The Daily Reckoning: Weekend Edition
April 15-16, 2006
Baltimore, Maryland
by Dr. Kurt Richebächer
MARKET REVIEW: WHAT NEXT?According to the consensus forecasts, the U.S. economy is in robust shape
and will continue to forge ahead at recent growth rates of around 3.5% for
as far as the eye can see. Looking at the various big imbalances, we see
an economy in very bad structural shape. There are really two key
questions: first, soft or hard landing of the housing bubble? And second,
is business fixed investment taking over from consumer spending as the
economy's driver?
Trying to make our own judgment, we scrutinize the recent data flow.
Putting particular weight on the housing bubble, we observe distinctly
more weakness than strength, and we think that this weakness is sure to
accelerate. Mr. Bernanke seized the occasion of his first address to
stress again his familiar view that under present conditions the flat
yield curve is quite harmless because interest rates are still at historic
lows.
As it happens, we disagree with both sides. What matters more than
interest rates is monetary tightness. We are sure that the emergence of an
inverted yield curve in the past reflected truly tight money. This time,
the Fed has maintained full monetary looseness, as measured by the growth
of high-powered money and credit. The changes in the U.S. yield curve are
the mere product of rate hikes at the short end.
Yet it had an important effect, not on the U.S. economy, but on the U.S.
currency. The rate hikes at the short end curbed dollar-funded carry
trade. But instead of closing their positions, many carry traders shifted
their funding to the currencies with low interest rates - yen, euro and
Swiss franc. The new result: a strong dollar on top of very low U.S.
long-term interest rates.
The great question now is what may most probably upset the U.S. bubble
system, now heavily exposed to carry trade in foreign currencies. We think
the main threat is obvious, and actually in the making. That is a
weakening U.S. economy forcing the Fed to stop its rate hikes, and later
to cut them. Relatively strong U.S. economic growth and the rising
interest rate differential at the short end have been a main pillar of the
dollar's strength.
A weakening U.S. economy is bound to crack this pillar. Due to the
gigantic leverage implicit to carry trade, a modest rise of the yen, euro
and Swiss franc against the dollar by just 2-3 percentage points is enough
to abruptly torpedo the whole carry trade in these currencies, triggering
a fire sale of unimaginable proportions of both dollars and U.S. bonds. In
our view, this is plainly written on the wall, and a true miracle is
needed to avoid this debacle.
This has just happened to the Icelandic krona, the New Zealand dollar and
several other minor currencies crashing by double-digit rates. The point
is that owing to the heavy leverage involved, conditions for a violent
chaotic unwinding are prone to abruptly evolve. Any selling may quickly
turn into an unstoppable avalanche when participants suddenly recognize a
risk. Since early last year, shorting the yen, the euro and the Swiss
franc has been deemed to be a safe, one-way bet. This can suddenly
change.
There is no way to know the depth and pervasiveness of the U.S. carry
trade funded in foreign currencies. In our view, it must be immense,
simply because there exist no domestic savings to fund the rampant credit
expansion. The whole U.S. financial system is built on carry trade,
borrowing short and lending long.
As to the general hopes that a weakening economy will lower long-term
rates and boost bond prices, we have to warn that the rapid unwinding of
the carry trade in response to dollar weakness will probably overwhelm
this effect and send U.S. bond prices sharply downward.
Dr. Kurt Richebächer
for The Daily Reckoning