Frustrations of a Central Banker: The Bond Vigilantes
As I have discussed previously; in order for currencies to be sound and functioning, there must be a profit-motive in owning them. In our particular age of irredeemable fiat currencies, this gives rise to a strangely significant bond market.
The profit-motive involved with fiat currencies:
It is my contention that market prices will tend to imply that the entire stock of central banking liabilities (central bank notes & reserve balances) will only purchase a proportion of that central bank’s assets. This can been understood readily by a simple example: Suppose there existed a fiat currency consisting of ‘greshams-law notes’. Say, the entire stock of 100 notes was backed by 100 ounces of gold. Each note is some kind of claim on a proportion of the central bank’s assets (1 ounce of gold); so can we imagine that – in the market – people would trade more than one once of gold for 1 greshams-law note? I contend not. Rather, I say that market prices will reflect the fact that ‘greshams-law notes’ are ‘good for’ – at most – 1 ounce of gold.
So, the question is; what proportion of the Federal Reserve’s assets would have to be given up in order to acquire the entirety of its liabilities? In other words, what is the discount from par involved with purchasing federal reserve notes at market prices?
Looking at the following chart of the composition of the Federal Reserve’s assets, which market is primarily involved with demanding the discount from par?
The government bond market.
The peculiar implications for central bankers:
The degree to which federal reserve notes trade at discounts from par has enormous implications for the burden of dollar debts and dollar redemption liabilities (e.g. demand deposits). Furthermore, due to the interconnectedness of global fiat currencies, the implications can spread worldwide. In particular, I contend the discount from par can make all the difference for the effectiveness of balance sheet expansions by central banks. For example, it can help us figure out if the Fed will be ‘pushing on a string’ or not.
When Federal Reserve notes trade at heavy discounts from par, the degree to which a balance sheet expansion dilutes the dollar is elevated. Conversely, when Federal Reserve notes trade at small discounts from par, the degree to which a balance sheet expansion dilutes the dollar is muted.
If we consider the notion that heavy discounts from par come with heightened inflation worries and that – conversely – small discounts come with heightened deflation fears, we can see the laughable folly of a central banker’s job. Precisely when they are spurred on (by us) to tighten aggressively, their actions have elevated implications. Whereas precisely when they are spurred on to loosen aggressively, their actions have muted implications. The result? ‘Over-tightening’ at ‘inflation panic’ extremes and ‘pushing on a string’ during ‘deflationary spirals’.
Irredeemable fiat currencies trade at ‘discounts from par’. The implication is that central bankers are virtually doomed to failure precisely at the worst times to fail. For the contrarian investor this can be significant: for we can oppose people who trade on premises such as ‘the central bank is not tightening enough’ or ‘the central bank is printing too much’. When public pronouncements and news stories are in one mind, we can insure against the prospect that they’re wrong.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012