Certificates of Confiscation

Steve Saretsky -

The Bank of Canada provided guidance for how it plans to eventually remove stimulus, saying it will first raise interest rates before curbing its holdings of government bonds. The Bank has been using two major policies for suppressing interest rates, first by leaving its overnight policy rate near zero, and secondly by purchasing hundreds of billions of government bonds. Macklem and co believe they’ll start gradually raising interest rates sometime in 2022. My question is how?

As of Q4 2020, Canada’s total credit to the non-financial sector sits at a staggering 359% of GDP according to the Bank of International Settlements. This is one of the highest totals in the G-20, right alongside Japan. The Japanese economy has been suffering under a mountain of debt for decades, with current credit to non-financial sector debt sitting at 418% of GDP.  In other words they’re caught in a debt trap and haven’t been able to raise interest rates for over two decades. The Bank of Japan has been forced to keep interest rates pinned to the floor, requiring them to soak up government debt in order to keep bond yields and thus borrowing costs stable. The BoJ now owns over 48% of the entire bond market.

Back to Canada, where the debt loads are marginally less bad. Interest rates are frozen at zero and the Bank of Canada now owns 40% of the total government of Canada bond market. Are we turning Japanese? Sure looks like it.

Don’t forget, Canada & Japan are not alone. Most of the developed market is saddled with heavy debt loads. So now what? Financial historian Russell Napier suggests there are really only four policy options.

1. Very high real economic growth
2. Austerity
3. Debt default
4. Hyperinflation and or financial repression

Let’s discuss. Solution number 1 is ideal, however, very hard to do when society is already burdened with debt. Debt weights tremendously on growth.

Austerity, unlikely. The pandemic has reminded politicians they have access to a money printer and it feels good to print entitlements. Without government spending, economic growth would be negative.

Debt default, very painful, and is never actively pursued, but rather forcefully comes to light after all policy options are exhausted, including option 4.

And finally, option 4, which is hyperinflation or financial repression. While we currently have a bout of “transitory” inflation, I would not call it hyperinflation. However, inflation is currently running at over 3% and bond yields around 1%. Government bonds are yielding a real return of negative 2% or more. These are guaranteed certificates of confiscation, and are indicative of financial repression.

I don’t know how this all plays out, but it makes me extremely skeptical of any discussion around the Bank of Canada suddenly finding the light and normalizing interest rates. Given the levels of debt, any rise in interest rates will only damper economic growth as more income goes towards servicing debt payments, ultimately worsening debt to GDP ratios.

Let’s watch.

Three Things I’m Watching:

1. Canadian homeowners have an average equity position of 77% (not including HELOC) thanks to rapid increases in home prices. (Source: Edge Analytics)

2. Real yields on European junk debt have fallen below ZERO for the first time, a sign of financial repression. (Source: Bloomberg)

3. Bank of Canada’s bond buying spree has stabilized after a rapid expansion during the pandemic. (Source: Bloomberg)

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