Category: Economics

The federal reserve’s balance sheet is telling of where monetary policy is going:

(You can view the longer term chart here)

It peaked on June 10th and the next week’s update (June 17th) showed a minor contraction.

From the last interest rate announcement, we had the following implementation note:

* Increase the System Open Market Account holdings of Treasury securities, agency mortgage-backed securities (MBS), and agency commercial mortgage-backed securities (CMBS) at least at the current pace to sustain smooth functioning of markets for these securities, thereby fostering effective transmission of monetary policy to broader financial conditions.
* Conduct term and overnight repurchase agreement operations to support effective policy implementation and the smooth functioning of short-term U.S. dollar funding markets.
* Conduct overnight reverse repurchase agreement operations at an offering rate of 0.00 percent and with a per-counterparty limit of $30 billion per day; the per-counterparty limit can be temporarily increased at the discretion of the Chair.
* Roll over at auction all principal payments from the Federal Reserve’s holdings of Treasury securities and reinvest all principal payments from the Federal Reserve’s holdings of agency debt and agency MBS in agency MBS and all principal payments from holdings of agency CMBS in agency CMBS.

Things are continuing, but monetary injection is not going to be the rocket ship that it was. The 3 trillion dollars of liquidity thrown into the system will have to take its time to transmit into the real economy (if indeed, it does at all).

I will point out that during the 2008-2009 economic crisis, essentially the same response was there – the primary liquidity injection was done in the 4th quarter of 2008, but it took some time from 2009 onwards in order for stock prices to really jump up. All analogies have different variables at play, and this is most certainly not the 2008-2009 economic crisis (nor the great depression) so again, the playbook here is going to be quite different.

I’ll also point out that the Bank of Canada is getting into the business of inflating its own balance sheet, albeit not nearly at the pace that the Federal Reserve has (even adjusting for the relative sizes of the countries).

The post-COVID-19 world is going to incur a material extra cost to doing street level business, at least if they want to do things “by the book”, which includes abiding by yet another layer of regulatory burden from health and worker’s compensation board agencies, lest the authorities pull your business license. Individuals can flaunt the unwritten laws of social distancing with little consequence, but businesses have much more to risk if they do not toe the line.

Getting plexiglass installed, and distributing masks and faceshields to employees, isn’t free. The labour to disinfect everything and to maintain it, isn’t free. Having your square footage utilization ratio decrease by a factor of 2 or 2.5, most definitely is not free, especially in urban centres where retail leasing prices are (or were) sky-high.

Good example of an article: Shops are reopening after COVID-19, and some are adding a new line to your bill to pay for it.

Psychologically speaking, a surcharge is ill-advised in competitive businesses. Customers will feel like they’re getting ripped off. Smarter businesses will embed it into the sticker price.

But the underlying point is that within businesses that have to deal with other human beings close and up-front, fixed and variable costs are going to increase. This is a cost burden that all such businesses will have to face, so it will give a natural competitive advantage to those that don’t have to put up with such costs, or those that can amortize fixed costs over a wider base.

These costs are not going to materially add value to the customer, but because they will be spread amongst all in-person business participants, the customer will have to pay for them.

If it isn’t obvious already, businesses that do not have much in the way of a physical presence will gain one more competitive advantage, relative to those businesses that serve customers in-person.

We are all forced to be closet macroeconomists and for that, I’d suggest reading Ray Dalio’s primer on money, credit and debt:

More specifically, the ability of central banks to be stimulative ends when the central bank loses its ability to produce money and credit growth that pass through the economic system to produce real economic growth. That lost ability of central bankers typically takes place when debt levels are high, interest rates can’t be adequately lowered, and the creation of money and credit increases financial asset prices more than it increases actual economic activity. At such times those who are holding the debt (which is someone else’s promise to give them currency) typically want to exchange the currency debt they are holding for other storeholds of wealth. When it is widely perceived that the money and the debt assets that are promises to receive money are not good storeholds of wealth, the long-term debt cycle is at its end, and a restructuring of the monetary system has to occur. In other words the long-term debt cycle runs from 1) low debt and debt burdens (which gives those who control money and credit growth plenty of capacity to create debt and with it to create buying power for borrowers and a high likelihood that the lender who is holding debt assets will get repaid with good real returns) to 2) high debt and debt burdens with little capacity to create buying power for borrowers and a low likelihood that the lender will be repaid with good returns. At the end of the long-term debt cycle there is essentially no more stimulant in the bottle (i.e., no more ability of central bankers to extend the debt cycle) so there needs to be a debt restructuring or debt devaluation to reduce the debt burdens and start this cycle over again.

Does this remind you of anything that is going on right now?

With monetary policy at an effective zero bound (I don’t really care whether the interest rate is 0.25%, 0.75% or -0.5%, it is effectively zero and the negative bound is the ability to store paper currency underneath the mattress), the ability for central banks to stimulate the economy (without causing reams of economic damage with massive inflation) is effectively toast. The large recent failure was to not attempt a better normalization after it was perfectly evident the 2008-2009 economic crisis was passing, coupled with the US government not being fiscally responsible. In Canada, Harper was on the right track (he got the budget balanced and the Bank of Canada was able to escape the economic crisis with far less intervention than the US Federal Reserve), but Trudeau and the Liberals have done an exceedingly fine job of reversing this, and now Canada is basically in the same boat as the USA – central banks are employing quantitative easing as a last resort to stimulate economic activity.

The big difference this time is that when the government also mandates a shutdown of the economy, it doesn’t matter how much stimulus you put out there, the real economy is not going to respond. Why would a restaurant owner at this point in time make any investment at all when you have talks of COVID-19’s “second wave” and this can just start all over again?

The real interesting implications occur after one asks what the new currency will look like when it goes from fiat back to something that the public has confidence in. Will that be gold, or bitcoin (or some other crypto)? My big problem with bitcoin, and most cryptocurrencies in terms of them providing a “hard asset” is the dominance of the hash – most of the power in the network has been increasingly centralized to miner pools and it is getting to the point where the possibility and allure of collusion is effectively the equivalent of 51% of people deciding to steal the 49%’s capital.

I would deem it more likely that central banks will try to introduce a parallel currency.

Crude oil is down the biggest percentage I have seen in my investing history – West Texas Intermediate (WTI) currently down 20% (from a close at US$41 to US$33 presently). Brent is about US$37. There is no way to describe this other than a crash.

Canadian oil has been trading at a heavy differential, with Western Canadian select closing last Friday at US$28/barrel.

Needless to say, this is going down on Monday, probably to around US$22/barrel if we keep things at a 20% discount to WTI.

There is no Canadian oil company that can survive at this price level. Even though there are some companies where this is under the marginal cost of extraction (e.g. looking at CNQ’s last year, they had a CAD$12.41 marginal cost of extraction for their North American production, not including royalties) you still have costs associated with drilling and financing to pay off, and a US$22/barrel model completely destroys this.

Some obvious implications are that capital spending is going to decrease to the bare minimum, even more so than what has previously been announced. High cost production is going to be shut down, and we will be seeing another wave of insolvencies in the energy sector. Not pretty at all.

In these high-volatility situations, there is always money to be made by correct timing and correct decision-making, and right now the winners are those that don’t have a single barrel of crude oil in their portfolio. There will be spillover, however, plenty of it.

For example, geopolitically, countries that are heavily reliant on crude imports can’t continue to function for very long. Iran, for instance. Rock-bottom crude oil prices will have ripple effects that are not immediately obvious on a first order level of thought.