It's the Bubbles, Dummy
The carry trade stimulates a virtuous circle of credit creation. But should the circle be interrupted, things quickly get vicious. Here’s the good doctor’s prognosis…
The further fate of America’s consumer borrowing and spending binge is of major concern at this juncture. Last year, in particular, it was the key prop to the U.S. economy. If it definitively falters, the recovery will surely derail.
The creation of a huge carry trade in bonds was crucial in lowering mortgage rates. Consequently, a massive mortgage refinancing bubble was provoked, characterized by massive home equity extraction. This freshly created equity provided the funds for simultaneous bubbles in housing and stocks. Soaring pseudo wealth was then offered as collateral to facilitate the borrowing binge.
All of a sudden, sliding asset prices have hammered these highly leveraged asset and credit bubbles. Ironically, the trigger was pulled by a string of strong economic data. Fretting about higher inflation and a possible hike in short-term rates, heavily leveraged investors started cautionary liquidations. But given the leverage, more and more selling was bound to follow. In short, investors had simply become too optimistic, giddy from the artificially low interest rates.
There can be no question that, in time, badly performing financial markets will take their toll on general sentiment. The change in sentiment always comes after the markets have already declined dramatically – falls that most people are not prepared for. A recently published OECD report spells pure optimism about the world economic prospects and thus provides a warning that markets may be about to fall.
Bond Bubble: Appetite for Risk Lifts Markets
In its March Quarterly Review, under the title ‘Appetite for Risk Lifts Markets,’ the Bank for International Settlements in Basel, Switzerland, reports, "Financial markets around the world rallied into the new year, adding to the impressive gains recorded in 2003. Improvements in global growth prospects and corporate finances, coupled with a robust appetite for risk, underpinned increases in equity and credit prices. Not even further revelations of corporate malfeasance seemed to unsettle investors." We hasten to add that the Bank has been highly critical of this development.
As we have already said, the sudden rise in long-term U.S. rates, which started in mid-March, was not caused by bad news, but by unexpectedly good news. For us, it is an unbelievable irony that the strong employment gains were so coveted by the Fed yet, at the same time, ultimately proved to be the needle that pricked the bond bubble.
To quote Ramsay King on this point: "It will be an irony of biblical proportion if dubious employment gains spook the markets, which then impairs the economy, which in turn costs Bush the election. That irony would be compounded if there was any political maneuvering or pressure to produce great but unwarranted employment numbers."
For us, and for Mr. King, it is a great irony that the prevailing perception of a strongly rebounding U.S. economy, which caused interest rates to rise so suddenly, is so badly flawed in the first place. Consumer spending has effectively slumped during the first quarter. What’s more, the recent impairment of the mortgage refinancing bubble is a compelling reason to assume that the consumer- spending slump will continue to get worse.
Bond Bubble: Consumer Overborrowing
Thanks to all these bubbles, the American consumer borrowed a mind-boggling $879.9 billion last year, having borrowed $775.7 billion the year before. However, most of the borrowed money went into housing and stock purchases, fueling the rise in their prices, rather than into living expenses.
Pursuing the discussion about the outlook for stock markets, it strikes us that the question of potential buyers and their finances is never touched upon. In the late 1990s, the necessary funding came primarily from American and foreign corporations through huge stock buybacks and frenzied merger and acquisition activity. Private households just jumped on the running bandwagon.
Since 2000, all buying on these accounts has vanished. Last year, private households stepped in as the standalone buyer. With poor income growth and virtually no savings at their disposal, their stock buying implicitly depended on heavy borrowing from the mortgage-refinancing boom. But having largely depleted this source of funds, we see a grossly overvalued stock market without any potential buyers.
During the past two to three years, the U.S. economy and its financial system obtained an unusually high dose of monetary and fiscal stimulus. Yet it was really the interplay of three bubbles undefined in bonds, housing, and mortgage refinancing undefined that enabled the consumer to sustain such an elevated level of spending. Meanwhile employment and income growth fell precipitously.
Bond Bubble: Extreme Imbalance
Manifestly, these policies, having involved heavy rigging of markets, were a palliative that prevented disaster for the U.S. economy in the short run. But instead of redressing the economic and financial imbalances from the prior boom, these policies propelled the imbalances to new extremes. After all, the U.S. economy is now, in many ways, in worse shape than ever before.
There has been some involuntary unwinding of the global reflation trades. Yet we have still only seen the tip of the iceberg. It is our view that the leverage used in the carry trading of bonds, in particular, has grown to such an absurd scale that orderly deleveraging is now impossible.
To point out the obvious: The asset and credit bubbles that have been inflating consumer spending undefined bonds, stocks, mortgage refinancing undefined are plainly deflating. The property bubble will soon follow for lack of funding. In short, we see savage deflation for the asset markets, but stagflation for the economy – and it is so obvious that no one can see it. This will soon change.
Dr. Kurt Richebächer
for The Daily Reckoning
June 16, 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."
Yesterday, America passed another milestone on its road to ruin.
Nobody seemed to notice; but there it was on the left hand side:
"More than half U.S. debt now in foreign hands," said a headline in the British press: "Figures from the Federal Reserve reveal that $1,653bn, or 50.6 per cent of liquid Treasuries, were held by foreign investors at the end of the first quarter. "Foreign ownership of the bonds rose by $170bn between January and March, with central banks – mainly in Asia – estimated to account for about $96bn of this."
Our colleagues – most of them – are pretty sure the foreigners are making a big mistake. "Interest rates are headed up," say nearly every pair of lips that speak on the subject. If interest rates go up, as expected, the value of those low-yielding U.S. notes and bonds goes down.
Interest rates are going up, say the same lips, because inflation rates are rising. "Inflation monster awakens," reports a headline from UPI.
Paul Volcker knocked the inflation monster out 20 years ago. The brute has been sleeping soundly ever since. What prompts the alarmed headline was news that the consumer price index jumped 0.6% last month – or an annual rate of more than 7%.
Inflation is stirring, snorting, and pulling at the sheets. Whether he is awaking now…or later…we’re not sure.
Chicago Fed governor Michael Moskow wrote in the Wall Street Journal yesterday that the Fed has the situation under control. Apparently, it is standing over the monster with a hammer in its hand.
But this is the same Fed that let the beast run wild for 90 years. Based on the evidence, the Fed is such a poor watchman…it’s as likely to knock itself out as the monster it created.
Trends in interest rates and inflation run in very long cycles. The last bottom in Treasury yields occurred in 1946 – when they fell to 1.93%. Then, for the next 35 years, yields rose along with inflation – reaching 14% in 1981. Then, finally, big Paul Volcker picked up his sledgehammer.
Since then, bond yields have been going down again. That is a period of 23 years. Inflation has been asleep long enough, you might think. Time for reveille?
If so, yesterday, foreigners didn’t hear the trumpet blow. They bought more…and long bonds rose.
For more news, we turn to Addison…
Addison Wiggin, from the Baltimore HQ…
– The latest CPI reading was released yesterday. In May, inflation rose by 0.6%, the largest monthly jump in three and a half years. The number exceeded expectations. Would the reader care to guess how the bond market reacted to this news?
– "U.S. Treasury debt enjoyed its biggest rally in more than three months on Tuesday," screams Reuters. Your editor had to quickly re-read the headline. Sure enough…30-year rates declined 16 basis points to 5.37%.
– As we read on, it seems that the jump was almost entirely fuelled by the prices of energy and gasoline…and milk! And apparently, if you strip these three items from the calculation, inflation actually decreased. Year-over-year inflation declined from 1.8% to 1.7%, says Reuters. "The moderation in core consumer inflation gave a big relief to financial markets, which had started to fret the central bank was falling behind in the curve."
– Of course, energy, gasoline and milk are hardly insignificant. In fact, they are probably the three items that every single household in America consumes every single day. As Bill succinctly explained on Monday, "Officially, inflation is running at 4.4% over the last 12 months. Take out food and energy and the rate sinks to only 1.8%. But it is food and energy that is in short supply in the world, especially in the fast-developing world. New factories in China can produce all the flip-flops the world could ever want, at lower and lower prices. But they can’t produce oil…and they can’t produce beef. As the Chinese get richer, they’re going to want more of both."
– In perfect harmony with the bond market – and as the promise of higher interest rates receded – the dollar sank. As of late last night, the euro buys $1.215, up from $1.206 the night before.
– Gold performed well yesterday, reacting to the dollar’s fall. Bullion added $4.90 to $388 by close of business in New York.
– As astute readers will already be aware, low inflation suits bullion just fine. Gold bulls know that the longer the Fed drags its heels, the more stubborn the inflation will eventually be.
– And for an idea on what to expect in the future in terms of inflation, we turn to the past for help. As inflation is the theme of today’s notes, it will come as no surprise that we choose the ’70s for today’s discussion.
– M3 money supply, the best predictor of inflation, rose by 94% over the 7-year period from 1966 to 1973, according to an article by Martin Hutchinson at United Press International. Consequently, from 1974 to 1981, price inflation averaged 9.4% per annum.
– Between 1968 and 1970, the stock market fell sharply, only to recover strongly into 1972. During that time, the economy was in recession, but the recession was mild, having been tempered by deficit spending. Price inflation, distinct from M3 inflation, burst out of the gate in 1973. A much deeper recession followed, and by 1982, the stock market had lost 75% in real terms.
– We realize that the economic situation of the 1970s is very different from that of today. For a start, today’s debt levels and stock valuations are much higher. Nevertheless, there are many similarities. We draw your attention, dear reader, to the M3 growth rate between 1996 and 2004, which Martin Hutchinson calculates to be at 93%, or 8.5% per annum. Here comes the price inflation, rationalizes Hutchinson, placing us in 1973, purely in terms of the inflationary cycle.
– Conventional wisdom holds that President Bush’s campaign is being supported by the economy and damaged by the unrest in Iraq. But if his analysis is correct, Hutchinson comes to the exact opposite conclusion. We could be about to enter another recession, he says; while Iraq, enjoying the high oil price and its newly granted sovereignty, could actual emerge as a prop for the Bush campaign.
– We love the contrarian feel of the argument that says, as the election approaches, "go long Iraq, short the Dow." The trade got even cheaper today…markets rallied while a sabotage attack closed deliveries from Iraq’s main oil export terminal in Basra.
– The Dow added 46 points, to 10,380, while the Nasdaq gained 26 to end the session at 1,996. Meanwhile in Iraq, both the major pipelines to the south were closed, reports Reuters, although only one was damaged. Repairs could take 7-10 days, "costing Baghdad $60 million a day at current market prices if no deliveries are resumed."
– Tomorrow, we eagerly await the latest report on the PPI. The number should have been released last week, but was delayed "owing to technical difficulties." This is the second delay this year and further stimulates suggestions that the Labor department needed more time to manipulate the data. The political imperative to suppress inflation could hardly be stronger than at present.
Bill Bonner, back in London…
*** What difference does it make if foreigners buy our debt? This was George Gilder’s question in Las Vegas. We recall it now not to make fun of it…but only to try to answer it more fully.
Of course, in a cosmic sense…it makes no difference at all. One person’s debt is another’s asset. Americans owe. Asians are owed. Asians have an asset. Americans have a liability. One country makes things; the other buys them. One country outsources…the other insources. One people gets richer, another gets poorer. The universe is in balance.
We have nothing against Asians. Heck, last night we went out with our daughter, Maria…first to see Tennessee William’s "Suddenly Last Summer" at the theatre…and then to a late dinner in London’s Chinatown. We had our multi- cultural experience and were perfectly happy with it. Thanks to Chinese cuisine and Chinese factories our lives are more interesting. Richer.
We’re happy, too, to see the Asians making money. It took the West more than 200 years to reach this stage of economic and technological development. The Asians seem to be compressing the entire process into a couple of generations. Bravo…and bully for them. And heaven is as happy to see a rich man from China arrive at its gate as it is to welcome a rich Californian. Why should we be any different?
Still, it is a little sad, too, to see our own countrymen sinking into debt and delusion. We fear they will be unhappy when they realize what they have done.
*** Here’s an interesting little note. Sir Michael Marnot reports the results of his study, which merely confirms our suspicions about the anti-smoking hysteria. A 60-year-old rich smoker has less chance of dropping dead than a 60- year-old poor non-smoker, he concludes. Watch out, dear reader, poverty kills. Why then are there no federally mandated warnings on shares of e-bay and Yahoo? The two companies have P/Es of 108 and 146, respectively. Together, investors buy and sell their stocks as though they were worth a combined $100 billion – or 22 times sales.
*** A report from our man-on-the-scene…Dan Denning…now in India…
"I’ll begin with the obvious issue on U.S. investors’ minds: outsourcing. I came to India as an outsourcing skeptic. That is, my initial impression is that it’s a far bigger issue in the press than it is in the economy, or for investors. I’ve revised that opinion."
"Outsourcing IS a big industry here in India. You have a well-educated, English speaking population willing to work at a discount to Western Labor costs. Multi-national firms like British Airways are finding that their Indian workers are also able to deliver substantial cost savings over and above the cost of labor.
"An example would be in the airline industry and the efficiency of code-share tickets. BA pays a fee to other airlines when you buy a ticket through BA, but take part of your journey on a different carrier. The problem for BA is that, prior to outsourcing, it wasn’t managing those claims efficiently, verifying that it wasn’t overpaying, not to mention the labor hours spent in actually processing the claims (or reimbursing the other carrier.) BA was able to compound its outsourcing cost-savings through the additional efforts of its Indian employees to actually run the operation more efficiently.
"[My contact here] figures that twenty percent of all Western services could be headed to the Indian outsourcing market. That makes it a major industry in India, and probably an investable theme if you can find the right outsourcing firms.
"As a skeptic, I objected that outsourcing might have diminished domestic benefit because the profits of the firms were going to multinationals, not Indian firms. Perhaps, came the answer. But even if the benefit were just the wages and taxes being paid by multinationals, it would be well worth it for India to develop the industry along its current trajectory.
"I won’t say I’m sold. I think as a political issue, outsourcing is over done. Americans tend to look at it purely as an issue of American jobs…[but] political concerns won’t stop the trend…"
*** And the latest from the other side of the outsourcing equation – Byron King in Pittsburgh:
And to think that, as we lose our traditional allies, we will also be:
1) On the back side of the "peak oil" curve;
2) Massively in debt, at every level of society;
3) Aging as a nation, with bottomless unfunded social insurance obligations; and
4) Underinvested in our own productive economy, after decades of raw consumption.
I do not presume to know how civilizations fail and fall. But if this is not part and parcel of it, I cannot imagine what is.
*** Ken Gewertz, from the Harvard News Office:
British Prime Minister Tony Blair’s dogged support for President Bush’s Iraq war seems to many to reaffirm the "special relationship" that has existed between Britain and the United States ever since the two countries patched up their differences over the American Revolution.
"Don’t count on it," warned historian Niall Ferguson in a talk on Tuesday (June 8) at the Phi Beta Kappa Literary Exercises in Sanders Theatre.
Ferguson, a prolific and controversial scholar who will join the Harvard History Department in 2004-05, provided the oration at the 223rd Phi Beta Kappa Literary Exercises. David P. Smith was this year’s poet.
Ferguson did not dispute the existence of America and Britain’s special relationship. In fact, in his opening remarks he downplayed the significance of the American War of Independence, calling it "a minor interruption in an otherwise cordial relationship." Considering that conflict, the amity and cooperation between the two countries has been remarkable, he said. "In a world of interminable blood feuds, ours was a very short spat."
Moreover, in its essential outlook and national character, the United States "remains indelibly a British creation," Ferguson said. Despite its division between church and state, America continues to define itself by the doctrines of evangelical Protestantism that formed the spiritual heritage of its earliest settlers. Americans still see themselves as a chosen people driven by Manifest Destiny, nationalism, and the work ethic, a set of values "terribly familiar to historians of the British Empire." America even finds itself waging wars on the same battlegrounds (Asia, the Middle East) in which the defenders of the British hegemony struggled.
The problem is that as America becomes more like Britain, Britain is becoming more Europeanized, undergoing a marked decline in religious faith, a growing skepticism about patriotism, and developing a more relaxed, more European attitude toward work. The transformation may help to explain the current unpopularity among citizens of the United Kingdom of Blair’s support for the Iraq War.
"The Americans are the British and the British have become Europeans," Ferguson said. "Isn’t it lovely – you have become us, even as we have ceased being us."