The Daily Reckoning PRESENTS: Curiouser and curiouser…as the yield curve flattens earlier than expected, the consensus seems to not worry – even though this phenomenon has always signaled a recession in the past. The Good Doctor explores…
The biggest puzzle of the past two years lies in the behavior of intermediate and long-term U.S. interest rates. They have stayed at their unusual lows in the face of general economic euphoria and a 300-basis-point uplift by the Federal Reserve.
As a consequence, the yield curve has flattened much earlier than expected. While the consensus does not seem to worry, it is a fact that in the past this has always signaled an impending recession. Why not this time?
Without offering any explanation, Fed Chairman Alan Greenspan recently argued that a flat yield curve would not act as a recessionary signal this time, while incoming Chairman Ben Bernanke sought to provide an alternative benign explanation with his “global savings glut” speech in early 2005.
The search for sound and logical reasons continues. Many see a main reason in the large bond purchases of Asian central banks. Mr. Greenspan, in particular, has argued that the low longer-term interest rates reflect the Fed’s eminent policy posture over the past few years, leading to the low core rate of inflation and sharply diminished risk premiums.
None of these explanations holds water. Without question, the U.S. bond purchases by Asian central banks help to keep U.S. longer-term bond yields down. Yet they are grossly insufficient to accommodate the credit deluge flooding the U.S. economy and its asset markets at these low rates.
In the United States, it is the popular assumption that long-term interest rates are fundamentally determined by inflation rates and expectations. The additional new feature now is diminished risk premiums. Past experience may suggest this connection, but past experience is pretty worthless under the present diametrically different conditions of exploding credit and collapsing savings.
To have low interest rates, it definitely requires more than just a low inflation rate and confidence in the central bank. It requires a sufficient flow of money to accommodate the ongoing credit expansion, including the bond purchases. What has happened in the United States in the past four or five years is an unprecedented money and credit deluge, holding short-term and long-term interest rates at record lows.
The first decisive question to ask in the face of this extraordinary development is the source of all that money accommodating the credit deluge. Principally, there are two possibilities. The difference is of crucial importance. The one source is the limited supply of savings; the other one is possibly unlimited inflationary money and credit inflation.
It happens that in the United States’ case, the identification of that source is particularly easy. With savings in collapse, credit accommodation must essentially have come in total from inflationary money and credit creation. Implicitly, this applies equally for asset purchases, whether housing, stocks or bonds, for which the steep yield of the last few years was the ideal condition.
After Treasuries, the leveraged speculators turned to higher-yielding investment-grade corporates. Then it was junk bonds, then emerging debt and then structured credit. What has lowered U.S. longer-term interest rates and squeezed the risk premiums was manifestly the unprecedented credit excess going into carry trade, engineered by the Fed.
This talk of diminished risk premiums as the cause of the low long-term interest rates virtually puts the truth on its head. As yields fell across the board, the speculators had to incur rising risks in order to maintain their spread in carry trade.
For us, Greenspan’s reference to low-risk premiums as an explanation for the low long-term rates just serves as a diversion from the all-too-obvious true cause: the greatest credit excesses in history.
Recognition of these facts has to be the starting point for any assessment of the future course of U.S. longer-term interest rates. A total collapse of the carry trade, a sure consequence of an inverting yield curve, would send long-term rates soaring.
While Mr. Greenspan has argued that the yield curve no longer plays the same crucial role for the economy as in the past, we think that under these conditions it matters more than ever, both for the economy and the financial system.
All the more puzzling is the stubbornness of the low long-term interest rates, defying the yield curve’s actual flattening. One possible explanation is a major shift in the financing of the carry trade to a cheaper euro and, in particular, yen. Strikingly, the growth of financial credit, i.e., by financial institutions other than the banking system, showed a steep plunge in the third quarter.
In the end, though, one has to assume that leveraged speculators stick to their bond holdings or even add to them, expecting that a weakening economy will force the Fed to sharp new rate cuts.
Although strongly sympathizing with the downbeat forecasts for the U.S. economy, we have trouble with the optimistic assumptions of still lower long-term interest rates. The starting point for our doubts is the preposterous pace of credit expansion shown in non-financial credit, despite 12 rate hikes, with no sign of the slightest letup.
So far, there has been zero monetary tightening. The just-published Flow of Funds Accounts of the Federal Reserve shows a rise in nonfinancial credit for the third quarter of 2005 to a new record-high annual rate of $2,296.6 billion, of which, also a record high, consumer credit was $1,235.9 billion.
To understand the problem of credit excess, it needs a historical perspective.
These numbers make horrible reading in two respects. One is the sharp acceleration in the speed of credit growth over the years, and the other is the stunning contrast between exploding credit and collapsing savings.
Now compare the credit figures of the 1990s with those since 2000. Even in the boom year of 2000, non-financial credit expanded by just $864.7 billion. During the first three quarters of 2005, it has – after rapid acceleration – been expanding by $2,202.2 billion at annual rate.
The difference is shocking. Even more shocking is the extremely poor job growth resulting from this unprecedented credit deluge. During the first four years of the recovery after the 2001 recession, decried as a “jobless recovery,” employment grew by 7.6%. For the current recovery, it is 2.6%.
There has, in short, been a dramatic deterioration in the traction of credit growth on economic activity. It was in the early 1990s, actually, already much lower than in the earlier decades of the postwar period.
It should be clear that this has serious negative implications, if this disconnect becomes structural. Closer investigation of the underlying causes compels us to the conclusion that, in fact, it is structural, and this for obvious reasons.
Money and credit growth do not have determined economic effects. It is decisive to whom and for what purpose credit is extended. In this respect, the past 20 years have witnessed substantial changes in all industrialized countries. But these changes have mainly been most drastic in the United States for two reasons. One reason is a general growing propensity toward consumption; and the other reason is an obsession with shareholder value, at the expense of organic capital investment.
In earlier years, credit generally financed spending in the economy. Businesses borrowed for capital investment, and consumers borrowed for purchasing durables and housing. All this borrowing impacted national product and incomes directly and positively.
But starting in the 1980s, new credit in the United States increasingly went into two other outlets outside the national product. One was soaring imports, as reflected in the ballooning U.S. trade deficit, and the other was asset purchases in the domestic and global markets.
One of the results is a general confusion about inflation. Historically, American policymakers and economists in general only recognize one single kind of inflation – rising consumer and producer prices, particularly the former. To understand inflation, however, it is necessary to distinguish between cause and effect.
There is always one and the same cause, and that is excessive money and credit creation. But depending on possible different uses of the borrowed money, there can be very different effects. By the early 1980s, a sharply accelerating money supply in relation to GDP aroused great fears of a comeback of consumer price inflation that tenaciously failed to materialize. Even for the experts in the central banks, it took some time to realize the obvious, that credit excess was fueling inflation in asset prices, instead.
A trade deficit, in turn, implicitly reflects the fact that a country spends in excess of its production. For this to happen, it inexorably needs credit, enabling people to spend in excess of their current income. From this perspective, it, too, is manifestly an expression of inflation.
People borrow to spend. Observing a sharply accelerating credit expansion, it is, in general, easy to identify the target of this spending. There cannot be the slightest doubt for anybody that the credit deluge of the past few years in the United States has mainly flooded into housing – boosting its prices. Yet policymakers and many economists dare to flatly deny the direct connection.
In his first speech as Fed governor (October 2002), Mr. Bernanke said, “Another possible indicator of bubbles cited by some authors is the rapid growth of credit, particularly bank credit. Some of the observed correlation may reflect simply the tendency of both credit and asset prices to rise during economic booms.”
It certainly needs a lot of courage to discard such a blatantly obvious causal connection as merely coincidence.
Dr. Kurt Richebächer
for The Daily Reckoning
January 17, 2006
Editor’s Note: The Fed has remained irrationally confident in the U.S economy – because they can’t afford from American consumers to see the truth – that the basis for this confidence is a shamelessly fraudulent farce of trumped-up statistics. Fortunately, Dr. Richebächer isn’t afraid to tell the truth.
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 year will be another year of “easy money,” says AFP. Asian exporters want to keep their currencies cheap to help exports. Europeans want cheap money to lift employment. Oil exporters have so much money they don’t know what to do with it. (Venezuela is so desperate to get rid of money, it is offering to lend to its neighbors. More below.) And, of course, Americans are printing the stuff in bulk. If the money supply in the United States were to continue expanding at the current rate, it would add more new money in 18 months than the current value of all the gold ever mined since the days of King Midas.
Why so much new money? The empire needs it.
Wars, floods, bread, circuses – an empire is an expensive business. The U.S. federal deficit was more than $300 billion last year. This year it is expected to rise to over $400 billion, perhaps even beating the record set in 2004. Meanwhile, in external commerce, the nation spends $700 billion more than it receives each year. Already, the net external debt of the United States approaches $3 trillion.
The exact day on which Alan Greenspan discovered easy money is recorded in our first book, Financial Reckoning Day. It was in the mid 1990s, the day after he made his famous “irrational exuberance” speech, in which he worried about over-valuations in the stock market. Congress called him in. “Do you know who pays your salary?” the pols asked him. His job was to pump up asset prices, they reminded him, not hold them down. The maestro stood up, waved his hands, and did what he was told to do. He never looked back. America has been a land of E-Z money ever since.
Richard Benson explains:
“After Alan Greenspan gave his famous ‘irrational exuberance’ speech about the stock market, he stopped being rational and prudent, and became rational and profligate. He discovered that the stock market bubble – fostered by too much easy credit – made consumers feel really wealthy. By letting money and credit run wild, the economy roared, and rising stock market prices created such a false sense of wealth that consumers stopped saving. By 2000, Americans had hardly saved anything and domestic savings to recycle didn’t exist. Around this time, Mr. Greenspan declared that ‘bubbles should not be popped’ but the Federal Reserve’s job would be to clean up the mess if the bubbles collapsed on their own. So, how does a popped bubble get cleaned up? With easy money, of course!”
But easy money, like easy virtue, has its time and place. A policy of E-Z money all the time, soon leads to too much money.
Alan Greenspan’s response to the tech stock bubble was easier money. Interest rates went to near zero…and stayed there for two years. The result was a new, bigger and more dangerous bubble – in housing.
“By 2004, it was time to help another sitting president to get re-elected,” Benson continues. “The housing market was booming and home equity extraction added about $800 billion (a year) to spending, even though this spending left a massive trail of debt.
“In looking back now, you can’t help but notice how the economic model has changed. For decades, America had an economic model built around recycling savings into investment. In a few short years, those savings have simply vanished and our society has become comfortably cavalier about borrowing far more than they earn.”
But just as you never know when a woman of easy virtue will join the church choir, you never know when easy money will start playing hard to get. A test of just how easy money will be in 2006 is coming in the next 90 days, says Bloomberg. The United States is asking lenders for $171 billion in U.S. Treasury notes and bonds. The most recent auction of T-notes was a disappointment; there was surprisingly little demand.
Maybe lenders, mostly foreign, are getting tired of so much U.S. debt. If so, money won’t be as easy as everyone expects. Not that the dollar is likely to become an honest currency, but it might not give itself away so cheaply.
More news from our team at The Rude Awakening…
Bill Bonner, back in London with more thoughts…
*** Uh oh…the house-price boom seems to be over – even in Hawaii. Yes, on the island of Oahu, for example, the median house sold for $418,000 in November. That was 8% less than the year before.
“This is happening all over the country,” explains Dan Denning. “People’s houses are losing value all the time – and they don’t even realize it.”
“Folks who refinanced a year or two ago are finding out their homes are worth less than the appraised value. All over the country, appraisals have been inflated by lenders eager to make loans, and real estate agents eager to close the deal, whatever it takes.
“I predict that this appraisal scandal will explode soon in the mainstream media. When this mess falls apart, the whole country will discover how lenders and real estate agents have pressured appraisers to overvalue homes.”
[Ed. Note: Unfortunately for us, these giant lenders can’t afford even a small downturn – much less the wave of defaults that will be coming their way once this downward spiral really picks up steam.
*** Here at The Daily Reckoning we often say that we are connoisseurs of the absurd, forever collecting facts and tidbits to regale you, dear reader. While reading through Steve Forbes’ book, Flat Tax Revolution, we came across this incongruous morsel:
“Abraham Lincoln’s Gettysburg Address, which defined the character of our nation, is all of 268 words. The Declaration of Independence runs about 1,300 words. The Constitution, which has served us for more than 2 centuries, comes to some 5,000 words. The Holy Bible has 773,000 words. The federal income tax code and all of its attendant rules and regulations: 9 million words and rising.”
Stay tuned…we’ll have an essay from Flat Tax Revolution for you tomorrow…
*** Does E-Z money really help? Are lottery winners really better off? Do nations that get huge windfalls from oil or gold really prosper? Should you give your children large amounts of money?
Venezuela is floating on easy money from oil revenues. Still, that doesn’t prevent its leaders from sinking the entire country.
“Venezuelans are facing a growing shortage of staple foods as producers and wholesalers stop deliveries amid tightening government price controls and collapsing margins,” says a recent press report. “Coffee, sugar and beans have become scarce or absent in stores this week as suppliers await notification of official prices. President Hugo Chávez introduced caps on the prices of basic goods three years ago, in theory to ensure lower costs for the poor. But while prices have since been lifted periodically to offset rising output costs, suppliers say the increases have been too slow. In some cases, production costs exceed the official price.”
*** Get the E-Z money while you can. That seems to be the chant of America’s upper management. Who cares about the shareholders! Stiff the creditors! To heck with the employees! We read in yesterday’s paper that UAL executives will share out $115 million in a settlement with creditors, as the airline comes out of bankruptcy. The new CEO will get $8 million in salary, signing bonus and various other emoluments looted from their rightful owners. Plus, if we read it right, he will get millions more in stock options.
Could no one be found who would do the work for less? U.S. airlines tend to go broke – even when managed by the best industry professionals money can buy. Why not save some money and let them go broke under the direction of an honest mechanic?