The
Faustian Bargain by guggenheimpartners.com
Since 2008,
governments that have relied upon quantitative easing instead of undertaking
structural reforms have arguably entered into a Faustian bargain of epic
proportions. What are the potential consequences of global central banks
printing trillions of dollars, euros, pounds, francs, and yen in an attempt to
provide short-term fixes for their nations’ long-term economic problems?
In Goethe’s 1831 drama Faust, the devil persuades a
bankrupt emperor to print and spend vast quantities of paper money as a short-term
fix for his country’s fiscal problems. As a consequence, the empire ultimately
unravels and descends into chaos. Today, governments that have relied upon
quantitative easing (QE) instead of undertaking necessary structural reforms
have arguably entered into the grandest Faustian bargain in financial history.
As a result of multi-trillion dollar
quantitative easing programs, central banks around the world have compromised
their ability to control the money supply, making them vulnerable to runaway inflation.
When interest rates rise, the market value of central bank assets could fall
below the face value of their liabilities, potentially rendering the banks
incapable of protecting the stability and purchasing power of their currencies.
In the Beginning, There Was Gold
To better understand the potential
consequences of quantitative easing, it is useful to review the historical
evolution of central banking. Early central banks acted as clearing houses for
gold. Individuals and trading companies placed their bullion on deposit at a
central bank and received a claim that could be redeemed upon demand. The
system’s strength was largely derived from its simplicity. This innovation had
a profound effect on global trade. In the British Empire, for example, it meant
a gold-backed pound note from London could be used for commercial purposes in
Bombay.
Today, the gold standard no longer
exists and for the first time the entire global monetary system is built on a
foundation of fiat currencies. This monetary paradigm works because of an
abiding faith that paper money will be accepted as a medium of exchange and
remain a store of value. At the core of this system is the presumption that
central banks, as the issuers of paper money, have enough assets that can be readily
sold in the event that their currencies’ value begins to fall and the money
supply needs to be reduced. When confidence in a central bank’s ability to
reduce its money supply in a sufficient amount to maintain its currency’s
purchasing power is drawn into question, there is a risk of a currency crisis
or even hyperinflation.
While Europe has had central banking
since the 17th century, the United States did not have a central bank until the
beginning of the 20th century. As a direct result of the panic of 1907, the
Progressive political movement created the Federal Reserve System in 1913.
Under the newly created Federal Reserve, the definition of eligible central
bank reserve assets was extended beyond gold to include short-term bills of
trade such as bankers’ acceptances. By expanding the definition of reserve
assets the Federal Reserve had the ability to temporarily increase the money
supply in excess of the amount of its gold reserves, to provide elasticity to
credit markets. This incremental flexibility in money creation was designed to
reduce the risk of panics which had plagued the U.S. through most of the 19th
century under the gold standard.
During the Great Depression of the 1930s
the Federal Reserve sought greater flexibility and leverage. In 1934, the
Federal Reserve noteholders’ right to convert paper to gold on demand was
unexpectedly revoked and the U.S. government seized all of the citizenry’s gold
holdings. Subsequently, the Treasury arbitrarily re-valued the price of gold
from $20.70 to $35 per ounce. Nevertheless, the presumption remained that every
U.S. dollar was “as good as gold” because the Federal Reserve continued to hold
bullion as its primary reserve asset.
A Dangerous Game
In 1935, the Federal Reserve was also
granted “temporary” emergency powers allowing it to begin using Treasury
securities, or government debt, as a reserve asset. The problem with Treasury
securities as a reserve asset is that, unlike gold, they are affected by
changes in the level of interest rates. The impact of interest rates on the
value of these securities is commonly measured in units of time and price
sensitivity referred to as duration.
The higher the duration of an asset, the
more sensitive its price is to changes in interest rates. For example, an
upward move in interest rates will cause the value of a bond with a duration of
10 years to fall by 10 times the value of a bond with a duration of one year.
DURATION: A way of measuring the
sensitivity of a bond’s value to changes in interest rates. A bond’s duration
is the number of years it takes for its cash flows to equal the price for which
the lender (investor) bought the bond. A bond without periodic payments
(zero-coupon bonds) has a duration equal to its term to maturity.
As the Federal Reserve’s holdings of
Treasury securities increased relative to its gold holdings, its portfolio took
on greater duration risk. For the first time, the potential existed that rising
interest rates could cause the market value of the Federal Reserve’s assets to
fall below the face value of its liabilities (Federal Reserve notes). This was
not a concern under the tautological gold-backed system because the value of a
central bank’s outstanding notes was directly tied to the amount of gold in its
vaults.
The way to minimize the risk of a
meaningful decline in the value of balance sheet capital resulting from a rise
in interest rates was for central banks to maintain a relatively low
debt-to-equity ratio while keeping a relatively short interest rate duration on
its assets. By maintaining this discipline the Federal Reserve was virtually
assured of having enough liquid assets at market levels to repurchase dollars
without incurring large losses on its portfolio.
A Quantitative Quagmire
From the 1930s until the early part of
the current century, the Federal Reserve was able to engage in relatively
effective monetary policy. In 2008, just prior to the first of two rounds of
quantitative easing, the Federal Reserve had $41 billion in capital and roughly
$872 billion in liabilities, resulting in a debt-to-equity ratio of roughly
21-to-1. The Federal Reserve’s asset portfolio included $480 billion in
Treasury securities with an average duration of about 2.5 years. Therefore, a
100 basis point increase in interest rates would have caused the value of its
portfolio to fall by 2.5%, or $12 billion. A loss of that magnitude would have
been severe but not devastating.
Beginning in 2008, the monetary
orthodoxy of the previous 95 years quickly disappeared. By 2011, the Federal
Reserve’s portfolio consisted of more than $2.6 trillion in Treasury and agency
securities, mortgage bonds, and other obligations. This resulted in an increase
in the central bank’s debt-to-equity ratio to roughly 51-to-1. Under Operation
Twist the Federal Reserve swapped its short-term Treasury securities holdings
for longer-term ones in an attempt to induce borrowing and growth in the
economy. This caused an extension of the duration of the Federal Reserve’s
portfolio to more than eight years.
Now, a 100 basis-point increase in
interest rates would cause the market value of the Federal Reserve’s assets to
fall by about 8% or approximately $200 billion which would leave the Federal
Reserve with a capital deficit of $150 billion, rendering it insolvent under
Generally Accepted Accounting Principles (GAAP). Although this may not happen
in the immediate future, if interest rates rose five percentage points the
Federal Reserve could lose more than a trillion dollars from its fixed income
portfolio.
Staring Into a Monetary Abyss
Unlikely as it seems in a world of
zero-bound interest rates, someday, as the economy continues to expand, the
demand for credit will increase to the point that interest rates will begin to
rise. In time, significantly stronger growth will create economic bottlenecks,
placing upward pressure on prices. At that time the Federal Reserve would be
expected to restrain credit growth by selling securities, resulting in a
further increase in interest rates.
As interest rates rise, the market value
of the Federal Reserve’s assets will fall. It could then become apparent that
the face value of the Federal Reserve’s obligations had become greater than the
market value of its assets. This could leave the Federal Reserve without enough
liquid assets to sell to protect the purchasing power of the dollar, resulting
in a downward spiral in its value.
If the dollar weakens relative to other
currencies, its use as a reserve currency, and the safety of U.S. Treasuries,
could falter. Given the United States’ dependence on foreign capital to finance
its large fiscal deficits, a reduction in foreign flows could cause Treasury
securities to lose a significant amount of value. The Federal Reserve could
then find itself having to support the price of the country’s debt by becoming
the buyer of last resort for Treasury securities. This scenario would closely
resemble events unfolding in the periphery of Europe today. By printing
increasing amounts of money to finance the national debt, the Federal Reserve
would lose control of its ability to manage the money supply, leaving the
government hostage to its printing press.
Investment Implications
To hedge against deterioration in the
dollar’s purchasing power, investors have already begun migrating toward hard
assets such as gold, commercial real estate, artwork, collectibles, and rare
consumer products like fine wines. Such diversification may have significant
barriers to entry, however, considering the risks built into financial assets,
long-term investment portfolios should be at least partially composed of
tangible assets.
Other areas that are likely to perform
well in the immediate term due to effects of quantitative easing are
credit-related instruments including bank-loans and asset-backed securities.
High yield debt should perform well because abundant liquidity means default
rates will remain low. Additionally, the ongoing balance sheet expansion by the
European Central Bank means European equity prices are likely to outperform
U.S. equities over the coming years.
Long-duration, fixed-rate assets such as
government bonds are likely to underperform. Given the primacy of Treasury
securities in the Federal Reserve’s current yield curve management program,
Treasury bonds will come under the greatest pressure once the Federal Reserve
ends QE. This asset class’ yields have fallen by over 1100 basis points in the
past three decades. While no one knows if we have reached the bottom for
Treasury rates, staying in the market for the final 50 or 60 basis points
appears imprudent. As Jim Grant has noted, investors’ perception of U.S.
Treasuries – and most sovereign debt – is shifting from representing risk-free
return to “return-free risk.” Now is a better time to sell Treasury securities
than to buy them, and for the stout of heart this is an opportunity to set
short positions in the asset class.
An Uncertain Future
Half a year before the centennial of
central banking in the U.S., neither policymakers nor investors have much to
celebrate. By abandoning monetary orthodoxy and pursuing large-scale asset
purchases, global central banks have increased the risk of inflation and
compromised their ability to stamp it out. Inordinately higher leverage ratios
and the extension of central bank portfolio duration means governments now face
the potential for central bank solvency crises. It is too early to predict exactly
how this Faustian bargain will play out; but, with each additional paper note
that rolls off the printing press or gets conjured up in the ether, the
likelihood of a happy ending becomes increasingly evanescent.
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