Fiat Currency and German Bonds

Member Group : Lincoln Institute

"Germany sells Five-year debt at Negative Yield for First Time on Record", screams the article from Wall Street Journal. The subtitle also stated "Move reflects plummeting borrowing costs across Europe".

Germany was able to sell $3.72 billion of five-year bonds at a negative interest rate of .08%. In essence those who lent Germany this money were willing to pay the German government for the privilege of the government holding the investor’s funds for 5 years. The move reflects, in reality, that investors are more concerned about the return of principle than the return on principle.

The German negative interest rate comes on top of similar negative interest rates in Denmark, Switzerland, Finland, and Japan.

The disastrous consequences of the current economic policies allow negative interest rates to occur. Negative interest rates are a clear sign of an impending deflationary spiral.

The extraordinarily cheap monetary policy of the ECB, Bank of Japan, Bank of England, and most notably the Federal Reserve have set the stage for one of the greatest economic catastrophes in history.

The absence of any risk premium, or premium that is charged by a lender to a borrower for the risk of default and inflation, sets the stage for a massive defaults and fair value consequences on the balance sheets and income statements of anyone holding such debt.

While the stock market in the United States is continuing to benefit from this cheap money at the present time, it will not be able to sustain such levels for much longer. Whether the market will continue to benefit from a negative interest rate environment is very similar to the skepticism that was rearing its head at the beginning of the real estate debacle in 2008 and bubble in 2000.

The concern is not that the stock market will burst, but when.

It is irrational that one would lend money and pay for the privilege of doing that. It is the economic equivalent of "no-doc" loans and negative amortizing mortgages of 2007.

When the ECB attempted to raise interest rates in 2011, the European economic results were disastrous and were immediately followed by frequent interest rate cuts to the point where negative interest rates are now the European norm. The European economic slowdown that followed from a one half of 1% interest rate increase has shocked the free world.

At the current time, the Federal Reserve in the United States is contemplating raising rates due to perceived improving economic conditions in the United States. The impact of raising these rates is unknown since the United States may be the world’s last safe haven. A potential consequence though is that the impact of raising rates could be quite a shock to the economy.

Just as the housing market and the dotcom stocks became overinflated, the stock market is displaying similar overvaluations due to the "free money" Federal Reserve policies since 2008.

Naysayers to a market correction are quick to point out that the price-to-earnings multiples of the current market pricing are reasonable. I would agree as long as those earnings remain steady they are accurate.

However, all of that changes in a negative interest rate climate due to deflationary concerns. Market triggers to a major market correction include the Federal Reserve’s inability to raise interest rates, minimal gains in real wages, declining commodity prices, and increasing national debt. Once one or more of those triggers are rupture, corporate earnings will decline with a concurrent decline in the stock market and economic activity.

Many believe that the Federal Reserve could step in once again to curtail any adverse affect of prior quantitative easing efforts just as the ECB is doing in Europe.

The coming crisis is different and monetary policies of the Federal Reserve may be limited.

The audit of the Federal Reserve reflects a severely overleveraged balance sheet. Despite severe misgivings about the scope of the "audit", the audit for 2013 shows that the Federal Reserve is leveraged 73 times its capital base. Only public confidence in the dollar will say what is too high of a degree of leverage!

It is important to note, though, that during the financial debacle of 2008 firms such as Bear Stearns and Lehman Brothers were leveraged over 30 to 1.

The reality of the negative interest rates, the Federal Reserve’s excessive leverage, and monetary policy and fiscal policy in general, are that such policies only work should there be an acceptance of our currency – our fiat currency.

Should any issues occur with the willingness to accept our currency by major players in the financial markets, the economic consequences of such an action would be to devalue our currency on the one hand or result in a massive deflationary spiral in the United States on the other.

Lack of dealing with crisis in financial markets for decades by using short-term, quick fix measures, without the appropriate financial discipline, is a recipe for disaster.

The solutions to the current crisis are many. But those solutions require discipline, and a need to be honest with the electorate of the depth of the problems.

Should rational and fiscally disciplined solutions not be addressed quickly, the probability of avoiding another financial disaster worse than 2008 is bleak.

Reducing spending, reducing uncertainty, and developing long-term solutions that are fiscally disciplined increase the likelihood that we will weather this storm.

Should we choose the easy way out, 2015 or 2016 will make 2008 look mild in comparison.

Col. Frank Ryan, CPA, USMCR (Ret) and served in Iraq and briefly in Afghanistan and specializes in corporate restructuring and lectures on ethics for the state CPA societies. He has served on numerous boards of publicly traded and non-profit organizations. He can be reached at [email protected] and twitter at @fryan1951.