Are you aware that almost one-third of global government debt now charges the lender interest that is paid to the borrower? This is known as a Negative Interest Rate Policy (NIRP) and has been slowly replacing a Zero Interest Rate Policy (ZIRP). Almost everyone knows that savings pay next to nothing at present (ZIRP). But increasingly across the globe, governments are charging investors a fee to loan them money. And this policy remains an open possibility in the United States according to Federal Reserve Chairwoman Janet Yellen and is supported by the IMF. Before we start to dig into the details behind this unbelievable reality, it is important to take a breath and recall what happened the last time our economy entered Bizarro World unbeknownst to the general public.
Too many people have a "head in the sand" mentality in regard to our economic system. They readily ignore the incredible stresses that exist, at least they ignore them until those stresses start breaking things. Remember 2007, BEFORE the housing bubble burst became obvious and the markets collapsed? The Dow Jones Industrial Average was hitting new all-time highs in October 2007 surpassing the 14,000 level. By March 2009, the Dow was closing in on 6,500 and everyone wondered what had happened. That led to TARP, bailouts, stimulus, and a movement by Central Banks around the world into totally uncharted waters. But a scant 18 months before the peak in fear, the stock market had been at all-time high levels, a peak in greed. Anyone sounding a warning bell in the summer of 2007 was shouted down as a "fear monger." Many analysts were very bullish right at the market peak. Our own government as well as the forecast of the IMF showed solid growth and smooth sailing. Only a prescient few sensed danger.
Two things stood in the way of perpetual prosperity. The first is that pesky thing likened unto gravity. It turns out that you can't keep expanding credit (especially to those with questionable credit ratings via sub-prime loans) forever without consequence. The second thing is that there were (and are) those incentivized to see the system fail, whether for profit or malice. They were smart enough to exploit the absurdity to meet their purposes. Some of those motivated by profit had warned of troubles and when regularly ignored simply took steps to protect themselves and make some money on the side. Who can blame them? This is essential the story of "The Big Short," now a major motion picture. On the other hand, there were also enemies of the United States who saw an economic collapse as an opening to take down the once-great superpower without the risk of military conflict.
In 1999, two Senior Colonels of the People's Liberation Army wrote a seminal book with the title Unrestricted Warfare. It basically suggested that America (or any superpower) could be defeated without direct military conflict. The formula was rather simple. First, you build up the weapon of capital. To many, this is easier said than done. But if you are China with a mercantilist policy enforced by a Communist dictatorship and augmented by cyber espionage, ready to take advantage of a gullible world, it's not impossible. The Chinese built up $3.7 trillion in foreign currency reserves in a little over a decade. Likewise, if you are a major oil exporter, intent on spreading Shariah law or at least funding your brand of Islamic jihad, you can put away some capital as a weapon, especially when oil prices hit $150/barrel. Even Russia under Putin built up substantial currency reserves over a period as the bubble was developing.
The second step in the Chinese formula is to launch a sneak attack against financial markets. That's why you need the capital, either as the weapon or to insulate against the blowback. While this would seem to be the tricky part, the fact is that such a weapon is intended to be used when an economy is most vulnerable. An attack on the stock market, for example, can only trigger a serious economic problem if done in conjunction with a genuine economic problem. Otherwise, the markets will recover with limited damage. In the case of 2008, however, there was a very serious problem. As we have discussed, it was in this context that Putin approached the Chinese in the summer of 2008 with a plot to destabilize America by attacking Fannie Mae and Freddie Mac. We know that the Russians have continued to probe for existential weakness, recently focusing on cyber weapons against the stock exchange as well as manipulation points with Exchange Traded Funds.
The third step is in many cases coincident with the second. It is to bury a hacker detachment and computer virus. Essentially, this means being prepared to massively disrupt your enemy using cyber means. There should be little doubt that Russia, China, Iran, North Korea, and ISIS have all developed very sophisticated cyber capabilities and are continually testing them. The Chinese handbook suggested making it so that ATMs stopped working along with traffic signals, and the power grid. It is important to note that the Chinese consider an EMP to be the ultimate cyber weapon. [To learn more about the EMP risk, click HERE.]
Ultimately, the goal is to be so disruptive that society itself begins to collapse with massive street riots and a political crisis. In fact, this is perhaps the most necessary step—the undermining of civil society. It is important to have the enemy target unable to function effectively enough to provide a united response. The goal is to force so much infighting that society crumbles, making the nation malleable enough for international control. When we first started discussing this intended goal, most observers (even professional politicos and military strategists) argued that America was far too stable. Of course, in 2008 we had an economic meltdown that many believe was hours or less from collapsing civil society. And since then we have seen massive riots and such a divided electorate that the unthinkable seems now to be very real.
But that is enough of a history lesson. We had a massive crisis including a clear, albeit unrecognized, attack. America is still standing. In many ways it could be argued that our relative position in the world has been enhanced in some regard. The dollar emerged as a stronger currency. No other nation seems currently positioned to challenge our dominance. Our domestic energy industry has blossomed. In fact, many people now predict a bright future for the good ‘ol USA.
The problem is that much of the supposed recovery is artificial. In fact, some estimate that 93% of the stock market recovery was engineered by the Federal Reserve. That is nowhere near as sustainable as natural growth. In fact, every time we have seen a reduction in stimulus, we've also seen a give back in market gains. Recently, the market has rallied on the notion of "lower for longer."
What if we are back to the "ignorance seems like bliss" status of 2007? Are there true existential problems in play that society as a whole is missing? Unfortunately, the answer is yes. The credit bubble of nine years ago seems small in some ways compared to the massive global debt building today. Derivatives, that played such a large role in 2008-09 have expanded again. Central banks around the world have provided so much credit that borrowers are actually paid to borrow money. And that is the real absurdity at play today. Negative Interest Rates.
If you open the headlines, you will read that Japan is mired in serious deflation. Yet, the Bank of Japan has set interest rates such that the lender pays the borrower. They are not alone. A total of $7 trillion is loaned under these bizarre circumstances including loans in Europe. The problem is that negative interest rates make what was once right-side up become upside down. Consider that under normal circumstances, easier credit and low interest rates should logically increase borrowing. That's true to a point but if rates get low enough savers will stop putting their money in the bank. If interest rates go negative, mattress sales rise as people stuff money into their mattress rather than paying people to keep it for them. In reality, at-home safe sales have exploded in Japan. The net effect is that lower or negative interest rates can actually decrease available credit for all but the highest rated borrowers. Less money in the bank means fewer loans to small businesses. There comes a point at which the traditional banking function ceases all together. Banks want to eliminate depositors and are afraid to loan money.
Under normal circumstances, a low interest rate paid to depositors would encourage banks to lend money at higher interest rates and profit from the spread. But with the massive amount of new regulations unleashed and the hangover worries of financial system steadiness and "too big to fail," banks have been afraid to lend. What they do instead is buy government bonds deemed safe. This crowds out the needed lending for growth and slowly shifts the economy from one supported by private industry to one increasingly controlled by government. No wonder there seems to be so little growth anywhere.
One of the things that has happened that runs contrary to all pre-NIRP logic is that the currency of the nation best known for having negative interest rates has actually been rising in value, including against the U.S. dollar. Conventional wisdom would suggest that any currency with a negative yield would fall, not rise, against the dollar. Who wants to hold a currency that costs money to hold? This simply underscores how bizarre everything has become. A recent BARRON's story points out the troubling aspects of the Yen's recent rise:
The yen's rise also could be the "canary in a coal mine for global risk assets," according to BCA Daily Insights. Japan's currency and stock markets tend to be leading indicators for the U.S. equity market, having peaked ahead of the major tops in the Standard & Poor's 500 index in 2000 and 2007.
There could be two reasons for this, BCA continues. The yen is a "funding currency"; that is, it's borrowed to finance investments in other, higher-yielding assets in good times. When the tide turns and those positions are unwound, the yen borrowings are repaid, boosting demand for the currency.
In addition, JPMorgan economist Nikolaos Panigirtzoglou writes, reversal of yen currency hedges—a popular strategy that has been used in U.S. exchange-traded funds—by overseas buyers of Japanese stocks could have been huge this year: some $288 billion. BCA adds, "Because of demographic head winds, the Japanese economy is driven by the global business, as opposed to organic domestic demand. Weakness in Japanese stocks could herald slower global growth."
Even the most optimistic of Pollyanna forecasters recognize that these are uncharted waters. Yet the band plays on as if ignoring this absurdity will mean that it won't have consequences. After all, most of the $7 trillion of negative-interest deposits is in far away places like Japan. At present, Central Banks seem to have everything under control. We have little doubt, however, that current circumstances are stressing the system in hidden ways. And the repercussions could be severe. Here are just a few of the potential concerns:
- Financial crash could end capitalism as we know it.
- Savers are devastated.
- Investors are devastated.
- The Japanese bond market could burst with devastating consequences.
- A new currency war could break out.
- Even if we buck the NIRP/ZIRP trend, rising domestic Treasury yields could collapse growth and push America to insolvency.
- A war on cash to force everyone back into the banking system. This sets up for very centralized control with a correspondent diminishing of personal freedom.
The truth is that we don't know for certain exactly how the current bubble might resolve. As mentioned before, these are uncharted waters. Central banks are hoping to reignite price inflation and then keep it contained. But the more negative interest rates have become, the greater the deflationary impact. It is the opposite of what had been expected.
For those who desire to see the current monetary system fail (and be replaced), this situation is rife with opportunity. Certainly the transition to a new system would be painful. But the world has gone through these changes before and eventually stabilized under new leadership.
This goes back to the Chinese military plan for Unrestricted Warfare. There are clearly elements in Russia, China, North Korea, Iran, and even ISIS with the desire to upend America, even if it creates substantial global chaos in the process. More than ever we must be vigilant to guard against economic warfare and financial terrorism. Unfortunately, there is very little discussion between those charged with our national security and those who study, let alone understand the risks of NIRP.
Things might resolve peacefully over time. Or, this might be an opportunity for one or more of our enemies to conduct a sneak attack, hoping the ensuing chaos would be sufficient to topple the existing monetary order. The timing is especially dangerous with the expected government transition due to the 2016 election.
While we can't say for certain what the outcome will be, we do believe an attempt to be likely and should be expected. We urge policymakers and defense experts to prepare a Game Plan for the next economic attack. Individual investors should likewise consider a Game Plan in light of the possible shakeup in monetary order resulting from Negative Interest Rates. As with the 2008-09 collapse, there will be money to be made by those smart enough to understand the problem and nimble enough to profit from it.