Monday, May 03, 2004

SHOW ME THE $$$MONEY$$$ edition: The End of an Era of "low" interest rates


In the words of the indubitable Warren Buffet, "Be fearful when others are greedy, and greedy when others are fearful."

What when are we to make as MSNBC reports that the stock market has rallied before the meeting of the Federal Reserve Board tomorrow?

It's that people are still greedy, and so we should be cautious. Why should we be cautious? As MSNBC reports that the Commerce department states that the value of buildings put in place is hitting a record high. Starting to sound like a real estate bubble yet? At the same time, manufacturing is slowing down. So what we have is a divergence in trends. Real estate which represents the development and pricing of a fixed asset is approaching a fever pace, while the underlying economy is getting shot to hell.

Software company EDS is making cutbacks (DFP) and selling units to pay down debt (Forbes), Gateway cuts more jobs (MSNBC), and Win-Dixie a supermarket chain is cutting 10,000 jobs. While the Agribusiness giant ADM is doing quite handy, capital investment is going to China like the plant Volkswagon is building there.


The Asian Times has been quite bearish on the Chinese economy for some time now, and now these worries are becoming more mainstream as China's neighbors worry that its slowdown would cause their own economies to tumble. That's a valid worry, though the response should be more intellectually rigorous than this pathetic Friedman NYT column. He's reduced to literally praying for China's continued prosperity.

You don't believe me?

"Dear Heavenly Father, please ... Please see to it that he moves steadily and carefully toward restructuring the Chinese banking system and ridding it of its huge overhang of bad loans and corruption, before there is a real meltdown that would be felt around the world. Give him the wisdom to cool the overheated Chinese economy without creating a recession that would prompt China to stop importing like crazy and start just exporting like crazy. And Father, forgive us for all the bad words we used in recent years to describe China's leaders — terms like `Butchers of Beijing.' We did not mean it. We meant to say `Bankers of Beijing,' because their economy is now fueling growth all over Asia, bolstering Japan and sucking up imports from everywhere. May China's leaders live to 120, and may they enjoy 9 percent G.D.P. growth every year of their lives. Thank you, Father. Amen."

See? I wasn't joking. This guy is pathetic. First he calls the Iraq adventure wrong, and now he's reduced to praying like a little kid for China's continued health. He clearly understands the importance of China's economy, but he's got about as much analytical insight as a rock. And the NYT pays him to be on their op-ed page?

As it turns out the Chinese government has two mutually contradictory policy agendas which are about to crash together.

The problem is that China on one hand has a policy that systematically undervalues its currencies to the USA's in order to gain an export trade advantage. (BNA)

The other contradictory policy is that they are attempting to tighten credit standards and monetary policy in order to slow down their headlong economic growth. (Asia Times)

The fundamental problem with these two issues is that they're in conflict. As China's central banking system tightens money supply, this ordinarily would lead to less lending for ventures and therefore slow down development projects and growth. However, if foreign capital is readily available and is inexpensive because of the currency policy then all the domestic tightening does is shift investment from domestic capital investment to foreign capital investment. It is quite natural that if there is a perceived demand, even if it is purely speculative, that a supply will arise to fill it.

If Chinese ventures can't get sufficient credit from China's central bank to continue expansion, then they certainly can from foreign investors. This will lead to an over-reliance on foreign capital that will set the stage for a later Asian financial crisis redux.

"The Asian Development Bank (ADB) suggested in its annual Asian Development Outlook this week that a failure to loosen fixed exchange rates and astutely manage burgeoning offshore reserves had heightened the risks of another financial crisis."

Without emergency capital control protocols, the whole region is left vulnerable to a future capital flight episode. Now some people religiously oppose capital controls, but a difference should be noted between structural capital controls, nationalizing capital controls, and crisis capital controls. Structural capital controls like India's prevent or limit foreign investment, control, and repatriation of profits. They stabilize international investment and trade at the cost of damping it. Nationalizing capital controls reflect default of national debt or seizures of foreign investment assets and can cause both investor losses and curtail future possible foreign investment. After you've impounded all their assets, investors aren't keen to rush in again. The last type is no different from trading controls on the DJIA that prevent trading if large enough shifts in the markets occur. These are "brakes" and were used successfully by a country in the past Asian Financial Crisis in order to restabilize a panicy market about to engage in a firesale. These type of controls investors actually invite (except short-sellers) because they prevent losses and are good.


There is a looming crisis in American currency however. The aritficial stimulus and the failure to tighten credit standards has led to speculative buying and overextension of balance sheets of both private and corporate credit lines. This has produced a great deal of financially induced inflation with very little benefit in actual increase of economic production of goods or services. In addition there has been a wave of commodity inflation, that's pretty widespread. How widespread? Starbucks is raising its prices because of dairy costs. (MSNBC)

This has lead premeire investor Warrent Buffet in order to argue that inflation is going higher and that he is betting against the dollar.

Given that the Federal reserve seems determined not to repeat the "mistakes" of 1994 when it hiked interest rates "too fast" it probably won't try that again. This Reuters article discusses the risk of such policies:

Analysts who are concerned the Fed may raise rates too high too fast point to events in 1994 as a precedent. In February of that year the Fed ended a long period of ultra-low interest rates and began a tightening cycle that saw the fed funds rate increase by 3 percentage points by February 1995.

That rapid-fire tightening made mortgage and commercial borrowing much dearer, weakened the stock market and sent bond yields up more than 2 percentage points in a matter of months.

U.S. assets became less attractive to foreigners and sparked a 15-month decline in the dollar.


However the situation is much different than in 1994. This time around the risk may be in tightening interest rates too slowly. How could that happen?

If the dollar is over-valued, then a small interest hike could precipitate a market shift like a pebble unleashing an avalance. When in 1994 the interest rates hikes began, the rates were raised too fast meaning that the dollar strengthened relative to the peso. The Mexican central bank burned through its reserves and then the peso underwent free-fall from what was supposed to be a "controlled devaluation". Here is a summary and analysis of US policy and the Mexican Peso Devaluation Crisis by Brad Delong et al.. Here is another paper outlining the connection between a fear of a default and the crisis.

Now it is illogical to think that Treasury debt would be in imminent danger of even the perception of a potential default. However it is true that Treasure notes and bills, US debt, are overvalued but their unique position as a safe-haven causes them to be stable when other bubbles would have popped already. However their could be a retrenchment, foreign investors demanding a higher risk premium in the face of structural deficits and this could push the yield curve up.

If the Fed raised too slowly, then not only would financial inflation inflict our economy but foreign investors would see a drop in the demand for debt - and the corresponding dollars needed to finance such purchases. This would cause a short term fall in the value of the dollar.

At the same time, the Asian economies and particularly China are on the verge of a growth cycle and risk potentially overheating. With their undevalued currencies pegged to the dollar, they would be forced in the face of a dollar fall to intervene in order to purchase more Treasuries to prevent the "double whammy kicker" that Stephen Roach talks about here.

Yet this very move could push them over the edge into over-heating and "melting down" the Chinese economy because it would flood their economy with investment capital at the very same time they're trying to slow down GDP growth. The only resort would be to run the printing presses at maximum speed in Beijing, in order to keep their currency at its present dollar trading evel. This increase in money supply however would be almost certainly fatal to their attempts to keep their economy restrained within sustainable growth.

The fall of the dollar in general would continue to increase commodity price growth, leading to further commodity price driven inflation and the premium needed on the yield curve to attract investment would grow even further pushing interest rates up even higher. All of this because the Fed delayed hiking interest rates. The discussion is further pursued here at the Coalition for a Sound Dollar.


Essentially, no price is considered in any market to be "too high" or "too low". Values are always to be considered relative to risk vs reward, and supply and demand. The problem here lies with the dollar is in both. The risk in US treasuries is still being priced as if we were in the ninties and the government didn't have a structural debt problem. The supply of money is to put it simply too high for the actual structural asset business expansion that is truly occurring, and because of that is being siphoned into speculative activities that must create a crash later on when asset pricing becomes corrected to real fundamental values.

Given the risks involved, the Fed may at this point be damned if it does or damned if it doesn't. The real solution is not to get into this pass in the first place. If the Fed raises interest rates too quickly, it will avert a currency and debt crisis but spark a recession and stock market decline as well as a real estate bubble bursting that will cause a lot of economic pain. If the Fed raises interest rates too slowly, it will precipitate a currency, inflation, and US debt crisis as both commodity prices and foreign investment markets become overheated. On the whole, Fed Chief Alan Greenspan's policies have in the past too strongly leaned toward moral hazard and protectionism of the domestic equity markets.

At this point, there are some solutions but they are particularly complicated and technical. Needless to say the generally oversimplistic Federal Reserve Board will stick to tried and true as usual and precipitate major economic indigestion in the currency markets and the yeild curves of debt. Short selling the dollar on that bet seems to be a fairly sound trading position given the inflexibility of the Federal Reserve Board in past proceedings and their hide-bound ways.

How could have this crisis been averted? Partly by loosening credit standards going into any tightening of monetary policy, or previously having tightened credit standards going into the loosening of the monetary policy. There's no reason why they have to be in lock-step. There are other policy prescriptions that could work as well.

However, the fact is the fundamental value of the American economy relative to others is simply declining. A sign of this is that in a information age the United States is losing its predominant position as the premeire producer of scientific knowledge and patents. There is nothing wrong with this per se, but if we think about innovation and scientific and technological development as the measure of the value of US economic progress then clearly the United States can no longer count upon its currency or debt to recieve a special market dispensation and discount of risk. What that means is that we will no longer be able to borrow a great deal of money at very low interest rates anymore. We will be just like everyone else, and have to pay more to borrow money. In light of this, continued US structural deficits are not a problem that will occur in a time frame of decades but years. The past economic relationships that governed how much borrowing will increase interest rates will rapidly change in the next few years.

The era of special privledges for the US dollar and the low interest rates given on Treasury debt even in the face of huge deficits is coming to a close. As other countries catch up to us, we will see the interest rate yeild curve and currency valuations and the effect of deficit spending move in line with the rates afforded other countries by investors. However the market must first correct the special valuation rates afforded American debt and currency currently. Ironically, Alan Greenspan and company may be inadvertantly moving us straight into that situation.

Here is the NYT article on scientific knowledge production and the declining US advantage - hint it's gone already.

he United States has started to lose its worldwide dominance in critical areas of science and innovation, according to federal and private experts who point to strong evidence like prizes awarded to Americans and the number of papers in major professional journals.

Foreign advances in basic science now often rival or even exceed America's, apparently with little public awareness of the trend or its implications for jobs, industry, national security or the vigor of the nation's intellectual and cultural life.

"The rest of the world is catching up," said John E. Jankowski, a senior analyst at the National Science Foundation, the federal agency that tracks science trends. "Science excellence is no longer the domain of just the U.S."

Even analysts worried by the trend concede that an expansion of the world's brain trust, with new approaches, could invigorate the fight against disease, develop new sources of energy and wrestle with knotty environmental problems. But profits from the breakthroughs are likely to stay overseas, and this country will face competition for things like hiring scientific talent and getting space to showcase its work in top journals.

One area of international competition involves patents. Americans still win large numbers of them, but the percentage is falling as foreigners, especially Asians, have become more active and in some fields have seized the innovation lead. The United States' share of its own industrial patents has fallen steadily over the decades and now stands at 52 percent.

A more concrete decline can be seen in published research. Physical Review, a series of top physics journals, recently tracked a reversal in which American papers, in two decades, fell from the most to a minority. Last year the total was just 29 percent, down from 61 percent in 1983...


As the US fundamental value decreases, the superior market discount for US currency and debt (and therefore low interest rates) is going to have to come to an end!

On a lighter note here is a story that explores which car you should own to have more sex - hint porsche owners lose out.


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