The perils of using scrip and central bank digital currencies

For those not familiar with the noun scrip, look at the Wikipedia article.

Historically scrip was issued by large companies to physically remote workers, for usage in their own facilities. The Hudson’s Bay Company was a classic example of this. In some cases, company scrip was nearly as good as money.

Today in our 21st century, we have digital scrip in the form of Apple and Google Play cards, in addition to more generalized gift certificates and the like.

Cryptocurrency is another innovation which is functionally the scrip of those that voluntarily choose to engage in the transaction of such digital tokens.

Sovereign currency, such as the US dollar and UK Pound, historically used to represent a certain amount of gold or silver, but those days have long since passed. The fiat currencies we use are backed with a single promise, and that is the ability to pay taxes to the government. Other than this fundamental value, fiat currencies trade on the perception of value conveyed by their participants. While scrip definitionally is referring to non-sovereign currency, functionally speaking, the green, red and brown pieces of polymer we hand around is a form of scrip, albeit with more legal authority.

However, with the digitization of everything, we are witnessing the fragmentation of various scrip. We see increasingly sophisticated schemes by scrip issuers to incentivize various behaviours of the recipients.

One 20th century invention was the Air Miles concept – spend in a preferred manner and eventually receive enough to purchase a commodity “for free” that otherwise would be wasted – an empty airline seat.

On the advent of this came a whole plethora of reward schemes.

However, all of these schemes are subject to the issuer’s fiat. We have seen this in the sovereign context when a country decides to devalue a fixed-peg currency (just look at the Argentina Peso as a great example).

Also, nominally valued scrip is subject to the ravages of inflation. A Costco gift card purchased a couple years ago most certainly purchases a lot less today than it did when it was originally purchased.

It is interesting to note that strict gift cards (money for store credit) have legislative protection (at least in British Columbia) and must be held as a liability to the issuer in perpetuity.  Only monetary inflation of the underlying currency degrades the value of this scrip.

However, the story is different with reward schemes.  Similar to sovereign currency devaluations, owners can be spontaneously diluted. An airline seat costs more miles to purchase, or perhaps the availability of seating is less desirable.

Reward schemes are everywhere now, to the point where nearly every single major corporation out there with any retail presence has these annoying and low value (to the consumer) schemes to incentivize certain behaviours. The promoter of the program wants to pull off an Aimia (the payday is selling the accumulated customer data on the points program), while the end retailer wants to drive certain types of sales using scrip as incentive. It is nearly always to the detriment of the consumer.

In Canada, most recently I noticed the Freshco/Safeway/Sobeys chain (owned by Empire (TSX: EMP.A)) is subscribing to “Scene”, which was originally a creation of Cineplex (TSX: CGX) and Scotiabank (TSX: BNS) to give people free movies.

Other grocery stories, such as Save-on-Foods (Save on More) and Superstore/Shoppers Drug Mart (Loblaws/George Weston) (L.TO/WN.TO) have their own scrip schemes – PC Points.

Suncor (TSX: SU), via Petro Canada, runs a popular “Petro Points” scheme.

McDonalds (NYSE: MCD), and all the other fast food operations, which are “appifying” themselves, have their own arbitrary points system.

It goes on, and on and on, and the hapless consumer is plagued by the administrative burden of figuring out if any of this is worth the time/energy hassle to functionally get minor discounts off their aggregate purchases.

What’s great from the company perspective is that you can effectively be your own central bank and decide to pull the rug on your customers whenever you want without any recourse by those holding the scrip.

Nothing illustrated that better than Starbucks (Nasdaq: SBUX) pulling off a “Christmas surprise” on their rewards program.

Their original scheme was that for every dollar you purchased stuff at their stores, you would receive two stars. Accumulate 50 stars and get a free coffee. Accumulate 150 and get a free fancy drink.

Effective in February, they announced that this will now be 100 stars (a 100% inflation) and 200 stars (a 33% inflation), respectively.

What’s funny is that when the inevitable blowback came on Twitter, the generic response was:

Hello, we continually want to update the Starbucks Rewards program so that we’re meeting the changing needs of our members while ensuring we’re still able to deliver some of the benefits members know and love.

Learning the language of corporate-speak is a reason why I would perish in a corporate communications role. The dishonesty would drive me insane.

The reality is that I am sure there was a cottage industry of people banking Starbucks scrip and this liability (in addition to future liability) needed to get whittled down in the face of a rapidly escalating cost environment.

Fortunately, I do not subscribe to many of these schemes, but as scrip systems continue to get more and more fragmented, there may be less of a stimulatory effect on the consumer, resulting in a dimunition of such schemes as they aren’t going to be nearly as lucrative as the original scrip schemes were.

However, for now, definitely the lesson is if you’ve been accumulating scrip, it’s generally good to spend it as you get it.

The ultimate test of this theory will be when sovereign nations start to centralize currency distribution via the speculated central bank digital currency (CBDC) scheme. It will be politically inevitable that CBDCs will eventually be tinkered with in a manner similar to corporate reward schemes. “Buy ESG-compliant product XYZ for 20% less CBDC dollars!”, or “Donate to Ukraine and receive a 10% tax credit off of your capital gains tax on your next disposition of Russian corporate debt!”, etc.

Initially, the rollout of CBDCs will be a straight replacement for currency, but just like how the Income Tax Act has been perverted beyond all reason, the currency itself will be tinkered around with for political reasons to incentivize certain behaviours.

The difference between adding complexity to the Income Tax Act and adding complexity to your nation’s sovereign currency is that a currency derives value from being fungible and universally accepted.  A “rewards scheme” CBDC will inevitably chip away at this, which will ironically depreciate the value of such currency.

It makes me wonder if barter is going to make some sort of comeback.

The effort it takes to get a coal mine going

Headline: Ottawa says no to Glencore’s Sukunka open-pit coal mine project in B.C.

I don’t think anybody should be shocked these days that opening up a new coal mine in British Columbia is next to impossible. It will be killed at the environmental regulatory process.

Glencore has been at it since 2013 and halted in 2016 and 2018 to obtain more data on cariboo and water quality and perform further consultations with various First Nations bands. Interestingly enough, one of the identified impacted First Nations bands, McLeod Lake Indian Band, issued a letter in support of the project. The various reports made for fascinating reading.

On this post, I am not making judgement on the environment assessment process or to determine its efficacy or whether it was a good decision made or not; however, I will point out the obvious that this is not the only project to be bludgeoned on the entrails of the environmental ministry and it will not be the last. What this does, however, is provide a huge layer of incumbency protection on the existing projects (especially looking at Teck).

Practically speaking, there are two coal miners in British Columbia – Teck and privately-held Conuma Resources. Looking at their transparency reports (Teck, Conuma) it is like the proverbial elephant and mouse in terms of their contributions to the government.

The last (to my knowledge) issued environmental assessment certificate given to a coal miner in BC was to HD Mining in 2017 for their proposed 6 million ton a year metallurgical coal mine project near Tumbler Ridge, BC. While there was a very colourful story to this company almost a decade ago, today it is pretty obvious that the project is still dormant.

Considering that Teck got rid of its interest in its Quintette coal mine (for a not insubstantial $120 million) to Conuma very recently, there is still obvious economic value in these residual interests even if they are dormant.

However, developing a new mine from scratch in BC is going to be very difficult to clear through the government regulation. Incumbency protection is very significant.

Oil futures curve finally flipped

The following is an extract of the WTI oil futures curve:

The price of current-day (spot) crude is about 1% cheaper than the price of oil half a year out.

Let’s run a refresher course on the basic mechanics of futures pricing.

All things being equal, a clean futures curve will price the interest rate curve into forward prices, minus storage costs.

For instance, if today you can buy a barrel of oil for $100 and tomorrow you can sell it for $110, you would want to dig the trench in your backyard and store the oil there for a day so you can sell it for 10% profit. (You can do the math on an annualized return over a day!).

Ignoring storage costs, if you have to chew up $100 of capital to hold your oil, there is an implied carrying cost to holding that oil instead of selling it immediately to put into risk-free securities. This is a function of interest rates.

So a theoretical market would reflect this opportunity cost loss.

Let’s pretend your interest rate is 5%.

One would be indifferent to a $100 spot price today vs. $105 a year from now, again, emphasizing no storage costs.

For financial futures, other than a few electrons, there are no storage costs. This is why you see S&P 500 futures pricing up roughly a percent for each three months of the contract duration. Sophisticated funds can arbitrage by buying the index today and selling the future 3 months out, and pocket the spread – don’t forget about those equity dividends! This is a very roundabout way of investing in a 3 month interest product.

However, for commodities, there are storage costs and also the ebb of projected supply and demand characteristics of the underlying. An example from the natural gas market – the blowup at the Freeport LNG facility (which is still under repair) had their futures project, quite rapidly, increased supply over a limited time frame. When the promises of an early repair date evaporated quicker than LNG at room temperature, the futures curve adapted accordingly.

Another variable concerning physical commodities is that physical ownership might convey some other benefits that come with income – such as gold leasing.

Going back to crude futures, this is the first time awhile where the spot month is exhibiting a “normal” sloped curve, at least for the first half year or so. The “peak” of the curve is in October 2023 and then the price slopes downward again. This is an unusual situation.

It’s been clear to me since the June peak that the game has changed from one of scarcity to one of much more conventional metrics – can you identify the firms that will survive in a lower price environment? Do you actually want to be in a space that might potentially be a “grind to the bottom” again as companies increase capital investing and have balance sheets to sustain potentially unprofitable production?

We went through that in 2014, where supply really accelerated and crushed the crap out of the oil and natural gas market.

The question here is whether supply is nearly as constrained (either for ESG reasons or geological reasons) as the narrative would suggest.

Cash ETFs – Revisited

With the increase in Bank of Canada interest rates:

Cash ETFs:
(TSX: CASH) – gross yield 479bps – MER 13bps – net yield 466bps
(TSX: CSAV) – gross yield 396bps (November 24 distribution * 12, note not adjusted for recent rate increase(s)) – MER 16bps – this should be roughly in-line with the others
(TSX: HSAV) – gross yield 475bps – MER 12bps – net yield 463bps – CAUTION: trading above NAV, do your calculations accordingly
(TSX: PSA) – net yield 459bps

IBKR will give 368bps above CAD$13k.
HISA rates (one example): Home Trust gives 365bps.

Low duration, low risk, liquid:
(TSX: ZST) – 6 month effective duration – YTM 490bps – MER 16bps – net yield 474bps (November 30, 2022 numbers, note roughly 2/3rds investment-grade corporate debt here)
(TSX: XSB) – 2.7yr effective duration – YTM 410bps – MER 10bps – net yield 400bps

Sacrifice liquidity for yield:
GIC Direct is reporting 550bps rates (1 to 5 years).

US Dollar:
(TSX: HISU.U) – Cash ETF – MER 15bps
(TSX: PSU.U) – Cash ETF – MER 15bps
(NYSE: IBTD) – 0.58yr effective duration – YTM 454bps – MER 7bps – net yield 447bps – matures end of 2023
(NYSE: VGSH) – 1.9yr effective duration – YTM 460bps – MER 4bps – net yield 456bps

Bank of Canada raises interest rates

Bank of Canada link.

I was expecting a 25bps raise, but they did 50bps instead, which wasn’t entirely out of the realm of possibilities. The short-term bank rate is now 4.25%, while 10-year government debt yields 2.78% – extreme inversion.

The second to last paragraph of the relatively terse Bank of Canada announcement says (with my bold-font emphasis):

CPI inflation remained at 6.9% in October, with many of the goods and services Canadians regularly buy showing large price increases. Measures of core inflation remain around 5%. Three-month rates of change in core inflation have come down, an early indicator that price pressures may be losing momentum. However, inflation is still too high and short-term inflation expectations remain elevated. The longer that consumers and businesses expect inflation to be above the target, the greater the risk that elevated inflation becomes entrenched.

This “entrenchment” of inflation expectations is the key variable. As long as people believe in inflation, demand will continue to be high. Run through this thought experiment – if you think the purchasing power of your money is going into the toilet, what do you do? Buy more stuff while you can.

Also, we’re in the tail-end of what I will call the “covid effect”, namely after suffering from two years of lockdowns and general malaise, people are spending money because they haven’t been spending for the previous two years. This Christmas is probably going to be the end of it. In early 2023, I’m expecting a sobering-up period and this will probably be sharper than most expectations.

The last paragraph:

Looking ahead, Governing Council will be considering whether the policy interest rate needs to rise further to bring supply and demand back into balance and return inflation to target. Governing Council continues to assess how tighter monetary policy is working to slow demand, how supply challenges are resolving, and how inflation and inflation expectations are responding. Quantitative tightening is complementing increases in the policy rate. We are resolute in our commitment to achieving the 2% inflation target and restoring price stability for Canadians.

The “will be considering” is a very different change of language than “will need to rise” to describe the next interest rate action.

Finally, quantitative tightening is a slightly misleading term at the moment simply because there is only a billion dollars of Canada Mortgage Bonds due to mature on December 15, and then the next tranches of maturities is not until February 1st (with a $17 billion slab of near zero-coupon debt due for maturity). Reserves at the Bank of Canada continue to be around the $200 billion level and have not moved for the past 6 months or so:

Those banks are very happy to keep their money at the Bank of Canada and earning 4.25% – you’re certainly not going to give a sketchy customer a leveraged unsecured loan at 6%! The reserves will get bled out as QT resumes in February and concurrent with the Federal government doing what it does best – deficit spending.

My prediction for the January 25, 2023 announcement is a 0.25% rate increase to 4.5%. The expectations for retail sales during Christmas season might be even better than expected – especially given that we still aren’t very good at mentally adjusting the “same-store-sales” numbers down 10% to account for inflation!