Practical analysis for investment professionals
17 October 2016

The Mad Scientists of Monetary Policy

Victor Frankenstein was a promising young scientist who became obsessed with the notion of simulating life. After years of steadfast study and maniacal experimentation, he finally achieved his goal of imbuing life into inanimate matter. However, rather than marveling at the miracle of his achievement, he instead became horrified at his ignominious creation. Frankenstein’s monster was a terror who killed people Victor knew and loved.

Mary Shelley’s original novel, first published in 1818, is of course science fiction. But today, much like Dr. Frankenstein, central bankers are trying to create life in the financial system. Only unlike Frankenstein’s work, their financial experiments are all too real.

And unfortunately, there’s not just one mad scientist . . . but many. Who are today’s Drs. Frankenstein? Haruhiko Kuroda at the Bank of Japan (BOJ), Mario Draghi at the European Central Bank (ECB), and Janet Yellen at the US Federal Reserve. They each have a monster in their castle.

What do I mean? Central bankers have embraced extraordinary monetary policies to create economic growth where none would exist. How have they done this? By printing lots and lots of money and injecting it into the system through massive bond purchases. The aggregate bond market is growing, of course, but bonds are being purchased and locked away in central bank dungeons faster than new bonds are being issued.

At the present pace, central banks will soon run out of bonds to buy. The end game is in sight.

Beginning in March 2015, the ECB embarked on its own quantitative easing (QE) program, buying sovereign and agency bonds at an initial pace of €60 billion per month, which it then ramped up to €80 billion a month. Since then, the ECB’s balance sheet has grown from about €2 trillion to €3.4 trillion in just 18 months.

Though eurozone sovereign debt outstanding stands at €7.5 trillion, ECB rules dictate that it can only buy bonds between two and 30 years maturity and must yield more than -0.4%. According to Tradeweb, the maturity and yield restrictions renders €1.5 trillion in bonds ineligible for purchase by the ECB, bringing the total available for purchase down to €6.0 trillion. Also, the ECB cannot hold more than one third of a given issue or a given country’s debt.

Consequently, the problems at the individual country level are even more acute. Based on an analysis of the €1.13 trillion Bloomberg German bond index, more than 60% of German debt fails to meet the ECB’s yield criteria. According to UBS, the ECB will run out of German bonds to purchase within months.

The BOJ is pursuing a similar strategy, buying at a rate of ¥80 trillion (about $765 billion) Japanese government bonds (JGBs) per year. Against total debt outstanding of ¥1.1 quadrillion as of 30 June 2016, this translates into over 6.7% of the debt stock per year — and over 14.3% of GDP.

How does the Japanese government keep this game going? By issuing more bonds than the BOJ buys each year. You see, sovereign debt has a special relationship with money. When a government issues debt, it acts as a restraint on inflation. Conversely, when a government prints more money, as through QE, it acts as an inflationary force. (What exactly it inflates is a separate question.) For instance, the BOJ purchased ¥81 trillion of JGBs in 2015, however, Japan’s Ministry of Finance issued only ¥15 trillion in bonds — meaning the BOJ purchased more than five times what the government issued, as measured by the change in Japan’s government debt. Historically — before Abenomics — this relationship was reversed. The Japanese government issued about five times what the BOJ purchased. This program has been in place for three years. But can it continue?

The question is really one of agency. In order for Japan, the EU, or any country to continue propping up markets, it must be able to sell substantially more bonds than it buys (through the printing of money).

To sell bonds, these countries need willing buyers. By purchasing lots of bonds, the BOJ places a bid under bond prices, which gives private investors some assurance that bond prices will go up. This is the easy part.

Where it gets hard is once rates turn negative — and over $13 trillion of the global bond market is now priced with negative yields. Eventually, it will make more sense for investors to hold cash yielding 0% than to buy bonds at negative yields. When precisely storing and safeguarding cash becomes more attractive than the implicit security of buying bonds at a guaranteed loss is unclear. But there is a negative rate when the game will change and people will stop buying bonds and put their cash under their mattresses instead. This is when the monster runs loose in the city.

A central bank with the authority to print money can always print more. But this doesn’t mean that there will be enough bonds for the central bank to purchase. So as central banks run out of acceptable bonds, they will need to lower their standards or buy other types of assets. That is, central banks will buy risk assets like junk bonds and equities and private businesses and real estate. And in doing so, financial markets then reward risk taking — even when it ceases to be sensible. These are the incentives the mad scientists face and they clearly understand the writing on the wall.

Already, the ECB has widened its net by buying corporate bonds at a pace of roughly €2.5 billion per week (the ECB probably owns about €30 billion in corporate bonds as of 6 October 2016).

The ECB’s corporate bond buying has also spawned a second layer of agency costs: Investment banks and their corporate clients are now issuing corporate bonds tailor-made for the ECB corporate bond program through private placements. In such private placements, there is no prospectus, no press release, and no transparency. Moreover, the average yield on investment grade corporate bonds eligible for ECB purchase has fallen from 1.3% before the ECB announcement to 0.65% today.

Such low-cost financing encourages companies to take on risky projects that would ordinarily never come close to meeting return thresholds. The ECB has created a seller’s paradise that can be (temporarily) good for corporate management, but not necessarily for long-term value creation. It’s a classic case of build up now, blow up later.

Worldwide, low interest rates have pushed corporate debt to record levels. Nonfinancial corporate credit has risen to nearly 50% of GDP in emerging markets — an all-time high. The global corporate debt-to-EBITDA ratio has reached three — the highest ever recorded — in a supposedly healthy economy. In effect, companies are borrowing from the future to reward the present.

The BOJ has widened its net as well. In January 2015, it began purchasing equity exchange-traded funds (ETFs) and is on course to become the top owner of 55 stocks in the Nikkei 225 Index. In fact, in July 2016, the BOJ doubled its purchases of Japanese stocks. In some circles, the BOJ is now known as the Tokyo Whale.

Though the BOJ still owns less than 2% of all outstanding Japanese stocks, the devil is in the details. For instance, a company called Fast Retailing with a market cap of ¥3.6 trillion only has a free float of about 25% of outstanding shares. At the current pace, BOJ will own about 63% of Fast Retailing’s float by the end of the year. Incrementally, BOJ will encounter more and more limits to available assets. On the one hand, the shrinking supply will make it easier for them to drive up bond and stock prices. On the other, it will send interest rates lower (further into negative territory) and further separate security prices from underlying fundamentals. Not only is this a bad outcome for investors, these experiments are creating massive misallocations of capital.

But the BOJ isn’t just running out of stocks to buy, Japanese banks need to use JGBs as collateral in their day-to-day operations. Japan’s three largest banks, Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group, and Mizuho Financial Group each cannot reduce their holdings of JGBs much beyond their current levels without harming their current operations. “Considering the need for collateral and other factors, we generally don’t envision cutting the balance any further,” Mizuho spokesman Masako Shiono said. Mizuho’s assets are currently about 5.4% JGBs. Historically, Japanese banks held about 5% of total assets in JGBs. This figure increased to 20% when the BOJ first introduced zero interest rates in 1999. According to UBS economist Daiju Aoki, in-bank holdings of JGBs typically amount to 12%–13% of assets today. Mitsubishi currently has 9% of their assets in JGBs and indicates that it needs a minimum of 5%, or ¥15 trillion. Sumitomo is already below the others at 3.8% of assets, suggesting that it too has no further room to sell JGBs.

Japan Post Bank, another major holder of JGBs, has already cut its holdings by 42% since March 2013 when Abenomics was implemented, leaving approximately ¥80 trillion in JGBs on its balance sheet — just one year’s worth of QE (assuming the Post Bank would be willing to drive their holdings of JGBs down to zero). At the end of March, Japanese banks collectively held ¥94.7 trillion in JGBs (with maturities greater than one year) on their balance sheets. But they need to retain about ¥30 trillion as collateral to conduct day-to-day operations. So that leaves roughly ¥64.7 trillion JGBs available for sale as of March. Today, it might be as low as half that.

As if that weren’t enough, the BOJ is already buying corporate debt at 4% of its annual ¥80 trillion QE program. However, it is publicly considering expanding their purchase of corporate debt to include riskier junk bonds.

All this suggests that if the strategy remains the same, then the tactics must change.

In the United States, Yellen has called a halt to QE. But that hasn’t stopped the US government from devising ways to grow the bid on US bonds. For starters, QE at both the ECB and BOJ only encourages European and Japanese investors to purchase US government bonds (USGs), so this provides cover for the United States so long as the other two Drs. Frankenstein continue their experiments.

So the question is: Have all these people lost their minds? It really takes extraordinarily smart people to do extraordinarily stupid things. At what point will they choose to stop?

At one extreme, central banks can return to normal monetary policy and bring on a severe recession over the next two to three years. At the other, central bankers can continue the madness until they own every last asset on Earth and the experiment of freedom and free markets is all but destroyed.

Frankenstein’s monsters are now in the dungeon laboratories of central banks in the United States, Europe, and Japan, and the mad scientists are jolting them with electricity. Do we really want to find out what happens when the monsters wake up and break out? I don’t think so. But I think we will.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/CSA-Archive

About the Author(s)
Ron Rimkus, CFA

Ron Rimkus, CFA, was Director of Economics & Alternative Assets at CFA Institute, where he wrote about economics, monetary policy, currencies, global macro, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among other things). Previously, he served as SVP and Director of Large-cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, client service specialists, and marketing staff. He also served as a Senior Vice President and Lead Portfolio Manager of large-cap equity products at Mesirow Financial. Rimkus earned a BA degree in economics from Brown University and his MBA from the Anderson School of Management at UCLA. Topical Expertise: Alternative Investments · Economics

19 thoughts on “The Mad Scientists of Monetary Policy”

  1. Joachim Klement says:

    Dear Ron
    Excellent article! I would like to point out two things, though:
    1. As the example of Switzerland shows bond yields can become quite substantially negative without a run for cash because, (1) there is a group of captive buyers like pension funds and insurance companies that have to keep on buying them for regulatory and ALM reasons, and (2) central banks and retail/commercial banks can refuse to print more physical cash or refuse to pay out your assets in physical cash. In Switzerland the SNB controls the growth of M0 very tightly and some commercial banks have in their T&C that under certain conditions they can refuse to pay you in hard cash.
    2. Your analysis assumes a rather stable supply of sovereign bonds for the central banks. In theory fiscal easing could lead to a significant expansion of budget deficits and thus higher growth in sovereign bond supply. At least in some countries like Japan I would not put this into the realm of the impossible.

    1. Joachim, thanks for your insights on Switzerland! What you highlight in point #1 is really an extension of the agency costs I highlight in my article. I would expect governments to step up regulations that require banks, pension funds, etc to purchase more government bonds. In fact, this is the reason I included the U.S. government’s new myIRA program which channels retirement assets into US government bonds. It’s a shame that pension fund beneficiaries are forced to live with the ultimate consequences of these foolish actions. For politicians and government bureaucrats, it’s a classic case of “my gain, your pain.”

      Regarding your point #2, I beg to differ. I believe at some point the market cannot bear the purchase of the incremental bonds needed to finance widening deficits. (I suspect you agree…) At some point, the government may decide to simply monetize deficits… but if that comes to pass, I believe they will lose the market. Two things I try to watch closely are: a) the relationship of bonds issued by the government to bonds purchased by the central bank; and b) the relationship between a country’s CPI and monetary expansion. Regarding a), when bonds are monetized faster than they are issued, I expect monetary-induced bubbles to form. We can see this quite clearly with Japanese stocks since Abenomics policy was enacted in 2013. In the ten years ending in 2012, the BOJ only purchased about 25% of bonds issued. In the 2013 – 2015 period of Abenomics, the BOJ purchased about 5x the bonds issued. Since Abenomics was implemented in 2013, we see Japan 10-yr yields decline from +0.65% to roughly -0.04% today. We also see the Nikkei rise from roughly 9,000 to 17,000 today.

      Regarding b), when people lose faith in a currency, it tends to lose value faster than the government prints it, so consumer price inflation tends to accelerate faster than M0 growth. We see this in periods of macro-crises, perhaps most famously in the Germany Hyperinflation of 1920’s. Unfortunately, on an a priori basis, no one can predict definitively when the tipping point occurs, but I think these tools can help us observe it while it is happening.

  2. M Ashok, CFA says:

    Time and again the spotlight is always shifted to ECBs and BoJs. In your article, I see no numbers of the Fed and US Treasury activities. How much is the treasury outstanding? The US is skating a bit too long on the validity and strength USD. The unwinding therefore will start to happen in the US first, and not in Europe or Japan. Why do you think that the ECB and BoJ experiments are any dirtier than what the Fed is doing. Just because the debt is purchased by fellow bankrupt countries in a soon to be devalued ccy, doesn’t make the equation any holier.
    At least I see a change of tone in this article, compared to the previous ones where the usual rant of the sea of dollar inflows lifting the boats of emerging markets and how the tide would turn etc. The focus should be on America, where the unemployment is high, inflation is high, savings are low, home-prices are growing at unhealthy pace etc. A so-called powerful economy cannot bear 25bps rate hike over what 8 years.. is no good in my opinion.
    PS: Your statement ‘issuance of govt debt is a restrain on inflation’! That’s illogical. The money that govt raises is soon spent in unproductive ways which whips up inflation.

    1. M Ashok, thanks for your comments! Unfortunately, an article of this length does not allow a complete discussion of pertinent issues. You raise excellent points! I was simply trying to illustrate that central bankers and governments are now acting on the agency costs embedded in this situation – as central banks run into real world limitations on what they can buy, they are now buying lower quality/higher risk assets. As it happens, the ECB and BOJ are further along that curve of unorthodox buying of assets, than is the Fed. Also, my comments on government debt and inflation were not meant to be exhaustive. You correctly point out that government spending can be foolishly spent at massive scales that drive prices for certain goods and services higher. The essential point I was making here is that governments sell bonds in lieu of printing money to make up budget shortfalls. Why else would a government with a printing press even bother to sell bonds? Why not just monetize the fiscal deficit? In describing bond issuance as a restraint on inflation, I was correct. It stopped the government from printing that money and instead paid for the deficit with capital from the private sector. Inflation is of course a complex topic and I made no attempt here to be complete in dissecting all the forces at work. Thx again for your insightful comments!

      1. M Ashok, CFA says:

        Government spending accelerates inflation; and the only place in intelligent blogosphere where I find govt spending – through money raised by issuing debt- is a restraint on inflation is here.

        Defending that statement through axiomatic response doesn’t make it right either.

        The US government raises money through issuance of debt paper and the Fed prints paper currency (money) against it. This arrangement arises because constitutionally the government cannot print money and the Fed can. The latter being the independent, private body vested with money printing authority.

        So your response as to why a government with a printing press even bother to sell bonds is factually incorrect even to address it.

        This is only as far the legal arrangement is concerned. That doesn’t make the paper issued by the government, a debt in true sense. A true sense debt is one which is repaid through earnings/cashflows of the issuer. And the debt carries a healthy interest coupon etc. Firstly the US government never pays of its debt (that it doesn’t have the ability to pay is what is pertinent to today’s discussion). Can you show any period of time in recent history when the US government has effectively reduced the year-on-year debt outstanding through repayment only?

        And when the interest rates you get by owning such debt paper is near zero, isn’t it just a promise to repay principal? And that principal repayment coming through further debt issuance, essentially making it a ponzi scheme. The capital from the private sector, that you mentioned in your response, isn’t enough to keep the ball rolling. Which is why debt outstanding keeping mounting ($20 tn as of date?) every year. Raising interest rates would first cause refinancing of debt at higher rates. Which is detrimental to both private capital and government debt. The Fed would be killing private capital taxes by raising rates and would be forced to print more money to help repay govt debt maturities.

        So ironically status quo of near zero rates is best!

        Therefore, just because an IoU is issued it doesn’t make the arrangement holier than straight monetization of fiscal deficit (and I am not aware of any modern developed country practising monetization so that discussion is merely academic). Government carry on this “roundabout” way of funding its extravaganza precisely to appear ‘technical’. And this charade causes analysts/economists to get their thoughts muddled. To see through this (inflation caused by printing money) one need not be a professional economist.. actually it helps if one isn’t.

  3. Ignacio Benitez, CFA says:

    Ron – Thank you, thank you, thank you. We need more articles like this one to try stop this madness. Failing that, we may need to start demonstrating in front of their ‘ivory towers’ to demand they stop their experiments.

    1. Ignacio, as complex as the subject is, it needs to be packaged in a way so that John Q Public can understand. The gravity of the situation is immense. No politician wants to stop the train and get it back on track, no matter where the track leads. Thank you for your comments!

  4. Chuck t says:

    Great article. This will be the catalyst of our next great recession. When it happens is the big question.

    1. Chuck t, thank you for your comments!

  5. Liju Jose says:

    One of the best articles I’ve read all year long! Great job!

    One more thing, if or when a correction/recession does occur, both bonds and stocks (and most real assets) are likely to fall. In that case, where do I park my savings now? Is holding cash the only option? What asset could go up (other than gold) during a recession of this kind? Do you have any thoughts on how to capitalise on the eventuality of this madness?

    1. Chuck t says:

      Online savings acct paying 1% is your safest bet.

    2. Hi Liju, thx for your comments! There is no absolute basis for favoring any one asset – even gold. That said, there are and will always be opportunities. In researching the German hyperinflation of the 1920’s, I recall many retailers were driven to ruin, while a select few others became wealthy. I’m going to refrain from anything that might be construed as financial advice per se. Though, I think you might find other crises illuminating.

  6. First things first: Audit the Fed.

    Otherwise: If there’s a difference between macroeconomics and astrology, I’ve never discerned it.

  7. Neil says:

    Great Article ron. All the comments are interesting as well. So with the latest information we hear from the Fed about letting the economy overheat a bit mean that the Fed won’t reduce their balance sheet at all? And is there anyway they can create a managed recession or soft landing by slowing or reversing the purchase of the new and outstanding debt while BOJ/ECB buy a little in the meantime? I think you alluded to that hand-off but wasn’t sure what the net effect was. Is it keeping the yield curve anchored basically where it’s currently at?

  8. MF, CFA says:

    Great article. It all seems so clear, but I can´t stop asking myself… ¿why do central banks insist in this kind of ponzi scheme? and ¿Why is that I see very few people in media and academia (well known economists) seriously opposing this and predicting doomsday?
    Most of them (central bankers) are VERY VERY smart people… It is very hard to believe they’re just so stupid they can´t see all this… As I see it: either they have some rational that goes far beyond my understanding (which is not that far) or they are just ripping us off… ¿Do you have an opinion? Regards.

    1. Hi MF,

      Thx for your comments! Don’t presume that this is strictly about intelligence. Understanding intelligence is a whole field of inquiry unto itself, which I don’t have the space to get into here. Yes, central bankers are smart people, but this isn’t so much about intelligence as beliefs. I don’t think you should presume that central bankers automatically have the public’s best interest in mind. I think they have the government’s interest in mind and may or may not have the public’s interest in mind.

      All it takes for someone to choose a wrong [intellectual] path is holding onto a set of beliefs that are faulty in some way. My personal view of central bankers is a combination of the following: over-statement of what they can control (cognitive problem); belief that their models of the economy are complete (micro-macro bias); arrogance that they can choose what is best for people (emotional problem) better than the people themselves as expressed through the market (comprised of billions of choices by millions of people); agency costs (my gain, your pain), and diffusion of cause and effect (Newton’s second law applies to economics – for every action, there is an equal and opposite reaction. However in markets, a single action by the central bank [to raise interest rates, or reduce the money supply, or by long dated bonds, etc.] creates a diffuse reaction leaving consequences for millions of different people and institutions – some of whom benefit and some of whom are harmed.) As a result, the relationship between cause and effect can be opaque.

      Of these, perhaps the most insidious is that central bankers, academics and politicians all share the same fringe benefit that they personally do not pay the costs of being wrong. The public at large does. Look at the US inflation of the 1970’s, Nixon’s getting off the gold standard in his attempts to support his re-election in 1972, the Austrian hyperinflation of 1920’s, etc., etc.. Central banks’ very existence supports the power of government, and if it ends poorly, which this likely will, the central bankers, the academics and the politicians will likely escape blame. Just as they have so many times before.

    2. MF, CFA says:

      Thanks again for your time and opinions I really appreciate.

  9. Peter says:

    Could they not send money to citizens? The amount of assets, goods and services that citizens could buy or spend on is almost limitless, seems far more than just the financial assets of the world.

  10. Dan says:

    Great article, Ron.

    It’s good to see so many members of the CFA istitute questioning the logic of these bizarre policies, which will almost certainly end in tears.

    As you so rightly point out “when a government prints more money, as through QE, it acts as an inflationary force. (What exactly it inflates is a separate question.)” and their experiment is “creating massive misallocations of capital”. From what I can see, they appear to routinely dismiss these crucial facts.

    Thanks again.

Leave a Reply

Your email address will not be published. Required fields are marked *

By continuing to use the site, you agree to the use of cookies. more information

The cookie settings on this website are set to "allow cookies" to give you the best browsing experience possible. If you continue to use this website without changing your cookie settings or you click "Accept" below then you are consenting to this.