‘A little knowledge is a dangerous thing’, to paraphrase Alexander Pope (An Essay on Criticism, 1711). Pope said a little learning is a dangerous thing. Learning and knowledge aren’t the same. But for the purposes of today’s letter, they’re close enough. Why?
Because political and financial authorities have just enough knowledge to think they’re doing the right thing. But in reality, they’re making it up as they go along. Guided by an instinct for control and a habit of hubris, they are taking all of us over a cliff. Civilisation may never recover from the disaster they are driving us towards.
Example one: the reverse repurchase market with the Federal Reserve. It’s an obscure corner of the financial system. Usually it doesn’t matter. But it does now. The Fed (and other central banks) have flooded so much cash into the financial system with Quantitative Easing (QE) that it has no place to go.
That’s what’s happening in the reverse repo market in the US. On Friday, market participants (mostly money market funds that invest in short-term corporate and government debt) parked US$756 billion in cash with the Fed overnight. In exchange, they received short-term Treasury bills. It was a record high in overnight reverse repos, although you can see from the chart activity has been spiking in recent weeks:
Too much cash, nowhere to go
To make a long story short — and to avoid going into an anatomy lesson about the guts of the global financial system — this is about short-term interest rates wanting to go negative. And it’s about how the Fed has caused that and why it wants to avoid it. It’s about too much cash chasing too few assets with a real yield. And how all that could lead to the crash we’ve been expecting at The Bonner-Denning Letter.
First off, interest rates don’t have a mind of their own. They are set, in a free market, by the demand for money and the supply of it. In an unfree market, where the central bank sets a target interest rate, they are manipulated. In this case, the Fed has pumped so much money into the bond market (the Fed’s balance sheet went over US$8 trillion last week), that bond prices have gone up and bond yields have gone down. Bond yields would go down even further (negative even) if the Fed had not intervened last week.
Negative yields on short-term debt are a problem for the US$4 trillion money market fund industry. Money market funds invest mostly in short-term corporate and government debt. They must earn some sort of yield on that to cover their operating expenses. If they don’t, there’s trouble. It’s called ‘breaking the buck’, where the net asset value of the fund falls below US$1.
The heart of the trouble is there’s too much cash in the system. In a reverse repurchase agreement, a financial player deposits cash overnight with the Fed. The Fed, in turn, gives that player short-term government bills or notes. What’s really going on?
On the one hand, the money market funds can’t find any other place to put the cash. They have to do something with it. The Fed increased the overnight deposit rate on reverse repos to 0.05% after its meeting last week. That partly explains the Thursday spike to three quarters of a trillion dollars.
On the other hand, the Fed has to prevent its target rate from going negative. And it wants to absorb some of the cash it’s flooded the system with. Hence the higher overnight interest rate on reverse repos. It’s mopping up cash to prevent rates from going lower.
What’s especially odd about this situation is that in a standard credit bubble, where there’s too much cash and credit created by artificially-low interest rates, the money finds an outlet. It inflates house prices (Australia), or commodities (oil), or speculative assets (non-fungible tokens, Bitcoin [BTC]). Excess credit creation is like water and the liquidity always finds an asset to inflate.
Only this time, it’s not finding anywhere to go. Money market funds could invest in stocks. But stocks are too volatile. The short-term swings in stocks would put the value of cash at risk. And money market funds attract cash because they are LIKE cash — easy to buy and sell quickly.
Besides, stocks are expensive. Yale economist Robert Shiller’s cyclically-adjusted price-to-earnings ratio, which smooths on the P/E ratio by looking at it over a number of years, is higher than at any time in history, save the peak of the dotcom bubble. Stocks are not cheap at this point in the cycle.
Is this how the greatest bubble in everything, ever, ends? When there’s no place left to put excess cash to work? Historically, bubbles pop when there’s some external shock. Or when the last greatest fool is in the market and there’s no one left to buy. Is that the case?
The greatest fool of all is the Fed. It may end up being the buyer of last resort in financial markets. The bubble it’s inflated looks increasingly unstable. Watch this space.
Meanwhile, a little knowledge in Victoria — that you can create a permanent state of emergency and indefinitely suspend democracy — seems to have taken hold at the highest reaches of state government. Multiple news outlets report that the Andrews government is talking with three crossbenchers in parliament to secure enough votes to make pandemic laws permanent.
If the reports are correct, the proposed changes would mean the government doesn’t have to seek parliamentary authority to extend the state of emergency measures. Those measures authorise it to impose lockdowns and other measures to control a pandemic. It would simply have that power on an executive basis, with or without the approval of the parliament (if I understand it correctly). And you’d assume it would have broad authority to decide what constitutes a pandemic, or even just a public health emergency.
Has there ever been a greater menace to the rule of law and freedom in Australia than the government of Dan Andrews? His lust for authoritarian control over millions of people is now verging on psychopathic. This is par for the course for most senior politicians. But Andrews is taking it to new, unprecedented levels in Australia.
When he is long gone and, hopefully, when the rule of law has returned to Victoria and Australia, people will study this episode carefully. It should never happen again, where one man or a few people have such widespread and arbitrary control over the lives and livelihoods of millions of people. It’s more dangerous than any virus ever could be.
Editor, The Rum Rebellion
The Bonner-Denning Letter is co-authored by Port Phillip Publishing founder Dan Denning and legendary investment writer and publisher Bill Bonner. It connects the dots between markets, politics, and history as one of the only macroeconomic, ‘top-down’ newsletters in Australia. For a big picture perspective on the past, the present, and your investment future, click here for details on how to subscribe.