A whale in the waters of negative yields

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In nature, the mighty whale depends upon the lowly plankton for its survival and the same analogy rightly applies to global developed economies, which have dominated trade and finance at the expense of developing nations. Now the tides may be turning as once minuscule global economies find themselves in possession of a plethora of reserves. The hunted may be turning into the hunter and the global monetary system, which has evolved and morphed over the past century – but always in the direction of easier, cheaper and more abundant credit – may have reached a point at which it can no longer operate in the same way. Major changes to our global monetary system may lie on a visible horizon.

The struggle between financial whales and plankton – powerful reserve-ladened creditors and much weaker debt-ladened borrowers – is significantly dependent on the successful functioning of how the world conducts and pays for commerce (our global monetary system). Historically, several different systems have been employed but they have either been commodity-based systems – gold and silver primarily – or a fiat system – paper money. After rejecting the gold standard at Bretton Woods in 1944, developed nations accepted a hybrid based on dollar convertibility and the fixing of gold at $35 per ounce.

When that was overwhelmed by US fiscal deficits and dollar printing in the late 1960s, President Nixon ushered in a rather loosely defined system that was still dollar-dependent for trade and monetary transactions but relied on the consolidated “good behaviour” of G7 central banks to print money parsimoniously and to target inflation close to 2 per cent.

Heartened by Paul Volcker in 1979, markets and economies gradually accepted this implicit promise and global credit markets and their economies grew like baby whales, swallowing up tonnes of debt-related plankton as they matured. The global monetary system seemed to be working smoothly, and instead of Shamu, it was labelled the “great moderation”.

Functioning yes, but perhaps not so moderately or smoothly – especially since 2008. Policy responses by fiscal and monetary authorities have managed to prevent substantial haircutting of the $200tn or so of financial assets that comprise our global monetary system, yet in the process have increased the risk and lowered the yield of sovereign securities which represent its core.

Soaring debt to gross domestic product ratios in previously sacrosanct triple A countries have made funding increasingly a function of central banks as opposed to private market investors. Quantitative easing and longer-term refinancing operations totalling trillions have been publicly spawned in recent years. In the process, however, yields and future returns have plunged, presenting not a warm Pacific Ocean of positive real interest rates, but a frigid, Arctic ice-ladened sea of nominal yields when compared with those 2 per cent inflation targets of prior decades.

Both the lower-quality and lower yields of previously sacrosanct debt therefore represent a potential breaking point in our now 40-year-old global monetary system. Neither condition was considered probable as recently as five years ago. Now, however, with even the US suffering a credit downgrade to AA+ and offering negative 200 basis point policy rates for the privilege of investing in Treasury bills, the willingness of creditors – as opposed to debtors – to support the existing system may soon fade.

While all monetary systems are a struggle between debtors and creditors, it is usually creditor nations that establish the rules for transitions to new regimes. Such was the case in the late 1960s as France threatened to empty Fort Knox unless a new standard was imposed. Now, with dollar reserves widely dispersed in China, Japan, Brazil and other surplus nations, it is fair to assume that there will come a point where 2 per cent negative real interest rates fail to compensate for the advantages heretofore gained in buying sovereign bonds.

There is the potential for both public and private market creditors to effect a change in how credit is funded and dispersed – our global monetary system. What that will look like is a conjecture, but it is likely to be more hard money as opposed to fiat-based, or if still fiat centric, less oriented to a dollar-based reserve currency.

The world’s financial markets seem obsessed with daily monetary and fiscal policy evolutions in euroland which form the basis for risk on/risk off days in the marketplace and the overall successful deployment of carry strategies so important to asset market total returns. Euroland is just a localised tumour, however. The developing credit cancer may be metastasised, and the global monetary system fatally flawed by increasingly risky and unacceptably low yields, produced by the debt crisis and policy responses to it. The great white whale lies on the horizon. Investors should sail carefully.

Bill Gross is founder and co-chief investment officer of Pimco

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