Fiat currencies trade at discounts to par: Corollary 2 – Central bankers behaving like naughty children

The other day, I alluded to the analogy that central bankers are like naughty children; – they move the goal-posts after a shot at goal has already been taken. Here, I’ll explore the implications of this, and ask: could a period of ‘scarcity of money’ occur before debauched monetary policies have the platform to take hold?

 

When the Fed engages in monetary policy, it changes the stock of assets that back the volume of Federal Reserve notes in existence. I explain why this happens here. Every time they buy or sell something, the dollar in your pocket changes. It’s still called a dollar, but it’s no longer ‘good for’ what it used to be ‘good for’.

 

In recent years, the Fed has attempted to tweak the economy by drastically increasing its balance sheet. The most notable instance was QE1, when the Fed bought $600 billion of mortgage-backed securities. By doing so, they diluted each federal reserve note in existence, and made them ‘good for’ a big chunk of mortgage-backed securities. The effect was that – miraculously – all those people who owned mortgage-backed securities and owed dollars (e.g. banks, GSEs, etc.) came back from the graveyard of insolvency. People had taken their shots at goal (long MBS short dollar), and the Fed moved the goal-posts to make them score ( they bought MBSs with new dollars). Although this makes my blood boil, I’ll leave the ruminations to someone else.

 

So, how can this help us with our portfolio allocations? How does it help us in anticipating potential scenarios?

 

The important thing to note is that: the Fed didn’t know where to move the goal-posts until the shot had already been taken. It took a period of profound market stress to induce actions by the Fed. So when we think about the commonly uttered phrase; ‘oh, the Fed will just print money’, we should note that we do not know in advance how they will print money. But what we do know, is that they will have to wait and see before they act (which assets will they buy with new dollars?). Furthermore, the fact that the Fed isn’t typically alert (but instead, lagging) suggests that it will take a profound down-move to get them seriously printing. If you’re skeptical about the Fed being ‘lagging’ in it’s intellectual convictions, I point you to the works of Robert Prechter.

 

This is very important for portfolio allocation; for being ‘long things – short currency’ during periods of a ‘scarcity of money’ would be very painful. Indeed, one could lose everything in the endeavor of preparing for inflation.

 

A note on the legitimacy of the inflation calls by Faber, Rogers et al.

 

And yet I agree with Marc Faber and Jim Rogers! How can this be? How do I square all of the above? The answer lies in the fact that the art of financial speculation is a very personal thing. Not only does one’s personal situation factor in, but one must study oneself with great courage and clarity.

 

After years of successful financial speculation and businesses, Marc Faber and Jim Rogers undoubtedly would have 1) significant wealth around the world, and 2) PhD’s in themselves. They can afford to take long positions and hold them for years and years without sacrificing their lifestyles and well being. Indeed, any drawdown is just an opportunity to add (which they can do without fearing the consequences of their positions).   Furthermore, after years of experience they – probably – understand how they’ll deal with those drawdowns and thus can prepare for their reactions. In short, they can survive and prosper in the intermediate period when the shot has been taken, but the Fed is deciding where to move the goal-posts.

 

You and I, however, are not as rich as Jim Rogers (don’t worry, we’ll get there!). For example, my wealth would have to be several times what it is, to allow me to be (fearlessly) long (I’m only 22 years-old). Furthermore, I want to be rich! Why am I saying this? Well, you should note that people like me own ETFs, mutual funds, and other collective investment schemes. Our redemptions matter! In the intermediate phases, even if one were fearlessly long an ETF or mutual fund, one should note that others are imprudently long those very same ETFs and mutual funds!

 

Conclusion:

 

Due to the nature of central banks and fiat currencies, severe inflation will probably be preceded by a profound ‘scarcity of money’. Even if we regard inflation as inevitable, one should only be ‘long things – short fiat currencies’ (right now) if one could afford to lie on a beach during an 80% drawdown. (note: I mean ‘afford’ here in the sense of wealth AND strength of mind).
Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression

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Posted Mar 2, 2011