“Good as money,” proclaimed the ad for Twenty Grand vodka infused with Cognac.
Being a beer drinker, and never having cashed in a Budweiser to pay for a fill-up at the local gas station, I said to myself, “Man, that must be really good stuff!”
Even in a financial meltdown, I thought, you could use it in place of cash, diamonds, gold or Bitcoins!
And if the Mongol hordes descend upon us during a future revolution, who wouldn't prefer a few belts of Twenty Grand on the way out, instead of some shiny rocks and a slingshot?
Well, not being inebriated at that moment, I immediately shifted focus to a more serious topic.
What is money? A medium of exchange and a store of value is a rather succinct definition, but we generally think of it as cash or perhaps checks that reflect some balance of ready cash at a friendly bank.
Yet as technology and financial innovation have progressed over the past few decades, and as central banks have validated the liquidity and price of various forms of credit tenuously, it seems that the definition of money has been extended; not perhaps to a bottle of Twenty Grand vodka but at least to some other rather liquid forms of near-currency such as money market funds, institutional “repo” and short-term Treasuries “guaranteed” by the Federal Reserve to trade at par over the next few years.
All of the above are close to serving as a “medium of exchange” because they presumably can be converted overnight at the holder's whim, without loss, and then transferred to a savings or checking account. It has been the objective of the Fed over the past few years to make even-more-innovative forms of money by supporting stock and bond prices at cost on an ever-ascending scale, thereby assuring holders via a “Bernanke put” that they might just as well own stocks as the cash in their purses.
Gosh, a decade or so ago, a house almost became a money substitute. MEW — or mortgage equity withdrawal — could be liquefied instantaneously, based on a “never go down” housing market. You could equitize your home and go sailing off into the sunset on a new 28-foot skiff on any day but Sunday.
IS IT 'MONEY GOOD'?
So as long as liquid assets can hold par/cost with an option to increase in price, these new forms of credit or equity might be considered “money” or something better. They might therefore represent a store of value in addition to serving as a convertible medium of exchange.
But then, that phrase “good as money” on the vodka bottle kept coming back to haunt me. Is all this newfangled money actually “money good”? Tech and Fed liquidity may have allowed them to serve as modern media of exchange, but are they legitimate stores of value?
The past decade proved that houses were merely homes and not ATM machines. They were not “good as money.”
Likewise, the Fed's -modern-day liquid-wealth creations such as bonds and stocks may suffer a similar fate at a future bubbled price, whether it be 1.5% for a 10-year Treasury or a Dow Jones Industrial Average that hits 16,000.
But let's not go there and speak of a bubble popping. Let's more immediately speak about current and future haircuts when we question the “goodness of money.”
Harvard professor Carmen Reinhart has said with historical observation that we are in an environment where politicians and central bankers are reluctant to allow write-offs: limited entitlement cuts, fiscally, no asset price sinkholes, monetarily. Yet if there are no spending cuts or asset price write-offs, then it is hard to see how deficits and outstanding debt as a percentage of gross domestic product can ever be reduced.
Granted, the ability of central banks to avoid a debt deflation in recent years has been critical to stabilizing global economies. And too, there have been write-offs — in home mortgages in the United States, for example, and sovereign debt in Greece.
ASSESSING THE COST
But the cost of these strategies, which avoid what I simplistically call haircuts, has been high, and their ability to reduce overall debt/GDP ratios is questionable.
Fed Chairman Ben S. Bernanke has admitted that the cost of zero-bound interest rates, for instance, extracts a toll on pension funds and individual savers.
Some of his Fed colleagues have spoken out about the negative aspects of quantitative easing and future difficulties of exit strategies, should they ever take place. (They won't.)
So policies come with a cost even as they act magically to float asset prices higher, making many of them appear “good as money” — shots of vodka notwithstanding.
But the point of this outlook is that even if quantitative easings and near-zero-bound yields are able to refloat global economies and generate a semblance of old-normal real growth, they will do so by using historically tried-and-true haircuts that surreptitiously trim an asset holder's money without the person knowing that he or she had entered a barbershop. These haircuts are hidden forms of taxes that reduce an investor's purchasing power as manipulated interest rates lag inflation.
In the process, governments and their central banks theoretically reduce real debt levels, as well as the excessive liabilities of levered corporations and households. But they represent a hidden wealth transfer that belies the vaunted phrase “good as money.”
Before drinking up, let's examine these haircuts to see why they do not represent an authentic store of value even if their bubbly prices never pop. I will give each haircut a symbolic name.
1. Negative real interest rates: “trimming the bangs”
During and after World War II, most countries with high debt overloads resorted to capping interest rates artificially below the rate of inflation. They forced savers to accept negative real interest rates, which lowered the cost of government debt but prevented savers from keeping up with the cost of living.
Long Treasuries, for instance, were capped at 2.5%, while inflation was soaring toward double digits. The resulting negative real rates, together with an accelerating economy, allowed the U.S. economy to lower its Depression-era debt/GDP from 250% to a number almost half as much, but at a cost of capital market distortions.
Today, central banks are doing the same thing with near-zero-bound yields and effective caps on higher rates via quantitative easing. The Treasury's average cost of money is grinding steadily lower than 2%.
If current policies continue to be enforced, it eventually will be less than 1% because of the inclusion of T-bill and short-maturity financing. The government's gain, however, is the saver's loss.
Investors are being haircutted by at least 200 basis points, judged by historical standards, which in the past offered no QE and priced the federal funds rate close to the level of inflation. Large holders of U.S. government bonds, including China and Japan, will be repaid, but in the interim, they will be implicitly defaulted on or haircutted via negative real interest rates.
Are Treasuries money-good? Yes.
But are they good money? Not when current and future haircuts are considered.
These rather innocuous-seeming (-1%) and (-2%) real-rate haircuts aren't a bob or a mullet in hairstyle parlance. More like a “trimming of the bangs.”
But at the cut's conclusion, there is a lot of hair left on the floor.
2. Inflation/currency devaluation: the “Don Draper”
Inflation is your everyday “"Mad Men' — Don Draper” type of haircut. It has been around for a long time and we don't really give it a second thought, except when it is on top of a handsome head such as Jon Hamm's.
Inflation of 2%-plus a year — some say more — but what the heck, inflation is just like breathing. You just gotta have it for a modern-day levered economy to survive.
Sometimes, though, it gets out of control, and when it is unexpected, a decent hit to your bond and stock portfolio is a possibility.
If our TV idol Don Draper lives another decade or so on the airwaves, he will find out in the inflationary 1970s. Such was the example, as well, in the Weimar Republic in the 1920s and in modern-day Zimbabwe with its $100 trillion bill.
As central banks surreptitiously inflate, they also devalue their currency and purchasing power relative to other “hard money” countries. Either way, historical bouts of inflation or currency devaluation suggest that your investment portfolio may not be as good as the money you might be banking on.
3. Capital controls: the “Uncle Sam cut”
Uncle Sam with his rather dapper white hair and trimmed beard serves as a good example for this type of haircut, if only to show that even the United States can latch on to your money or capital.
Back in the 1930s, President Franklin D. Roosevelt instituted a rather blatant form of expropriation. All private ownership of gold was forbidden and subject to a $10,000 fine and 10 years in prison.
Today we have less obvious but similar forms of capital controls: currency pegging (China and many others), taxes on incoming capital (Brazil) and outright taxation/embargoes of bank deposits (Cyprus).
Governments use these methods to keep money out or to keep money in, the net result of which is a haircut on your capital or your potential return on capital. Future haircuts might even include a wealth tax.
Are gold and/or AA+ sovereign bonds good as money? Usually, but capital controls can clip you if you aren't careful.
4. Outright default: the “Dobbins”
Here is my favorite haircut, and I have named it the Dobbins in honor of this five-year bond issued in the 1920s with a beautiful gold seal and payable in dollars or machine guns. Bond holders got neither and so it represents the historical example of the ultimate haircut — the buzz, the shaved head, the Dobbins.
As suggested earlier, the objective of central banks is to prevent your portfolio from resembling a “Dobbins.” I have tweeted in the past that the Fed is where all bad bonds go to die.
That is half figurative and half literal, because central banks typically are limited from purchasing bonds payable in machine guns or subprime mortgages.
But by purchasing Treasuries and agency mortgages, the Fed successfully gave the private sector an incentive to do its bidding. This behavior reflects the admission that modern-day developed economies are asset-price-supported.
Unless prices can be floated upward continuously, defaults and debt deflation may emerge. Don't buy a Dobbins bond or a Dobbins-like asset, or a bond from a country whose central bank is buying stocks.
INVESTMENT STRATEGY
So it seems as if the barber has you cornered, doesn't it? Sort of like Sweeney Todd.
Let's acknowledge that possibility, along with the observation that all these haircuts imply lower-than-average future returns for bonds, stocks and other financial assets.
The easiest answer to the question of what to buy is simply to take your ball and go home.
That end game, however, results in a Treasury bill rate of 10 basis points or a negative yield in Germany, France and Northern European Union markets. So a bond and equity investor can choose to play with historically high risk to principal or quit the game and earn nothing.
Our advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions this year and perhaps beyond.
Although this outlook has indeed claimed that Treasuries are money good but not good money, they are better than cash, as long as central banks and dollar reserve countries (China, Japan) continue to participate. The same conclusion applies to credit risk alternatives such as corporate bonds and stocks.
Granted, this sounds a little like Chuck Prince and his dance floor metaphor, does it not? His example proved that dancing and full heads of hair aren't forever.
So give your own portfolio a trim as the year goes on. In doing so, you will give up some higher returns upfront in order to avoid the swift hand of Sweeney Todd.
There will be haircuts. Make sure your head doesn't go with it.
Bill Gross is co-founder and co-chief investment officer of Pacific Investment Management Co. LLC. This commentary originally appeared on Pimco's website.
