With every action by the ECB and the BOJ, the dollar gets stronger, oil and commodities go lower, and S&P 500 earnings get hit. That's bad for the US and it's bad for China and it's bad for global trade and it's bad for the global industrial and commodity complexes, but if you're Draghi or Kuroda you really don't care. Or rather, they might care, but when the payoff from being a currency "defector" becomes potentially greater than the payoff from being a currency "cooperator", there's a dominant strategy and it's called beggar-thy-neighbor.
That same dominant strategy exists for the US and China. For the US that means turning the monetary policy barge around from tightening to easing, and with every move Yellen makes, the dollar will go down, oil and commodities will go up, S&P 500 earnings will look better, and equity markets will rally. But it's a short-term rally because this will only spark further currency-weakening actions by the ECB and the BOJ, starting another leg down in the protectionist spiral. Wash, rinse, repeat.
The big loser in this spiraling dynamic is China. To torture the poker analogy a bit more, they're the short stack at this table -- not from a purely economic perspective (that's Japan), but from a political perspective (where Japan may actually be the strongest). It's political strength that matters most in this game, and the Chinese political regime is existentially vulnerable to declining volumes of global trade. They have no choice but to go all-in here to spur exports and domestic industrial production, and at some point they will. There are several ways China can shove their chips into the pot, but my guess is that they go all-in by floating the yuan. That will be the risk-off moment of this or any other year, an atomic bomb of deflationary power, and I think it's an easy putt from there to negative rates in the US.
Yes, that's right. Negative rates in the US. It's coming. It's inevitable, really, not because the FOMC wants negative rates -- they don't -- but because they must pursue negative rates out of national self-interest and sheer self-defense in a Competitive game where your adversaries (get used to that word) have rolled out the equivalent of mustard gas in the trench warfare that we're going to endure.
And that brings me to my second photo that's worth a thousand words, this from a recent meeting of Sweden's central bank, prior to their February reduction of interest rates to -0.5%.
I mean, this is what it's come to, right? Where smirking Ph.Ds who have never spent a day of their adult lives outside of the governmental or academic womb, where earringed, pony-tailed apparatchiks who have never managed a dime, who have never counseled a retired couple trying to live on their savings, now unilaterally and without limitation make political decisions that determine the fate of that retired couple. Not just in Sweden, but everywhere in the world. Yeah, I shouldn't mention the whole earring and pony-tail thing, but you know what? It's an intentional statement of identity, an identity that I recognize from my decade as a political science professor, an identity that not only elevates elegant theory over practical experience, but more than that, dismisses practical experience as inherently inferior to the tenets of an academic faith. It's the hubris, the overweening pride that oozes from this photo that makes me cringe. We've seen this movie before, and it always ends in tears. There's a reason that Pride is one of the Seven Deadly Sins, and nowhere is pride more dangerous than when it comes to financial "innovation." What the Gaussian copula was to securitized mortgages in 2008, negative rates are to monetary policy in 2016.
But here's the thing, and this is true for any Competitive game, whether it's poker or World War I or a Republican primary or strategic monetary policy -- once one player enjoys some success with a new strategy or a new weapon, ALL players must adopt that strategy or weapon, regardless of whether or not a player thinks it's distasteful or misguided. Even if you think you're doing the wrong thing in the long run, if you don't adopt the new strategy you're going to lose in the short run, and that's something no politician and no central banker can stomach. I'm reminded of the (in)famous line from Chuck Prince, former Citigroup CEO, in 2007: "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance." Just as all of the big banks were dancing to the music of Alt-A mortgages and trillions of dollars in mortgage-backed securitizations in 2007, so are all central bankers dancing to the music of negative rates and currency devaluation today. It was the rational move for Prince and Fuld and Thain and Mozilo then, and it's the rational move for Yellen and Draghi and Kuroda and Zhou today. Once negative rates (or liar loans or Trump-esque campaign tactics) are introduced into the field of battle you can't wish them away. You have to fight fire with fire until a big structure burns down, with the hope that at that point everyone can get together and rebuild. Or you can surrender. Welcome to the jungle.
W. Ben Hunt, Ph.D. is chief risk officer at Salient Partners.