The Daily Reckoning
Milford, Nova Scotia
Tuesday, July 06, 2004
The Daily Reckoning PRESENTS: "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...
A MOST SAVAGE CREDIT CRUNCH
by Dr. Kurt Richebächer
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.
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.
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.
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.
Regards,
Dr. Kurt Richebächer
for The Daily Reckoning