All actions of all men in the markets are various forms of arbitrage
Medieval thinkers were tempted to believe that if you
throw a rock it flies straight until it runs out of force, and then it falls
straight down. Economists are tempted to think of prices as a linear function
of the “money supply”, and interest rates to be based on “inflation
expectations”, which is to say expectations of rising prices.
The medieval thinkers, and the economists are “not
even wrong”, to borrow a phrase often attributed to physicist Wolfgang Pauli.
Science has to begin by going out to reality and observing what happens. Anyone
can see that in reality, these tempting assumptions do not fit what occurs.
In my series of essays on interest rates and
prices[1], I argued that the system has positive feedback and resonance, and
cannot be understood in terms of a linear model. When I began this series of
papers, the rate of interest was still falling to hit a new all-time low. Then
on May 5,2013, it began to shoot up. It rose 83% over a period of exactly four
months. That may or may not have been the peak (it has subsided a little since
then).
Several readers asked me if I thought this was the
beginning of a new rising cycle, or if I thought this was the End (of the
dollar). As I expressed in Part VI, the End will be driven by the withdrawal of
the gold bid on the dollar. Since early August, gold has become more and more abundant in the market.[2] I think it is safe
to say that this is not the end of the dollar, just yet. The
hyperinflationists’ stopped clock will have to remain wrong a while longer. I
said that the rising rate was a correction.
I am quite confident of this prediction, for all the
reasons I presented in the discussion of the falling cycle in Part V. But let’s
look at the question from a different perspective, to see if we end up with the
same conclusion.
In the gold standard, the rate of interest is the
spread between the gold coin and the gold bond. If the rate is higher, that is
equivalent to saying that the spread is wider. If the rate is lower, then this
spread is narrower.
A wider spread offers more incentive for people to
straddle it, an act that I define as arbitrage. Another
way of saying this is that a higher rate offers more incentive for people to
dishoard gold and lend it. If the rate falls, which is the same as saying if
the spread narrows, then there is less incentive and people will revert to
hoarding to avoid the risks and capital lock-up of lending. Savers who take the
bid on the interest rate (which is equivalent to taking the ask on the bond)
press the rate lower, which compresses the spread.
It goes almost without saying, that the spread could
never be compressed to zero (by the way, this is true for all arbitrage in all
free markets). There are forces tending to compress the spread, such as the
desire to earn interest by savers. But the lower the rate of interest, the
stronger the forces tending to widen the spread become. These include
entrepreneurial demand for credit, and most importantly the time preference of
the saver—his reluctance to delay gratification. There is no lending at zero
interest and nearly zero lending at near-zero interest.
I emphasize that interest is a spread to put the focus
on a universal principle of free markets. As I stated in my dissertation:
“All actions of all men in the markets are various forms of arbitrage.”
Arbitrage compresses the spread that is being
straddled. It lifts up the price of the long leg, and pushes down the price of
the short leg. If one buys eggs in the farm town, then the price of eggs there
will rise. If one sells eggs in the city center, then the price there will
fall.
In the gold standard, hoarding tends to lift the value
of the gold coin and depress the value of the bond. Lending tends to depress
the value of the coin and lift the value of the bond. The value of gold itself
is the closest thing to constant in the market, so in effect these two
arbitrages move the value of the bond. How is the value of the bond
measured—against what is it compared? Gold is the unit of account, the numeraire.
The value of the bond can move much farther than the
value of gold. But in this context it is important to be aware that gold is not
fixed, like some kind of intrinsic value. An analogy would be that if you jump
up, you push the Earth in the opposite direction. Its mass is so heavy that in
most contexts you can safely ignore the fact that the Earth experiences an
equal but opposite force. But this is not the same thing as saying the Earth is
fixed in position in its orbit.
The regime of irredeemable money behaves quite
differently than the gold standard (notwithstanding frivolous assertions by
some economists that the euro “works like” the gold standard). The interest
rate is still a spread. But what is it a spread between? Does arbitrage act on
this spread? Is there an essential difference between this and the arbitrage in
gold?
Analogous to gold, the rate of interest in paper
currency is the spread between the dollar and the bond. There are a number of
differences from gold. Most notably, there is little reason to hold the dollar
in preference to the government bond. Think about that.
In the gold standard, if you don’t like the risk or
interest of a bond, you can happily hold gold coins. But in irredeemable paper
currency, the dollar is itself a credit instrument backed by said government bond.
The dollar is the liability side of the Fed’s balance sheet, with the bond
being the asset. Why would anyone hold a zero-yield paper credit instrument in
preference to a non-zero-yield paper credit instrument (except as
speculation—see below)? And that leads to the key identification.
The Fed is the arbitrager of this spread!
The Fed is buying bonds, which lifts up the value of
the bond and pushes down the interest rate. Against these new assets, the Fed
is issuing more dollars. This tends to depress the value of the dollar. The
dollar has a lot of inertia, like gold. It has extremely high stocks to flows,
like gold. But unlike gold, the dollar’s value does fall with its quantity (if
not in the way that the quantity theory of money predicts). Whatever one might
say about the marginal utility of gold, the dollar’s marginal utility certainly
falls.
The Fed is involved in another arbitrage with the bond
and the dollar. The Fed lends dollars to banks, so that they can buy the
government bond (and other bonds). This lifts the value of the bond, just like
the Fed’s own bond purchases.
Astute readers will note that when the Fed lends to
banks to buy bonds, this is equivalent to stating that banks borrow from the
Fed to buy bonds. The banks are borrowing short to lend long, also called
duration mismatch.
This is not precisely an arbitrage between the dollar
and the bond. It is an arbitrage between the short-term lending and long-term
bond market. It is the spread between short- and long-term interest rates that
is compressed in this trade.
One difference between gold and paper is that, in
paper, there is a central planner who sets the short-term rate by diktat. Since
2008, Fed policy has pegged it to practically zero.
This makes for a lopsided “arbitrage”, which is not
really an arbitrage. One side is not free to move, even the slight amount of a
massive object. It is fixed by law, which is to say, force. The economy ought
to allow free movement of all prices, and now one point is bolted down. All
sorts of distortions will occur around it as tension builds.
I put “arbitrage” in scare quotes because it is not
really arbitrage. The Fed uses force to hand money to those cronies who have
access to this privilege. It is not arbitrage in the same way that a fence who
sells stolen goods is not a trader.
In any case, the rate on the short end of the yield
curve is fixed near zero today, while there is a pull on the long bond closer
to it. Is there any wonder that the rate on the long bond has a propensity to
fall?
Under the gold standard, borrowing short to lend long is
certainly not necessary.[3] However, in our paper system, it is an
integral part of the system, by its very design.
The government offers antiseptic terms for egregious
acts. For example, they use the pseudo-academic term “quantitative easing” to
refer to the dishonest practice of monetizing the debt. Similarly, they use the
dry euphemism “maturity transformation” to refer to borrowing short to lend
long, i.e. duration mismatch. Perhaps the term “transmogrification” would be
more appropriate, as this is nothing short of magic.
The saver is the owner of the money being lent out. It
is his preference that the bank must respect, and it is for his benefit that
the bank lends. When the saver says he may want his money back on demand, and
the bank presumes to lend it for 30 years, the bank is not “transforming”
anything except its fiduciary duty, its integrity, and its own soundness.
Depositors would not entrust their savings to such reckless banks, without the
soporific of deposit insurance to protect them from the consequences.
Under the gold standard, this irrational practice
would exist on the fringe on the line between what is legal and what is not
(except for the yield curve specialist, a topic I will treat in another paper),
a get-rich-quick scheme—if it existed at all (our jobs as monetary economists
are to bellow from the rooftops that this practice is destructive).
Today, duration mismatch is part of the official means
of executing the Fed’s monetary policy.
I have already covered how duration mismatch misallocates
the savers’ capital and when savers eventually pull it back, the result is that
the bank fails. I want to focus here on another facet. Pseudo-arbitrage between
short and long bonds destabilizes the yield curve.
By its very nature, borrowing short to lend long is a
brittle business model. One is committed to a long-term investment, but this is
at the mercy of the short-term funding market. If short-term rates rise, or if
borrowing is temporarily not possible, then the practitioner of this financial
voodoo may be forced to sell the long bond.
The original act of borrowing short to lend long
causes the interest rate on the long bond to fall. If the Fed wants to tighten
(not their policy post-2008!) and forces the short-term rate higher, then
players of the duration mismatch game may get caught off guard. They may be
reluctant to sell their long bonds at a loss, and hold on for a while. Or for
any number of other proximate causes, the yield curve can become inverted.
Side note: an inverted yield curve is widely
considered a harbinger of recession. The simple explanation is that the
marginal source of credit in the economy is suddenly more expensive. This
causes investment in everything to slow.
At times there is selling of the short bond, at times
aggressive buying. Sometimes there is a steady buying ramp of the long bond.
Sometimes there is a slow selling slide that turns into an avalanche. The yield curve moves and changes shape. As with the
rate of interest, the economy does best when the curve is stable. Sudden
balance sheet stress, selloffs, and volatility may benefit the speculators of
the world[4], but of course, it can only hurt productive businesses that are
financing factories, farms, mines, and hotels with credit.
Earlier, I referred to the only reason why someone
would choose to own the Fed’s liability—the dollar—in preference to its asset.
Unlike with gold, hoarding paper dollar bills serves no real purpose and incurs
needless risk of loss by theft. The holder of dollars is no safer. He avoids no
credit risk; he is exposed to the same risk as is the bondholder is exposed.
The sole reason to prefer the dollar is speculation.
As I described in Theory of Interest and Prices in
Paper Currency, the Fed destabilizes the rate of interest by its very
existence, its very nature, and its purpose. Per the above discussion, the Fed
and the speculators induce volatility in the yield curve, which can easily feed
back into volatility in the underlying rate of interest.
The reason to sell the bond is to avoid losses if
interest rates will rise. Speculators seek to front-run the Fed, duration
mismatchers, and other speculators. If the Fed will “taper” its purchase of
bonds, then that might lead to higher interest rates. Or at least, it might
make other speculators sell. Every speculator wants to sell first.
Consider the case of large banks borrowing short to
lend long. Let’s say that you have some information that their short-term
funding is either going to become much harder to obtain, or at least
significantly more expensive. What do you do?
You sell the bond. You, and many other speculators.
Everyone sells the bond.
Or, what if you have information that you think will
cause other speculators to sell bonds? It may not even be a legitimate factor,
either because the rumor is untrue (e.g. “the world is selling Treasury bonds”)
or because there is no valid economic reason to sell bonds based on it.
You sell the bond before they do, or you all try to
sell first.
I have been documenting numerous cases in the gold
market where traders use leverage to buy gold futures based on an announcement
or non-announcement by the Fed. These moves reverse themselves quickly. But no
one, especially if they are using leverage, wants to be on the wrong side of a
$50 move in gold. You sell ahead of the crowd, and you buy ahead of the crowd.
And they try to do it to you.
I think it is likely that one of these phenomena, or
something similar, has driven the rate on the 10-year Treasury up by 80%.
I would like to leave you with one take-away from this
paper and one from my series on the theory of interest and prices. In this
paper, I want everyone to think about the difference between the following two
statements:
1. The dollar is
falling in value
2. The rate of
interest in dollars must rise
It is tempting to assume that they are equivalent, but
the rate of interest is purely internal to the “closed loop” dollar system.
Unlike a free market, it does not operate under the forces of arbitrage. It
operates by government diktats, and hordes of speculators feed on the spoils
that fall like rotten food to the floor.
From my entire series, I would like the reader to
check and challenge the sacred-cow premises of macroeconomics, the aggregates,
the assumptions, the equations, and above all else, the linear thinking. I
encourage you to think about what incentives are offered under each scenario to
the market participants. No one even knows the true value of the monetary
aggregate and there is endless debate even among economists. The shopkeeper,
miner, farmer, warehouseman, manufacturer, or banker is not impelled to act
based on such abstractions.
They react to the incentives of profit and loss. Even
the consumer reacts to prices being lower in one particular store, or apples
being cheaper than pears. If you can think through how a particular market
event or change in government policy will remove old incentives and offer new
incentives, then you can understand the likely first-order effects in the
market. Of course each of these effects changes still other incentives.
It is not easy, but this is the approach that makes
economics a proper science.
P.S. As I do my final edits on this paper , there is a selloff in short US T-Bills, leading to an inversion at the
short end of the yield curve. This is due, of course, to the possible effect of
the partial government shutdown. The government is not going to default. If
this danger were real, then there would be much greater turmoil in every market
(and much more buying of gold as the only way to avoid catastrophic losses).
The selloff has two drivers. First, some holders of T-Bills need the cash on
the maturity date. They would prefer to liquidate now and hold “cash” rather
than incur the risk that they will not be paid on the maturity date. Second, of
course speculators want to front-run this trade. I put “cash” in scare quotes
because dollars in a bank account are the bank’s liability. The bank will not
be able to honor this liability if its asset—the US Treasury bond—defaults. The
“cash” will be worthless in the very scenario that bond sellers are hoping to
avoid by their very sales. When the scare and the shutdown end, then the 30-day
T-Bill will snap back to its typical rate near zero. Some clever speculators
will make a killing on this move.
[2] See the Monetary Metals Supply and Demand
Report
[3] I argue that it always fails in the end in Duration
Mismatch Always Fails
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