Simply put, modern monetary theory (MMT) postulates that a sovereign country with the ability to print its own currency should do so. This theory pokes fun at the idea that growing debt of a sovereign nation carries a risk of default and therefore too much debt is bad. The main speed limit on the amount of debt for MMT users is inflation. As long as there is no inflation, the theory calls for ever greater credit expansion and money printing. For countries with their own printing presses, like the United States, Japan, and China, the theory covers government spending plans based on a lot of borrowing. For regions such as Euroland, where there is no fiscal union (yet), the European Central Bank provides a kind of MMT by offering bonds from weaker countries at mind-blowing prices using credit. of the most solvent countries (Source: ECB app).

The extremely low level of currency volatility, as seen in the image of the JP Morgan Global FX Volatility Index (Source: Bloomberg, JP Morgan) has created an even more pernicious type of Modern Global Monetary Theory (GMMT) . In this theory, a sovereign country can print an infinite amount of its own currency and redeem the financial assets of other countries. For example, if the Japanese think their long-term economic outlook is bleak, they can print a whole bunch of yen, trade the yen for dollars, and buy US Treasuries with positive returns. As long as the currency vigilantes do not call a delay on this activity, Japanese public investors, for example, can take their odd money and buy enough bonds for a sufficient length of time where the principal repayment of dollars to the maturity on the bonds will provide real dollar income in the future. In this configuration, the coupon and the interest rates become irrelevant. In fact, an extension of this strategy would be to buy bonds in Europe at negative yields and have the redemption of European bonds provide euros in the future. Negative return is just the cost of getting something for nothing; that is to say real euros for a funny yen. But then, fun euros can be used to buy real dollar assets, then fun dollars can be used to buy other speculative assets on a global scale… you see the picture.

Imagine being able to use money from Monopoly, or in today’s vernacular, Robux (the digital currency from Roblox my daughter loves), to buy real money. For those unfamiliar with esports, think of airline miles as a currency that can be exchanged for dollars, where the amount of miles and how to earn them are set by the airlines. As long as there is an exchange of play money for real money, the owner of the play money should rationally enter into contracts to lock in the exchange for as long as possible. And yes, this is exactly what happens when a large amount of yen is exchanged for dollar denominated Treasury bills, or German bunds denominated in euros, Italian BTPs, French OATs, Spanish Bonos, etc. .

If a private citizen were to engage in this type of transaction – i.e. exchanging borrowed yen or euros for dollars – there would be a currency risk. This operation, well known as a cross-currency carry trade, is exposed to the risk that the currency in which the asset is held will weaken in the future and that the private investor will have to repay the loan at a rate of. unfavorable exchange rate, which would require more of the currency of the asset to be exchanged for maturing liabilities. But a sovereign does not have the same risks. Since the sovereign (in this case Japan) can print more yen, they can simply repay themselves by printing more yen. It’s MMT on steroids – call it “Turbo MMT”. What about the other way around; ie in our example the strengthening of the dollar? Well, now the ruler has a more valuable asset in the future, so he can exchange the dollars received in the redemption for more global goods. Face I win, face I win, as long as there is someone willing to take my currency for the promise of future cash flow in their currency.

As savvy readers will see, as long as currency volatility remains low and assets aren’t defaulting, this strategy works wonders. In an article I wrote in 2007 (Volatility and Carry Trade, Journal of Fixed Income), there is a deep theoretical link between currency volatility and carry trade, and the risk for this pink arbitrage is that currency volatility for some reason increases and the potential gains from carry trades for private investors are weakened. . For sovereigns, currency volatility means much less, unless the volatility is so great that it highlights the likelihood of an impending default on long-term bonds, or if there is a strike in the l ‘buyer against the currency of the sovereign concerned for the exchange. Using the previous example, think of an airline where you have accumulated a lot of miles, and the airline is likely to go bankrupt. The value of miles and the confidence of frequent flyers would suffer, including fewer travelers, although it’s likely that when the airline comes out of bankruptcy, the new program will still honor some or all of your miles. The momentum can result in a run on the currency, which is enough for arbitrage to collapse in the short term.

So, the main risk to global MMT international arbitration is not that the sovereign country will default, since by definition the sovereign can just print more money – we have examples everywhere (just look at Argentina for example) of rulers doing just that. The main risk is that the perception of increased risk leads investors to refuse to take sovereign currency as a medium of exchange. Panics in the forex markets are just as likely as panics in the credit markets, although we haven’t had a major one since the panic and run on the pound that only a few of us have. remember.

The obvious question then is: are we still there?

In my opinion, the water is heating up, but it is not yet boiling. The frog begins to feel some discomfort, but he is not yet ready to jump (or subconsciously boil until his death, as the myth says). For investors, the measures to be taken could be a little more definitive. If the global financial markets are at a point where a country with a gloomy economic outlook can create an income by lending fun money to others with a bright economic outlook, then at some point the forex markets need to turn around. readjust for this arbitration. With the incredibly low levels of currency volatility today, investors would be cautious to consider owning an option against a sharp and sudden collapse in the global MMT house of cards. Ultimately, exchange rates are the fundamental price balancing mechanism between countries. While it is difficult to determine the direction of individual currencies, it is much easier to imagine a world in which the return of currency volatility places limits on the ability to trade fictitious money for real money. real money.

A corollary for most investors is to also recognize that some of GMMT’s fun money has been invested in stocks. The risk of high currency market volatility is a cascading effect on the perception of risk by the stock market and the continued influx of foreign capital that will support an already stratospheric stock market. A sudden shutdown of foreign capital could be the cause of the next big hiccup in US stock markets. If the chain of “investing” based on fun money stops, asset market appreciation could suddenly stop.


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