It's a maelstrom in the market. Bond yields are spiraling lower forcing bond portfolio managers to buy stocks for yield and the CFO's of companies with high stock prices to issue stock to retire debt. The classic metrics of how corporate capital structure works is being twisted upside down with the unintended effects of negative interest rates around the world. It is enough to give one a case of the spins.

Classic finance theory teaches that debt is issued by a company with a fixed coupon at a lower financial cost than stock because it is backed by collateral such as land, buildings, and equipment which can be sold in the future in the event of bankruptcy to make the bond holder whole. Stock, on the other hand, is priced off the future cash-flow stream of the underling business and because that fluctuates it is riskier. Stocks must therefore promise a higher return then debt threw price appreciation and dividend yield. Strangely, in a world of deflation, the collateral held by companies gets less valuable in the future, while the cost of running the business gets cheaper. Stocks start to appear as a safe alternative to income investors because their future cash-flows are more reliable, while the value of the collateral less so.

The ECB (European Central Bank) has been trying to solve the problem of collapsing collateral prices by assuming that bonds are effectively the same as the underlying assets themselves and has bid up bond prices so much they offer negative yields. By accepting a negative yield, the ECB is willing to pay more for a bond than the interest and principle it will receive, i.e. they will take a loss and print money to do it. What does this do? Well, if you're a local Italian banker that has been sitting on a portfolio of mortgages that are backed by farmland or commercial property that is worth far less than its purchase price, your mortgagees are trapped. You can't refinance their mortgages unless your bank is willing to take a loss (or in other words a negative yield.) By buying up your banks bond debt at a higher price than it is worth the ECB is effectively making your banks whole by allowing you to pass the loss along to them while you consolidate with bigger and healthier banks. BUT the idea this will produce inflation is purely theoretical because with negative rates the older demographic (Italians have a low birth rate and are on average 10 years older than U.S. citizens), who can't earn interest on their savings, save more, which is deflationary. A similar problem plaguing Japan.

Inflation is engendered by a greater increase in the supply of monetary units in circulation today then future economic activity is expected to absorb. Deflation is engendered by a decrease in the supply of monetary units today which is less then economic activity in the future is expected to absorb. Google "bank cash shortages" lately? Central banks operate on the theory that a little inflation, excess cash in the economy, is good thing because it encourages economic growth as spenders try to increase their productivity in order to stay ahead of higher costs in the future. This "idea" is now directing ECB banks to consider the idea of offering negative yields to large savers, encouraging them to spend and invest more to generate growth. However, in a global economy this just pushes the savers elsewhere. The analogy of a spiraling maelstrom comes to mind, where savers around the world are like drowning seamen that are pulled from it into a nearly full lifeboat, paddling hard to stay on its periphery. If we imagine the US economy is the lifeboat with positive cash yield, as it pulls in more savers from around the world the boat gets slower and lower to the water, closer and closer to doom.

When currency was a physical coin made from a valuable or useful metal inflation and deflation was affected by the relative supply of those metals. At that time people understood the value of money to be the intrinsic value of the metal it contained. However, where gold, silver and copper coin were plentiful there was inflation, and where gold, silver and copper coin were in tight supply there was deflation. With the implementation of paper money, it was recognized that currency was actually the exchange of a promise, and the units of exchange themselves could be valueless. Currency was a promise to deliver a good or service of equal value in the future. Unfortunately, this also allowed bad actors to create monetary units out of thin air, printing currency without an offset with a hyper-inflationary result. Under our current banking system for each unit of currency the central bank prints, there is an offsetting unit of value created. A promise made today can also be backed by a more attractive promise in the future (bonds and their interest). As long as there exists a faith that the central bank is accounting for its monetary units correctly and the country's economic, fiscal, and legislative policies are rational, inflation can be nominal, controlled more or less by the relative ebbs and flows of real economic activity. Governments with an independent and well-run central bank can create some inflation by making too many promises today, but also by acting irrationally and cast doubt on their greater future promises. Referred to as "fiscal policy", bad or irrational policy can produce inflation as well.

Witness the dilemma created for the Germans and Japanese, societies that pride themselves on prudence, integrity, and efficiency being asked to stop saving and start spending or to act irrationally to promote inflation. In Germany a promise is a promise, whereas at the periphery of Europe a promise is like one made by the spinach flogging Popeye's pal Wimpey - "I'll gladly pay you Tuesday for a hamburger today." Wimpey's promises were always meet with just more promises next Tuesday. Germans and Japanese like the safety of promises kept today for their hamburger today. The ECB is asking Germans to wait for their hamburger until next Tuesday for promises far, far off in the future, driving some to shop for it in the US.

Investment Ideas

Author Conan Doyle wrote - "Once you have eliminated the impossible, whatever remains, no mater how improbable, must be the truth." What has been improbable for most of us to contemplate was that the mischievous folks in the investment banking system of the 70's (see stories regarding Solomon Bothers bond price manipulation) could force Treasury yield higher then seemed rational for a decade, and then nearly 30 years later these same banks could create a mortgage disaster in the 00's that would force yields lower then seems rational for a decade. The truth is that with nominal growth and inflation we should expect lower yields on bonds and higher yields on stocks. BUT, because of Fed, ECB, and JCB efforts to manufacture inflation the signals sent by the bond markets are not at rational levels. So, consider the words of Wimpy as you invest. High yield stocks like those in the Vanguard High Yield index ETF (ticker VYM yielding ~3.4%) are promising the hamburger equivalent of dividends today while low yielding stocks like those in the Vanguard Growth index ETF (ticker: VUG yielding ~1%) are promising the hamburger equivalent of dividends next Tuesday. Savers from around the world like to have their promises and hamburger today, preferring the safety of short-term Treasury bonds and high yielding stocks. As they exchange Euro and Yen for dollars, they create temporary shortages of physical dollars in the money markets which should force cash yields to stay relatively higher. If you're looking to stash some cash, consider Vanguards Prime Money Market fund (Ticker: VMMXX yielding ~2.0%) and have your promises and some hamburger today.