Thoughts From Camp Kotok 2019: China, MMT, And Lower/NIRP Rates

I recently had the pleasure of spending time chatting and fishing with market participants and other big-picture thinkers at the annual Camp Kotok (CK) event held at Leen’s Lodge in Grand Lake Stream, Maine.

CK is an invitation only event operated under the Chatham House Rule – so whilst we can’t publish names and sources, we’re free to discuss the information and viewpoints shared. Although conversations ranged widely from markets to politics, the three main areas of focus for the event revolved around all things China, modern monetary theory (MMT), and the prospect of low rates for longer. So here is what I learned at CK.

The China Complex

There were polarised opinions on the Chinese economy, its banking system, as well as on the ongoing US/China trade negotiations, but here are the key takeaways.

(1) Most fear a second Cold War as a result of China’s long-term plan of ultimately trying to unseat the US as the primary world power.

(2) The US needs better tactics to deal with the various challenges coming out from China (e.g. structural issues on how to deal with intellectual property etc.), as relying on additional tariffs will be counterproductive to the US and its allies.

(3) Dealing with China in the decades ahead is actually a bi-partisan issue and one that now has a record number of Americans holding an unfavorable view of China (see this chart by the PEW Research Center).

At CK we also heard from Dr. Ward, author of China’s Vision of Victory and founder of Atlas Organization. He has given me permission to discuss a few of the points he raised. From travels with truck caravans in Tibet and across the South China Sea by cargo ship in his early twenties, to accessing the Communist Party archive (that have now been closed to the world) while a PhD candidate at Oxford, to consulting for parts of the US government and Fortune 500 companies, Dr. Ward is an foremost expert of the rise of China and in the ways Chinese policymakers think.

It’s his belief that we need to understand how China envisions its place in the world. Makes complete sense, right? Yet it is how he explained it that really resonated with me and others. Ward stated that the West has never really asked what China truly wants but nonetheless expected them to embrace a rules-based world order while integrating with the global economy. This has led many Western businesses and military strategists to misread China’s true intentions for years. He dubs this the biggest challenge of our time: what does China want, how will it try to get it and what should America do?

Although US/China trade negotiations have been in a constant state of flux, most CK attendees were of the view that achieving a comprehensive deal now requires the US to make major concessions given how its been handled thus far this summer. Most thought that China will only agree to some form of trade deal after 1 October at the earliest – the 70^th anniversary of the founding of the Peoples Republic of China. China can also wait until 2020 or beyond as they are playing the long game with the US.

Serving MMT by the Campfire

Modern monetary theory has been in the news recently and was another key macro topic at the event. A simplified definition of MMT is that a country that can print its own currency doesn’t need to rely upon taxation or debt issuance to fund spending. Governments would produce more money and use fiscal policy to achieve full employment. MMT is not a new topic, of course, but recent advocates have put it back in the limelight as a potential tool either to elongate the current expansion, broaden the expansion to a larger subset of the population, and/or to climb out of the next recession.

The majority of the CK attendees were against the concept of using MMT. The debate centered on whether we have already seen a version of MMT with the multiple rounds of US and Global QE and, if not, how could it be effectively used without generating an uncontrollable inflationary response if MMT ends up being broadly successful?

As the weekend progressed, I sensed some shift towards the idea because of the current state of western nations. Comments ran along the lines of: in the next economic downturn QE cannot strictly be targeted at the financial world as calls for QE for the people will grow progressively louder. Also, even with all of the recent rounds of QE, inflation has yet to materialize so MMT and fiscal policy would help generate inflation, which has been hard to come by.

The main concern was that politicians would not be able to turn off MMT-based policy and that would eventually lead to colossal currency debasement. A few countered, however, that if everyone is doing it, perhaps just like the recent QE experience, MMT can be modulated.

Submerging Global Rates Linked to Negative Interest Rates Policy (NIRP)

The prevailing mood at CK, which I generally agree with, is that NIRP is leading to all sorts of distortions and will ultimately do more harm than good. It’s like a shipbuilder purposely building a leaky boat and then setting sail – only then to wonder why they ended up at the bottom of the ocean (or in our camp’s case, the low point of the lake).

Given that bond markets are largely fungible in a global bond portfolio context, it’s no surprise that the trillions of negatively yielding government bonds are pulling down US rates in the process. Some argued that NIRP has worked for other regions largely because the US still have positive rates and can handle large capital inflows. Now, putting aside FX translation costs, etc., that theory holds. Overall, places like Japan and Europe have been able to hunt for positive yields successfully, but that too has a limit.

Of course, there are many issues with NIRP, but two stand out as particularly relevant given the global bond rally that occurred during (and now continues after) the CK event.

(1) Once central banks commit to low rates it’s hard to fully unwind because it will lead to losses for those holding bonds with large price gains.

(2) A related issue is that once bonds stop rallying but their interest rates remain deeply in negative territory, any subsequent issuance and purchase of negative yielding bonds will erode the capital base of a fractional banking system over time.

Conclusion

Unless carry is massively positive via an upward sloping curve and bank funding costs are favorable to capture such carry, keeping rates negative on a permanent basis will automatically shrink the banking system in the regions that are deploying such a policy. Yield curve control could help delay the effects of NIRP but with the ongoing global reach for yield, it is going to be an uphill battle to keep global curves from flattening. This almost destines the world to stay in a low growth mode, keeping rates low too.

Ironically, given that central banks have already tried NIRP policies and QE, it is leading to concerns that MMT and the risks associated with it is next. Meanwhile a US/China trade miscalculation may result in the US being unable to avoid the drag from the global slowdown. And that will put the US into a recession, guaranteeing a global recession.

In the end, the 2019 CK event was productive and very informative platform to discuss these topics. However these themes illustrate that many of us are trying to pinpoint what exactly will end this expansion. The biggest question, of course, is what comes next?

George is a twenty years fixed income markets veteran. Over that time he has covered rates, structured products and credit. He worked both on the buy-side and sell-side.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)