A Most Savage Credit Crunch
"Greenspan has lured America into a horrible liquidity trap." Says The Good Doctor. From this point, an orderly unwinding is simply not possible. The explanation follows…
While the Fed hiked its rate by a paltry 25 basis points, the bond market used a hammer, raising 10-year Treasury yields by 100 basis points within just two weeks – that is, by nearly a full percentage point.
If the Fed truly and urgently wanted credit restraint, the action in the bond market should have pleased them. We suspect the abrupt surge of long-term rates has shocked them, because the resulting higher mortgage rates have effectually choked the mortgage refinancing bubble, presenting policymakers in the Fed with far more credit tightening than they really want.
All their hawkish talk, we presume, was intended rather to calm the inflation fears in the market by emphasizing the Fed’s anti-inflation vigilance, thereby hopefully moderating the rise in longer-term market rates. In any case, the talk about a rate hike was much ado about nothing.
In his London speech, Greenspan cited that "the rise in rates… has induced a dramatic fall in mortgage refinancing." According to the Mortgage Bankers Association (MBA), mortgage-financing activity in the United States in the week ending June 4 was down 68% compared to a year ago. The MBA’s Refinancing Index had even plunged by 85% year over year.
Bond Bubble: What Good Is a Quarter-Point Rate Hike?
Yet the impact of the higher interest rates seems to have been cushioned by a surge in the demand for adjustable rate mortgages (ARMs).
What exactly could or would the Fed accomplish with a quarter-point rate hike? What would that do to the economy and the financial system? In short, it would not be likely to change much, if anything at all. Even the carry trade would still be profitable at this higher rate.
In fact, the existing short-term rate of 1% is ridiculously low for a supposedly booming economy to begin with. But most of the profits derived from this record-low rate go to the financial system, funding its assets in large part by this rate. Manifestly, Wall Street firms, banks and hedge funds could easily cope with a slightly higher federal funds rate. For consumers and non-financial firms, the Fed’s 1% rate is pure theory – except for savers.
What truly matters, in particular for financial institutions heavily engaged in carry trade, are changes in the long-term rate, because they directly hit their capital, and that, of course, with high leverage. The rise by 100 basis points reduces the value of 10-year bonds by almost 10%. Given that the carry trade with bonds is generally leveraged at 20:1, or 5% equity, this loss of value in the bond holdings actually wipes out more than the invested capital.
In hindsight, it seems reasonable to say that by maintaining the consumer borrowing and spending binge in the face of plummeting income growth, the mortgage-refinancing bubble has been the U.S. economy’s lifeline. Consumer spending posted a new historical record in the sense that it outpaced total economic growth. With an overall increase of $625.8 billion, for the first time in history it exceeded the simultaneous GDP growth, up $581 billion. The consumer achieved this with a debt surge of $1,678.8 billion.
But as explained, this lifeline has been badly damaged. There is no spectacular collapse like that in the stock market of 2000-01. Yet a drastically deflating mortgage-refinancing bubble is sure to have a much greater effect on the economy. What is unfolding there is not just gradual credit restraint. It is a most savage credit crunch with obvious, most dismal consequences for consumer spending and the economy.
Bond Bubble: Nobody Notices the Rate Hike
All the more, it stuns us how little attention this fact is finding. Just weeks ago, the question of a possible quarter-point rate hike by the Fed provoked an agitated public discussion. Now there appears to be a savage credit crunch in the offing, and nobody seems to even notice.
In our view, the fate of the mortgage refinancing bubble and its further impact on the economy is presently the single-most important issue facing the U.S. economy. All other major GDP components are much too weak to take over as the new locomotive. Consider that nonresidential business investment contributed just 0.30 percentage points to real GDP growth in the first quarter of 2004. Consumer spending remains so predominant that any weakness on its part would instead pull down the other components.
Of the numerous economic data that America’s statisticians constantly publish, a single forthcoming number appears absolutely decisive under these circumstances. That is real consumer expenditures in May, in the Personal Income and Outlays report published June 28 (just after this letter has gone to the printer).
As earlier elucidated, the numbers for the first four months of 2004 have been unusually weak. Overall growth was $61.5 billion, or $184.5 billion at annual rate. This compares with an annualized increase in the fourth quarter of 2003 by $388.4 billion and an increase over the whole year by $297.7 billion. To speak of any traction in this economy is absurd. With the mortgage-refinancing bubble seriously jeopardized, more weakness is the only thing we can imagine for consumer spending.
The other bubble that gives us the greatest headache is the highly leveraged carry trade in longer-term bonds. We ask ourselves how this monstrous bubble, having certainly run into several trillion dollars, can ever be unwound without pushing market interest rates substantially upward.
Well, prices of longer-term bonds crashed in April-May. For 10-year bonds, the loss was close to 10%. For the time being, U.S. bonds have stabilized at their lowered level, as unwinding – in other words, selling – has drastically abated or stopped. But it is a deceptive stability. Such a huge bubble that has been built up over two or three years is not liquidated within weeks. For sure, the bulk of the carry trade still hangs over the markets.
The decisive point to see about the carry trade of bonds from a macro perspective is that huge purchases of bonds with borrowed money essentially result in artificially low longer-term interest rates. Normally, such purchases ought to come exclusively from current savings.
Bond Bubble: Unlimited Elasticity
While the U.S. economy has near-zero domestic savings, it possesses a financial system that, thanks to its central bank, knows no limit in credit and debt creation. It is a financial system of virtually unlimited "elasticity," one might say.
However, this extraordinary financial elasticity works overwhelmingly in two directions: personal consumption and financial speculation. During the 13 quarters from end 2000 to the first quarter of 2004, private household debt has soared by $2.52 trillion, or 36%, and financial sector debt by $2.9 trillion, or 35%. Jumping from $578.1 billion in 1980 to $11,280.6 billion in the first quarter of 2004, the debt of the financial sector in the United States has skyrocketed from 21% of GDP to 98.4%.
Mr. Greenspan keeps hailing this extraordinary ability of the U.S. financial system for expansion as a sign of superior efficiency. We increasingly wonder about its elasticity in the opposite direction, that is, when it comes to unwinding existing bubbles, regarding the immediate surge of long-term interest rates only as a first taste of things to come.
Building the huge carry-trade bubble of bonds during the past few years has been fun because the yield spread and rising bond prices lured ready buyers en masse. It was a pleasure for sellers and buyers. But we wonder from where the huge buying of bonds will come when selling pressure from the unwinding of this bubble will develop in earnest.
Imagine, America’s whole financial system has trillions of dollars in the same boat. But what can possibly trigger heavy selling of this kind? For sure, the Fed is desperate not to upset this boat with the major rate hikes that could do so. If it feels compelled to move in order to satisfy bond vigilantes, it will do no more than minimal, so to speak, rather symbolical rate hikes.
Considering the huge amounts involved in the U.S. carry trade, we think that this bubble has, actually, become far too big to allow for orderly unwinding, by which we mean unwinding with moderate interest effects. Under the conditions created by the Fed, it was easy to create virtually unlimited leveraged buying of bonds on the way up. But there are few willing buyers on the way down.
But to be sure, it is impossible to recreate these conditions. First of all, rate cutting by the Fed has spent its power; second, there will be upward pressure on interest rates from new credit demand; and third, being outrageously overloaded with highly leveraged bond holdings, the financial system will be a very reluctant buyer of new bonds.
All in all, the asset bubbles have over time become far too big to allow for orderly unwinding. With the highly leveraged carry trade in bonds alone running into several trillions of dollars, one has to wonder where and who the necessary potential buyers for these trillions are that would make such extensive deleveraging possible. The fact to see is that the Greenspan Fed has lured the U.S. financial system into a horrible liquidity trap.
Dr. Kurt Richebächer
for The Daily Reckoning
July 6, 2004
Editor’s note: Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer’s insightful analysis stems from the Austrian School of economics. France’s Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis."
This essay was adapted from an article in the July edition of:
The Richebächer Letter
Oh reader, dear reader…
Once again, we stopped dead in our tracks and gasped for air. The whole thing is a fraud we keep yelling. American capitalism – like its democracy – has become corrupt, degenerate, and enfeebled. But we are a lone voice lost in a vast wilderness of up-to-the-minute information and crackpot optimism.
And yet, there is the evidence, right there on the front page. "U.S. wages losing ground," says the Rocky Mountain News. The story is simple enough – simple enough even for an economist to understand. Wages rose 2.2% in the 12 months to the end of May. Inflation – CPI inflation, the kind that makes things more expensive for the people earning wage income – rose 3.1%.
We will do the math later. For the moment, we will just note that 2.2% is nearly 1% less than 3.1%. Ergo, the American wage-earner…the great broad back upon which the entire world economy now rests…got poorer.
Doesn’t anyone think it a little odd? We mean, this was a ‘recovery’ year. In every previous recovery, wages rose sharply. In this ‘recovery’ they are going down.
Of course, the inference is obvious: this recovery is like no previous recovery. It is like a duck that can’t swim…a giraffe without a long neck…a democrat with a brain or a tax-collector with a heart. In short, it is not what it pretends to be. It is not a recovery at all.
What’s more, the U.S. economy is supposed to be the most dynamic in the world. It is supposed to be making both the proletariat and the capitalists rich. But neither group is getting rich. Investors have gotten no capital gains for the last 6 years. And dividends? Don’t make us laugh.
And the great American jobs machine stalled out 3 decades ago. Since then, the typical wage-earning man has seen almost no swelling in his pay envelope. More recently, the Bush administration has watched over the loss of 1.5 million jobs. The job loss in manufacturing was much greater – 2.9 million. But enough greeters at Wal-Mart were hired to offset about half of them.
William Niskanen, an economist whose name was heard often during the Reagan years, guesses that falling real wages will be a fact of life in America for the next 5 to 10 years. What happens after that, he didn’t say.
On the second day of our visit to America we left it. We took the ferry to Canada… more ‘A Family of Euro-Snobs Rediscovers America,’ below…after the news:
Tom Dyson, from the Monumental City, reminiscing on the 4th of July…
– Your editor noticed a coin on the floor of the bar. It was at the foot of a beautiful woman. We were celebrating our independence and enjoying the firework display in the inner harbor area of Baltimore. A dirty, beer-soaked floor wasn’t going to stop your editor from picking up the coin; it was a quarter.
– We always pick up coins from the street. It’s not that we have either expensive tastes or insufficient funds, we don’t. And nor are we tight-fisted…it’s more a force of habit and superstition.
– The attractive woman noticed your editor scratching around on the floor for the coin. "Why did you do that?" she asked, in no uncertain terms, as your editor stood up beside her. She couldn’t understand why one would pick up a coin. We couldn’t understand why one wouldn’t.
– "I’m saving up," your Baltimore-based British editor lied. "I have both expensive tastes and insufficient funds."
– Here in the U.S.A., we find ourselves stooping down to the pavement frequently. In fact, so many pennies litter the streets that sometimes we don’t even have time to pick them all up. Rarely can we make it from one corner to the next without pausing to pick up a piece of the government’s copper. It never used to be like that.
– The reason is straightforward; give the world’s most wasteful people the world’s most rapidly inflating currency and you’ll get streets paved with copper…they used to be paved with gold.
– But the era of cheap money is over. And we think it unlikely the Federal Reserve is tempted to reinstate it just yet. Mr. Greenspan waited four years to move rates up, rather than down. The Great Enabler will need to see a whole slew of terrible date before reversing course now.
– Last Wednesday, the Fed’s short-term rate rose to 1.25% from 1% – the famous ’emergency’ level in search of an emergency. But what’s this? On Friday, the emergency showed up – two days too late – when the U.S. Labor Department reported that fewer than half the expected jobs were added in June. Only 112,000 payroll jobs showed up versus the 250,000 anticipated. April and May’s figures were revised down too. In total, the world’s largest single economy produced 173,000 fewer new jobs this spring than was hoped.
– But this is the problem. Using rock-bottom interest rates when the economy is supposedly growing and all the news and sentiment is positive is a very dangerous tactic. Good news inevitably changes to bad, and when it does, there won’t be any tonic left. The Fed has backed itself into a tight corner. What transpires from here will be very interesting…especially if you own large chunks of U.S. equities.
– Even as Wall Street traders hurried into their sports jackets and headed out the door for the long Independence Day weekend, they pushed the Dow down 51 points on Friday. It closed at 10,282 – some 89 points off for the week. Tech investors got whacked too, as the sell-off knocked the Nasdaq down another 0.5%…on top of Thursday’s 1.6% fall…to end Friday at 2,006 – nearly 20 points off for the week.
– The U.S. markets were closed yesterday for the holiday weekend. As a result, trade in Europe was thin…the bourses scarcely budged. The dollar was steady too after Friday’s currency-carnage, as was gold. After the jobs report came out on Friday, the dollar dropped over a cent and a half against both the euro and the pound. The dollar now floats around $1.23 and $1.83 respectively. Gold remains just shy of $400 and was virtually unchanged in yesterday’s trade.
– Sooner or later, Mr. Market is going to notice all the pennies lying around. But he won’t pick them up, not Mr. Market; he’ll dump them for gold. As for your editor, well, he’ll probably keep picking them up – the attractive woman in the bar gave him her phone number…
Bill Bonner, back in Nova Scotia…
*** From the Economist:
"The greenback has begun to slide again, while gold has staged a comeback to $400 an ounce. Since mid-May, the dollar has fallen by 4% on a trade-weighted basis. On the face of it, this seems peculiar. The dollar has started to fall again even as the chatter about interest-rate rises has got louder. Naively, you might expect a currency whose interest rates are about to rise to go up, not down. One explanation why the reverse has been the case is that the Fed has been late in stamping on inflationary pressures, so real interest rates, rates adjusted for inflation, are falling even as nominal rates are expected to rise. There might, however, be another explanation: that rising rates will make an already awful current-account deficit worse still, and that markets are again starting to realise that the only way in which this can be corrected in the long-term is by a sharply lower dollar."
America has become a ‘giant hedge fund,’ says Jim O’Neill, chief economist at Goldman Sachs. Even though the dollar fell from its high of Feb. ’02, the trade deficit got worse. That’s not supposed to happen. A falling dollar was supposed to make foreign-made goods more expensive. Americans were supposed to buy fewer of them. The trade deficit was supposed to shrink.
Instead, the trade deficit hit a new record of nearly $50 billion in the month of April. Why? Because America is such a great place to invest, say Gilder and Kudlow. Don’t worry about it!
But Americans themselves find that it is better to invest outside the U.S. While the Dow goes nowhere…and U.S. bonds provide the lowest yields in four decades, foreign markets give American investors a chance to make some money. In the first quarter, for example, foreign direct investment into the U.S. provided a return on investment of only 5.5%. Investment by American firms outside the U.S. on the other hand returned more than twice as much – 11.7%.
This encourages large American investors to act like hedge funds – they borrow at low U.S. rates and put the money overseas for higher returns. And thus has the whole country comes to resemble a risk-taking hedge fund, without the hedge. Americans, consumers as well as investors, borrow short at Greenspan’s giveaway rates and using the loot to buy foreign investments as well as foreign-made goods. And the whole shebang is underwritten by central bankers – Mr. Greenspan on one hand, with his ’emergency’ low rates…and foreign central bankers on the other, who recycle their countries’ trade surpluses buy buying U.S. Treasury debt.
Again, we stop in our tracks and gasp for air. Sell the dollar. Buy gold. Who knows how this ‘giant hedge fund’ is going to do…but we don’t want to have our money in it when it does it.
*** "Kerry is a mediocrity. He is a typical senator who votes for the moment. He isn’t a statesman."
"…if Kerry is elected, the doctrinaire Republicans will sell stocks for a day or two, but then the market will go up considerably."
– Seth Glickenhaus, the 90-year-old proprietor of Glickenhaus & Co., the $1 billion Manhattan-based money management firm, in a Barron’s interview, June 7, 2004.
*** Homeland Bound
"It’s unbelievable," said Elizabeth. She had spent much of the 8 hours of flight time between Paris and Newark catching up on American movies.
"It’s amazing how coarse and vulgar these movies are. I don’t think I’ve heard the f-word so many times in my entire life. I don’t remember people saying the word so casually. And in the movies, it’s not the bad guys who use the word, it’s the good guys. They use it as if to mean that they are serious – they don’t have time to be polite or delicate.
"In that one movie I watched, I don’t remember the name, but it was about some police who were trying to figure out what had happened to a girl who had been kidnapped from Harvard. She was the president’s daughter, or something. And it looked like an evil band of terrorists were behind it. But the police beat people up and killed several bad guys…and said ‘f***’ to one another all the time. It was as if they thought their work was so important, they couldn’t be bothered to be nice."
"Well, maybe the word has lost its meaning," her husband suggested. "The language has evolved. It just doesn’t have the same shock value you remember from your childhood. It’s no longer a verb. It’s just punctuation. You know, people say…’So good to see you. F***. Have a nice day. F***."
"That’s what I thought, but then I saw another movie in which a woman said she had ‘f***ed’ someone last night. I was shocked. This was on a family airplane. But no one seemed to take offense."