Fiat currencies trade at discounts to par
In the old days, currencies were redeemable into gold or silver (usually). In order for currency issuers (e.g. central banks) to honor their agreements, they would have to own more than they owed. Occasionally, it would be revealed that currency issuers owned less than what they owed. In these cases, their currencies would fall to discounts to par.
It is my contention that irredeemable fiat currencies virtually always trade at discounts to par. The implications can seem paradoxical, hence they can be potentially profitable.
But, what do I really mean by ‘discount to par’?
To start, let’s consider a redeemable currency. Let’s suppose that you owned a $20 note that was good for (say) 1 ounce of gold upon presentation at the bank. At any time you pleased, you could walk over to the bank, present the $20 note, and receive 1 ounce of gold.
Insofar as the bank was solvent, you would only be able to swap that $20 note for 1 ounce of gold outside the walls of the bank. For who would give you more than 1 ounce of gold for a note that is ‘good for’ 1 ounce of gold? Any such golden offerings would be quickly wiped out by profit-seeking individuals. So we can safely assume that – in this case – $20 would trade for 1 ounce of gold in the market.
But what if it became apparent that the bank could not cover all of its notes? That is, what if it became apparent that the bank owned too few ounces of gold to meet all of the $20 notes? In a free market, that bank would likely collapse and have to outwardly declare its insolvency. However, history tells us that this has been so unpalatable, that banks have been allowed to renege on their redemption liabilities. Does $20 still trade with 1 ounce of gold outside the walls of the bank? It is possible, but highly unlikely. If it were found out that the bank only had enough gold to meet half of the potential redemption requests, I would guess that you could (at most) swap your $20 note for 0.5 ounces of gold in the free market. This is what I mean when I say that a currency falls to a discount to par. Putting the above in common terms of speech; the gold price would rise to at least $40/ounce.
But what do such archaic concepts have to do with the present fiat currency model? Indeed, what relevance does this have to contrarian investing?
Modern fiat currencies are not redeemable into anything, yet they are backed by stuff. You cannot go anywhere to give your dollars for gold and bonds.
Just as people would not pay more than 1 ounce of gold for the $20 note, I contend that people would not pay more for a dollar than what it is backed by. In aggregate we can say that – at market prices – the maximum paid for the entire stock of federal reserve notes (and other liabilities on the fed), is the entire balance sheet of the Fed. Indeed, as federal reserve notes are not redeemable into anything, I think that one would only pay a fraction of the balance sheet of the Fed for the entire stock of federal reserve notes.
I understand that these topics are kind of peculiar and esoteric, so let me give a simple example. If (say) the Fed owned just 1 government bond and 1 ounce of gold, and issued 2 $1 notes, then what? I say that market prices would reflect that nobody would pay more than 1 government bond and 1 ounce of gold to acquire those $2. The market prices of 1 government bond plus 1 gold ounce would be at least $2.
Expanding this simple example out to reality again, we can start to see the peculiar importance of the bond vigilantes and the gold bugs! In aggregate, they twist and bend the burden of redeemability in dollars, and the burden of dollar debts.
With this understanding, let’s look at the composition of the Fed’s assets over the past few years:
As we can see, the dollar underwent a significant change in 2008/2009. The analogy I use for this is that the Fed is like a naughty child who moves the goal-posts after the shot has been taken.
Roughly speaking, the Fed owned lots of mortgage-backed securities by 2008, and owed dollars. Those dollars were mainly ’good for’ government bonds, bills and gold. When it became apparent that what they owed was better than what they owned, the Fed moved the goal-posts. They made dollars ‘good for’ long-term government bonds and mortgage-backed securities. Now what banks own is still pretty bad, but – importantly – what they owe (dollars) ain’t so great either.
(Incidentally, the Fed only moved the goal-posts after the shot was taken. Else how did they know which way to move them. This is important because it demonstrates that debauched monetary policies only come after profound periods of deflation.)
I will be exploring these concepts further in future posts, with a greater focus on my opinion on shorter-term trades. If there is sufficient interest, I will post some charts describing the discount and composition of the dollar since 1915.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012