Europe)

To our left we see Sam Benson (a.k.a rapper “Blac Youngsta”) being arrested and handcuffed in the parking lot of a Wells Fargo bank in Atlanta earlier this week, after he withdrew $200,000 of his own money from one of his bank accounts and took it in cash (later revisions of the story claim he was mistaken for a person fraudulently cashing a forged cheque.)

While I haven’t had direct experiences like the above (after all, I’m white), I do find it harder to deal with even larger bank deposits, and this is in Canada:

• One bank (RBC) tried to put a 30 day hold on a certified bank draft I was  depositing into one of my accounts. A certified bank draft is technically indistinguishable from a briefcase full of cash.
• Another bank (CIBC) did put a 30 day hold on a certified cheque which was also a deposit, the funny thing, I was both the payer and the payee – I was writing a cheque from one of my business accounts to another in order to move funds ahead of a business transaction. The bank froze the funds for 30 days (after I raised hell about it, they  ended up extending my credit line for the funds until the hold on my certified cheque elapsed).
  

Is the war on cash real? Aside from getting perp-walked for withdrawing it (above) or having any cash on your possession confiscated by police under civil asset forfeiture debacles, I notice a couple of data points that have me wondering if Big Institutional Money (Inc.) also sees the writing on the wall…

Like when I see something like the above… with yield pretty much in the toilet across the entire world and this thing (Directcash Payments Inc.) paying out near 13% in dividends, which they never seem to miss, my first thought is “what the hell is wrong with it?”

I’ll tell you what’s wrong with it: they’re in the business of operating ATM machines. That dispense… cash. Contrast with the yield on Spanish 10-year bonds (1.77%) or Portugal (2.77%) – hell compare it to Greek 10-year at 8.22% what is the always efficient “free market” telling us about the risk? 

One of the largest ATM manufacturers in the world (NCR) has been trying in vein to sell itself off, finally securing an investment from Blackstone ($820M in preferred shares) to “accelerate the company’s transformation into an integrated software and services company. ” Translation: “We’re pivoting the hell out of ATMs”.

Left to itself, NIRP would eventually give “cash” a built-in premium, and we can’t have that. Every body has to play. No exceptions.

Thus any form of currency which can preserve it’s buying power and has no counter-party risk will be anathema to the central planners.

I fully expect to see wholesale gold confiscation and banning of precious metals before all of this plays out, and bitcoin? Forget about it. You’ll end up like this guy just for thinking about it.

 

#4 Result: The Two-Tier Society

This trend of liquidity events crowding out old school business profits and capital formation inexorably pushes toward consolidation across every sector.

Any independent businesses, who choose eschew financialization find themselves at a competitive disadvantage, unable to operate at the same scale as the consolidated giants, many of which don’t even have to earn actual operating profits in order to reward their backers (mainly investment banks and various funds), it’s a pretty lopsided fight.

The scenario unfolding is one where wealth is increasingly sucked from the wider base of an economy and society (formerly known as “the middle class” and “small business”) into what I call “the capstone class”, that much smaller, well connected cabal on top that directly benefits from credit creation and enjoys the fruits of the market distortions now playing out.

(Many may equate this with the fabled “1%”, although I find that meme inaccurate. Statistically speaking I’m “of the 1%” and believe me, I’m not some anointed blue blood sitting here in a dark robe manipulating the world economy. I wish. I’m getting my nuts squeezed just like everybody else.)

The “benefits of capitalism” are extolled from the top, but the aforementioned dynamics insulate them from the vagaries of true competition, meanwhile the base of the pyramid is increasingly entrained with a perverse disenchantment of so-called “free markets” that is making soft-socialism increasingly palatable.

This is understandable: the game is hopelessly rigged against the middle class, and the blame is unfailingly laid at the feet of “runaway free markets”. It’s no wonder the masses will repudiate so-called “capitalism” and seek to band together under various collectivist mechanisms as a survival mechanism.

Being “rich” will be disdained and redistribution applauded. What makes it diabolical is that it will never be the capstone class whose wealth is redistributed, it’ll just be the assets of the upper middle class (those aren’t living hand-to-mouth …yet), essentially encouraging the rabble to redistribute the scraps of societal wealth amongst themselves whilst those on top continue to further consolidate the major assets and set the policies which feed the cycle.

In other words, it’ll be “capitalism at the top / socialism for the serfs” – a bifurcated society where the “haves” are the equity holders of all the wealth and the have nots end up holding the bag with all the debt.

More on the unfolding two-tier society (a.k.a “The Great Bifurcation”) in another post.

Now What?

After reviewing the post I thought “I can’t just leave it there. Where’s the hope?”, I often close my posts with a few bullet points “what can I do?” which are fairly consistent:

Get out of debt

But then again, if interest rates are truly trapped below at or near zero bound, why would you? Unless you were being punished for saving the money, then maybe it does make sense to liquidate your debt after all. In a climate of NIRP liquidating any debt with a positive rate of interest would approximate a yield on your cash.

Own gold.

Maybe not. Given what we’ve examined above, precious metals would not escape a “war on cash”. It’s not like it hasn’t happened before. Americans are up in arms because “Obama wants your guns”. I think what’s more likely to happen is that Hillary, or Jeb Bush, will come after your gold. And nobody will care.

About the only staples of advice I could offer that still stand up under this bizarro world we’re living in are personal choice Sovereign Individual type stuff:

• Kick any addictions you might have
• Watch less television, read more books
• Diversify geopolitically – own land, businesses and passports in different localities.

Alas, I don’t have any answers, not anymore. Everybody is being forced to play a game we’ll call “Mr Global” (not my phrase). If somebody comes up with a defense mechanism that preserves wealth under negative rates, cash verbotten, no gold, capital-controlled zero-yield economy, that sidesteps the game, they will simply change the rules to make whatever that is unprofitable or retroactively illegal.

That’s where we’re at. Sorry.

Also See:

• The System of The World (An infographic)
• We are living in a state of Keynesian Bliss
• Cronyism in the 21st Century (Piketty Refuted)