Photo Credit: Tim Green
The global banking system is sick. In fact, it is so sick that it wouldn’t be a stretch to say that many of our financial institutions are terminally ill. This phenomenon has largely been driven by absurdly low interest rates – perhaps the lowest across 5,000 years of recorded human history according to some financial commentators.
And it doesn’t look like the decline in yields is done quite yet.
Global bond yields plunged again in August 2019. The yields on German, French and Japanese 10-year notes plowed into negative territory during this time, while Swiss yields went even more negative than they had already been. The United States, that last bastion of positive return in a yield-starved world, saw its 10-year bond yields decline a stunning 100 basis points over the course of just a few months – from over 2.5% to an anemic 1.5%.
In Denmark right now one bank is offering negative-yielding mortgages, meaning that the bank will pay you to take out a loan!
This is crazy stuff.
So crazy, in fact, that the global banking system can’t survive in this environment long-term. And it isn’t just banks that are suffering, but also insurance companies and pension funds. All of these firms rely on significantly positive-yielding assets in order to survive. If negative yields persist for too many years, the financial industry will simply bleed capital until a crisis comes and knocks the entire rotten edifice over.
This alarming situation has created a desperate search for yield across the world.
But this reach for yield has prompted some banks to originate questionable commercial real estate loans (among others). The world only needs so many dollar-stores, fast food eateries and quaint cafes – a point we passed long ago. The only problem is that the yield-starved banking system didn’t quite get the message. Just like a shark has got to swim to stay alive, a bank has got to lend to keep its doors open – even it if means piling bad loans onto an already problematic balance sheet.
The situation in Europe isn’t any better. The newest global regulatory framework for banks (Basel III) gives financial firms wide latitude to determine the risk weighting applied to sovereign debt. The practical consequence of this loose regulatory regime is that most southern European banks have loaded up on their home country’s government bonds. This is an issue because the Portuguese, Spanish and Italian governments, while not currently in explicit default, are more or less insolvent. But banks located in those countries are stuffed to the gills with their national debt all the same.
It is an accident waiting to happen on an almost unimaginably grand scale.
In order to understand how the banking system came to such dire straits, a quick history lesson is in order. I will concentrate my historical financial analysis on the United States, which is also a reasonable proxy for the rest of the developed world in most cases. Although little known, the U.S. has actually experienced four distinct monetary regimes since the beginning of the 20th century.
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The Classical Gold Standard Era (before 1934): Under this financial regime the U.S. dollar was explicitly linked to gold, with $20.67 exchangeable for 1 troy ounce of the precious metal. The currency’s required gold-backing kept the dollar strong and stable. Foreign exchange rates were largely fixed because most nations had their currencies pegged in terms of gold. Interest rates were relatively low in absolute terms, but because inflation was so low, real (inflation-adjusted) yields were solidly positive. Governments typically ran small surpluses during this period (except during times of war).
The Bretton Woods Era (1934 to 1971): During the Bretton Woods period the U.S. dollar was still linked to gold, albeit at a reduced rate ($35 equaled 1 troy ounce). This precious metal link restrained money issuance and, by extension, inflation. U.S. citizens could not own gold or exchange their dollars for gold, however. Instead, only foreign governments and central banks could redeem dollars for gold. Global exchange rates were typically fixed against the U.S. dollar, providing stability in international trade and investment. Most governments ran balanced budgets outside of wartime and savers were consistently rewarded with positive real interest rates.
The Bretton Woods II Era (1971 – 2008): From the early 1970s until the 2000s, the world operated under a floating currency regime that was sometimes known as Bretton Woods II. The U.S. dollar was no longer pegged to gold or exchangeable for it. But both nominal and real interest rates were often quite high in order to instill confidence in this untested, pure fiat system. Governments were able to run increasingly large budget deficits, which was acceptable if the interest rate on the national debt was lower than the nominal growth rate of the economy. Central banks adamantly refused to monetize (print money to buy) government debt.
The Central Bank Era (2008 – present): Our newest currency regime is a pure fiat monetary system characterized by floating foreign exchange rates and non-convertibility, just like the Bretton Woods II era. However, real interest rates are almost always negative today, with nominal interest rates sometimes being negative as well (most notably in Europe and Japan). This is incredibly punishing for not only savers, but ultimately the banking system too. Governments run persistently massive budget deficits, leading to ballooning national debt loads. Central banks happily monetize government debt in size, raising the specter of future currency devaluations or hyperinflations. Outrageous securities market bubbles are embraced as a desirable growth transmission mechanism by increasingly desperate central banks.
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As you can plainly see, our current monetary regime (the Central Bank Era) is incredibly unstable. It is not a question of if it will fail, but simply a question of when and how it fails.
This is why I believe it is imperative for everyone to move some money out of the banking system. A financial disaster of some description is on its way and when it finally arrives it will be ugly beyond belief. It could take the form of a stock market crash, a bank bail-in or capital controls – no one really knows. But we do know that conventional financial products like stocks, bonds, CDs and savings accounts will not offer the protection that they might have in the past.
Instead we need to look to unconventional tangible assets like bullion, antiques, gemstones and fine art to help protect our net worth. And honestly, prices for hard assets are so low right now that you can buy practically anything in that list and expect to do well from a future return perspective. This means you can indulge your passion for antique samurai sword fittings or medieval European woodcut prints, safe in the knowledge you’re accumulating valuable financial assets that are completely independent from our teetering banking system.
Of course, if you’d like to pursue a more conservative course by purchasing gold and silver bullion, I can wholeheartedly recommend that as well. I’ve recently written an article on how to stack vintage JM & Engelhard silver bars in your retirement account.
I don’t really think it matters which specific strategy you choose, just as long as it involves getting some of your precious dollars (or euros, or pounds) out of our necrotic banking system and into something tangible. It is far better to be prudent today, rather than sorry tomorrow.
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