Last Thursday, the Federal Reserve published the minutes of their latest meeting. These minutes are a careful exercise in ‘copying and pasting;’ only a few words are changed or deleted each time. Last week the market was obsessed with one single word, waiting anxiously whether or not it would be removed.
Last Thursday, the Federal Reserve published the minutes of their latest meeting. These minutes are a careful exercise in ‘copying and pasting;’ only a few words are changed or deleted each time. Last week the market was obsessed with one single word, waiting anxiously whether or not it would be removed. What they did not know is that this one single word would lead to the greatest volatility on the foreign exchange markets in 20 years, even exceeding the volatility seen during the euro crisis.
The minutes of last Thursday show that Fed chairwoman Yellen is losing her patience. Or at least, the word ‘patience’ was deleted from the text. They put a strike through the sentence; “the Committee judges that it can be patient in beginning to normalize the stance of monetary policy” and replaced it with; “the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting.” Now it is expected that the Federal Reserve, under similar circumstances, will raise interest rates in June.
Some jokingly concluded that Yellen meant to say that she has “a patient lack of impatience”, or that “despite her impatience, she is still very patient.”
That one single word had serious consequences, among others an enormous 'short squeeze' in the EUR/USD. Having reached the 1.04 mark earlier, it shot up to 1.09 after the minutes were released. It subsequently crashed back down to 1.05/1.06. The latest update: the euro has gained some ground again, returning to 1.08.
These are intraday fluctuations of 3 to 4%.
The EUR/USD exchange rate has never been this volatile in the past 20 years, not even during the euro crisis.
The price of gold largely followed the currency fluctuations, but continued to rise steadily on Friday, as did silver.
The volatility on bond markets is also increasing. Given the historically low interest rates and the hoarding of bonds by central banks around the world, I naturally predicted that 2015 would be characterized by an unprecedented volatility on bonds markets.
By many, including market supervisory authorities, bonds are considered low-risk investments. Moreover, in calculating their equity value banks are allowed to classify government bonds as ‘risk-free assets’.
What many people do not seem to realize is that bond prices have been rising continuously for nearly forty years. It is like we have forgotten that interest rates may also increase. The average interest rate on 10-year government bonds (of the Netherlands, Germany, France, England and the US) has steadily declined in the past 35 years; from 13% (nominal) to nearly 0%.
It should not come as a surprise that last year, U.S. bond investors were rewarded handsomely. Not by the minimal interest rate payments, but due to increasing bond prices. Last year, they achieved a return nearing 25% on long-term U.S. bonds. Of this return, 88% originated from price gains.
Now I have asked myself a question this week: how large would the losses be, for you and the Dutch pension funds, if interest rates would merely increase to their historical average?
The interest rate on 10-year Dutch government bonds currently is approximately 0.25%. Meaning that whenever these are issued again, and the interest rates do not change, the price of the bond will equal €100. For the past 400 years the average interest rate equaled four to five percent. But for simplicity’s sake, let’s assume 4%.
If the interest rate increases to 4%, a bond with a coupon rate of 0.25% will be worth less than €70; a loss of 30%. If, instead, interest rates rise to levels observed in 1980, when interest rates on Dutch government bonds exceeded 11%, any idea what the price of the bond would be then? A mere €37, or in other words: a loss of 63%. Of course, at such interest rates, almost all governments in the western world would be bankrupt, given that a voluntary normalization of interest rates is excluded by the level of indebtedness of our governments.
Moreover, the Federal Reserve, with a straight face, claims that it will gradually raise the interest rates to 4% in the coming two years.
Do you still think that government bonds are risk-free?
Of course, the starter of all this, including the largest bond bubble ever, is the interventionist zeal of central banks.
The reduction of interest rates by central bank is, in fact, a (partial) ban on interest, just as was the case during the Middle Ages. The restriction on interest (payments) was one of the reasons that the Middle Ages were an era of poverty. The Dutch Golden Age did not start until the outdated ideas regarding interest were freed from the grip of religious beliefs. In the Middle Ages, capital accumulation was discouraged by banning interest (payments), while it is actually the source of economic prosperity.
Now, in 2015, we possess much more capital and live much more prosperous lives. But the current monetary policy by central banks encourages capital consumption, hurting the ability of an economy to meet our future needs, making us poorer.
In what kind of world do we live if one single word from the Fed’s minutes leads to the largest volatility on the foreign exchange markets in twenty years’ time?
Central banks have the financial market in a vice. The prices of stocks and bonds are increasingly less related to the financial strength of the counterparty, be it a business or government, and more often to an elite group that believes to know what the interest rate and money supply should be from a ‘top-down view’. The idea that fifteen years of zero interest rates and unprecedented balance sheet expansion by central banks can be unwound without paying any price is simply naive. There will come a moment that one or several economic superpowers will become involved in a foreign exchange crisis, or that central bankers and politicians are prepared to accept the painful consequences of a six-year long high by raising interest rates themselves.
We have a fairly good idea of what can happen when a centrally planned system, and the idea of engineered markets and individuals, comes to an abrupt end. The Berlin wall fell when central planning proved to be a disaster in, among others, former Soviet agricultural markets. The idea that money and credit markets can be an exception to the rule is plain nonsense. Just as central planning does not work in the food industry; it does not work in the money industry either.
After years of price manipulation and supply and demand disturbances by the central banks, we are headed towards a painful settlement.
A GoldRepublic customer rightly said that gold provides an insurance against the mismanagement from central banks for which we only have to pay a one-time premium. And the premium for that insurance is, for now, minimal.