If Cash Is Outlawed

By Russell Napier of the Electronic Research Interchange

Why we didn’t have negative nominal yields in the Depression and the end of QE

Oh the time will come up

When the winds will stop

And the breeze will cease to be breathin’,

Like the stillness in the wind

’Fore the hurricane begins —

The hour when the ship comes in.

.

And the words that are used

For to get the ship confused

Will not be understood as they’re spoken,

For the chains of the sea

Will have busted in the night

And will be buried at the bottom of the ocean.

.

–  When The Ship Comes In (Bob Dylan 1963)

The Napier Euro High Yield Capital Guarantee Fund (discussed in the November 12th edition of The Solid Ground) is almost ready for launch. It offers a unique combination of attributes to investors. It has significantly better risk/reward characteristics than both deposits and government debt securities. In short, it is a room full of Euro banknotes.

The launch of the fund will clearly mark the limits to monetary policy and thus the end to QE in Europe. The fund’s many attractive features include:

• a small negative yield (my fee), but it yields more than Euro bank deposits and most Euro denominated government debt securities.
• the assets are a liability of the central bank and not the commercial banks. While bank deposits, above the level guaranteed by governments, can be bailed-in and frozen during any bank reconstruction, the banknotes nominal value is assured by the central bank. The fund thus offers significant capital protection and enhanced liquidity to any bank deposit.
• unlike longer-dated debt securities of the government, the banknote will not suffer a loss in value should fears of inflation rear their ugly head. While the markets will begin to price future inflation into longer-dated fixed interest securities, the banknote holder suffers no loss at such apprehension. The fund would seek to move from banknotes should recorded inflation appear, as this would impact the real value of investments. The nominal value of the fund cannot decline if inflation expectations rise, ensuring significant protection compared to government debt securities.
• banknotes could be bid up, relative to deposits, as the authorities seek to restrict access. Last week Schweizer Radio und Fernsehen reported that a Swiss bank had refused to transform the deposits of a Swiss pension fund into banknotes and that the Swiss National Bank confirmed that they were against the hoarding of banknotes to avoid negative deposit rates. The ECB is just as likely to be against such bank runs as the SNB. Any move to restrict access to central bank liabilities (banknotes) and enforce the holding of commercial bank liabilities (bank deposits) is likely to lead to a premium of one over the other. Given the capital risk and lower yield on bank money, Gresham’s Law is likely to see banknotes becoming a store of value, while people seek to use the inferior bank deposit as a means of transaction. Banknotes traded at premiums to bank deposits, albeit in closed banks, in the US in the 1930s. A premium for banknotes would provide a rising nominal value for the fund.
• the fund would hold only Euro notes with a serial number beginning with X, the X denoting that these notes have been printed by Germany. Such notes could also be bid up relative to deposits and even other notes, should investors fear the demise of the Euro and the re-birth of the DM or a northern European ‘NEuro’. Should this occur, the nominal value of the fund would once more rise.
• a banknote owner will be able to shift capital to any jurisdiction where the Euro remains fungible. Restrictions on banknote withdrawals and transfers of deposits were imposed in Cyprus, as part of the plan to prevent the funding base of the Cypriot banks moving to other banks in the European Union. The ability to shift capital across borders, should such movement be outlawed, would likely lead to a premium developing for banknotes. Should this occur, the nominal value of the fund would, yet again, rise.
• notes would be held in denominations of 50 Euros. The authorities are already minded to ban the Euro 500 note (known by some as the ‘Bin Laden’ because it is known to exist but is rarely seen). It is rarely seen because the ‘Bin Laden’ is prized by criminals and those seeking to avoid taxation, meaning it’s increasingly likely to be recalled and abolished. Any ban on large denomination notes to combat illegal activity is unlikely, however, to affect the 50 Euro note given its key role in everyday transactions in Europe. Those bent on illegal activity may just have to get themselves bigger suitcases to stash their smaller denomination notes. A premium may develop for such notes, and such suitcases, and should this occur the nominal value of the fund would, you’ve guessed it, rise.

The fund produces an enhanced yield over bank deposits and most government debt securities, and cannot be subject to a decline in nominal value unlike bank deposits or government debt securities. In some fairly extreme cases it may even produce a capital gain relative to most money (bank deposits). The only likelihood of loss is in the case of an instant and material rise in inflation that would undermine the real value of the fund. However, unless such inflation developed virtually overnight the fund could be liquidated, without capital loss unlike government securities subjected to an inflationary shock.

The inflation protection offered by banknotes is thus significant given the current yield on government bonds. While government bond prices may rise somewhat further in a deflation, the banknote arbitrage opportunity suggests that the upside for government bond prices in a deflation is very limited. Government debt securities did not have negative nominal yields in the Great Depression despite gross deflation so why should they they have them now? Thus, those speculating on government bonds to see negative nominal yields go ever lower may not get the capital gains they think are coming their way. Banknotes may even perform as well in a deflation as government debt securities and offer much better protection should an inflationary future appear more likely.

Given this combination of risk characteristics, why would you want to own a government bond or a bank deposit when the Napier Euro High Yield Capital Guarantee Fund is available? (Before I am inundated with e-mails looking for a prospectus, I should point out that I am independent financial consultant and, am not regulated to look after client monies. Also, I don’t have a basement or a machine gun.)

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