There’s a lot hinging on this US election. But you can be sure of one thing. It won’t change the economic trajectory of the country. The US, like Europe, Japan, and China, is in a debt trap. They put themselves in and they can’t get out.
Sadly, Australia is following them all down the same path.
Yesterday, the Reserve Bank fired its last round of monetary ammunition. It’s really a blank. But it’s trying to convince you it fired a bazooka.
Don’t be fooled. This is a sign of a broken monetary system.
To understand why, today, and for the next few days, I’m going to publish an edited excerpt of a report I wrote for subscribers of Crisis & Opportunity last month. In it, I explain how the monetary system actually works.
The premise is that the global monetary system ceased to function properly in 2008. That’s why we’ve been in a world of never-ending quantitative easing (QE) ever since. COVID simply exposed the broken system once again.
So with QE kicking off in Australia, it’s worth understanding exactly how it works…
Financial markets veteran, Greg Canavan reveals the critical factors that affect the rise or fall of the Aussie dollar. Click here to download your free copy of ‘Will the Aussie Dollar Enjoy a Post-Pandemic Resurgence?’ to discover where the Aussie dollar is likely headed towards the end of 2020.
The fiscal and monetary response to the virus, both in Australia and around the world, is a sign of things to come. The next few years will see even greater government interference as it tries to ‘fix’ this broken system.
I don’t want you to think of this as being ‘bearish’. It’s not as simple as that. I just want you to understand how the system that houses your wealth works, to put you in a better position to manage it.
That is, how much of your portfolio should you have in shares, bonds, gold or cash? Which currencies?
Thinking about these issues and making a few simple (but important) adjustments could have a massive impact on your longer-term returns.
Now, if you’re someone that only likes to punt on small and microcap stocks, this big picture stuff may not appeal to you. But if you’re looking after a larger chunk of money, say your superannuation fund, this is really valuable information.
It will give you the correct framework to think about your portfolio. It will give you the information to understand whether consensus opinion is right or wrong about how markets are unfolding.
For example, as you’ll see, the whole ‘inflation’ narrative is nothing more than a short-term reaction to this year’s massive stimulus measures. Absent another bout of unprecedented action, this narrative will fade into 2021.
Commodity bulls beware!
I’ll address all the investment implications in the next monthly issue. Including:
- What markets and stocks/sectors you should be focused on right now.
- Where gold fits in all this?
- What currencies should you look at for your ‘cash allocation’?
- Should you still consider bonds as a part of your portfolio?
- Do cryptocurrencies have a role to play in the future financial system?
But for this month, I simply want to provide you with a framework for understanding the system that your wealth lives in. Only then will you have the comfort and confidence to make the right investments and portfolio allocations.
In this issue, I’m going to explain:
- Why the Fed’s QE is not money printing and why it won’t (and never will) create inflation. Ditto for other central banks.
- Why fiscal stimulus will only provide a short-term economic boost, and leave the economy in a deeper hole when it washes through the system.
- Why understanding the shadow banking system is the ‘missing link’ in the financial system. When you understand this, everything becomes much clearer.
- Why ‘disinflation’ is good for stocks and bonds, and why inflation will be a disaster for the stock market and asset prices in general.
There’s a bit to get through, so let’s get stuck in…
Why the Fed’s QE is not money printing and why it won’t (and never will) create inflation
To understand this point, you must first understand that it is the private banking system that creates money, not central banks.
They do this in two ways:
- The traditional way. That is, a bank makes a loan to an individual or business, securitised by an asset, which is usually property, or some other form of business assets. The bank creates the money and puts it into the borrowers account. The banks are only constrained in how much money they can create by the amount of capital reserves they have, and their willingness to take on risk. (That last point is an important one that I’ll come back to.)
- The other way is via the ‘shadow banking’ system. I’ll discuss the role of shadow banks later. But for now, understand that in the modern monetary system, non-banks create ‘money-like’ claims (not quite money in the way that traditional banks create deposits). This was a big part of the reason behind the boom preceding the 2008 credit crisis. Shadow banks effectively turned mortgage securities and their derivatives into cash, which unleashed huge speculation.
All a central bank can do is monetise existing assets. It cannot create ‘new’ money. It buys a treasury bond, for example, and pays for it by creating bank reserves. Bank reserves are not cash.
The bank that receives the reserves must deposit it with the Fed. It cannot buy other assets with it. Nor can bank reserves be used to buy goods and services.
QE (the purchasing of assets by a central bank) therefore simply shifts the composition of assets within the monetary system. It removes long-term treasuries and mortgage-backed securities, and replaces them with bank reserves.
That’s why, despite years and years of QE (not to mention the Japanese experience), you haven’t seen a pick up in inflation.
Does QE cause stock prices to rise?
So, if QE doesn’t cause consumer price inflation, it surely leads to asset price inflation, right?
This is where things get tricky.
For the system as a whole, QE does not create additional money/credit/purchasing power in financial markets. The level of assets remains the same. Remember, all the central bank does when it engages in QE is removes a long-dated bond and replaces it with bank reserves.
Where I think it does have an impact, though, is at the margin. For example, the hedge or pension fund who sells a Treasury bond to the bank (who sells it to the Fed) gets cash in return and buys another asset with it.
In the end — system wide — it all washes out as neutral. But I think it does provide some players with additional asset purchasing power. And this shows up in certain parts of the market. But overall, I don’t think the physical act of QE has a major impact across the board.
Where QE does have a big impact on stock prices is via the psychology effect. As long as people believe that QE is ‘money printing’ and causes stock prices to rise, QE will cause stock prices to rise. Confidence creates liquidity.
But stocks need more than just belief to sustain a bull market. If QE doesn’t explain the long bull market in stocks then, especially in US markets, what does?
I’ll answer that question, plus much more, over the next few days…
Editor, The Rum Rebellion