Financial repression the new buzzword

The latest Federal Open Market Committee Minutes contain something for everybody, but no direct mention of quantitative easing (QE) which will disappoint the Keynesian crowd (as it is always looking for an easy solution), but there was a clear indication that the FOMC is moving closer, if anything, to ease further.

The key sentences were:

•     Economy expanding moderately
•     Employment growth has slowed
•     Business Investment continued to advance
•     Household spending seems to be rising (important as its 70 percent of consumption)
•     Housing sector depressed
•     Inflation declined but long-term inflation remains stable
•     Member indicated they were more nervous about downside in employment, investment and growth which will lead to more QE if and when data confirms the slowdown.

Nothing spectacular but a continuation of 'wait-and-see and we will move when needed' - however market was looking for more - and got disappointed.

From my seat the main issues are that real rates have gone negative on the yield curve beyond five-year US Treasuries and the significant impact of what this will do to investments in the US and the world. (http://research.stlouisfed.org/fred2/series/DFII5/)

The negative real rates remind us that "financial repression" is now upon us. Financial repression is defined by Carmen Reinhart & M. Belen Sbrancia in their 2011 paper: "The Liquidation of government debt" as:

"One of the main goals financial repression is to keep nominal interest rates lower than would otherwise prevail. This effect, other things being equal, reduces the governments' interest expenses for a given stock of debt and contributes to deficit reduction. However, when financial repression produces negative real rates, this also reduces or liqudicates existing debts. It is a transfer from creditors(savers) to borrowers".

Crowding out the free market
This long sentence could be the most important you have read all year. The Harvard/Keynesian model of the world only operates with inflation as the main recipe for lowering debt, but in reality historically what policy makers have used has been negative real rates. Reinhart & Sbrancia go on to state:  That the financial repression happened from 1945 to 1980 with an average real rate below zero, this was followed by the Liberalisation area from 1980 to 2009 with positive real rates. In other words we are as dislocated from after World War II and we have a financial regime which not only seeks lower policy rates but also one which through regulation is putting ceilings on yields and hence investment return. We are crowding out the free market and replacing it with a financial repression, the main price being paid by the creditors(savers).

Seeking returns and access to positive compounding in a world of repression
This is important because negative real rates allow policy makers to extend the madness for longer, while the capital accepts inferior return. It is today okay to receive a negative yield on your investment as it's more about getting your money back, than getting a return on your money. It also increases the appeal of stocks to fixed income as earning negative real rates is not difficult for stocks to compete against. This explains the relative outperformance of high yield bonds and European stocks despite the EU debt crisis. Capital is seeking returns and access to positive compounding in a world of repression.

It will not however change the fact we are fundamentally in one of the biggest dislocations ever in financial markets:

• Yes, we can fund growing debt (due to the above), but
• No it will not work as capital ultimately refuses to accept these negative real rates by moving assets away from repressive governments who need to finance their debt.

This is the big difference between the last period of negative real rates in the period from 1945-1980: The financial market is now bigger, deeper and more diversified and certainly investors who are aware of this history as noted above (or hurry to read the paper) will shy away from being the ones who are deprived.

Conclusion:
No form of repression works! Look for massive outflow from the Eurozone to the non-Eurozone countries. Sweden is the new Switzerland. Look for equities to be gradually more loved as dividends offer better returns than repressive government bonds.....and look for a summer of discontent, before the low is seen.

Strategy:
FX: Still the same - and it's working beautifully thank you: +50% US dollar, 50% in NOK and SEK. Short AUD (again) and JPY versus it.

Tail-risk plays: Long 25% in Long some Stoxx50 put 2000, long GDX and HYG, and DXSP

Cash: 25%

Corporate bonds: European fund 50%

Safe travels,

Steen Jakobsen