FYI | Feb 10 2009
By Greg Peel
Who will buy this wonderful morning?
Such a sky you never did see!
Who will tie it up with a ribbon
And put it in a box for me?
– Oliver Twist, in a musical mood.
The US government has a problem. Indeed, the US government has many problems but lurking behind most of them is the need to spend trillions of dollars to rescue the sliding economy. Trillions of dollars that do not exist.
Prior to the credit crisis, the US was running the biggest current account deficit in world history. The bulk of this deficit was balanced on the other side of the ledger by surpluses in Japan and Germany, but ever more so, as the twenty-first century played out, by a growing surplus in China. China and the US enjoyed a symbiotic relationship by virtue of a renminbi pegged to the US dollar which thus rendered the renminbi grossly undervalued. As China became export manufacturer to the world, the flood of foreign currency receipts that followed should have pushed the value of the renminbi ever higher. But the peg ensured, instead, that prices of Chinese goods fell ever lower. This was no more so true than in the US.
The US sucked up Chinese exports on borrowed money. The Chinese then recycled their currency receipts by buying US bonds. By buying US bonds China was effectively “lending” money to the US taxpayer, who was then free to buy more Chinese goods. There were plenty of observers pointing out long before any “subprime crisis” that this neat little dichotomy was destined for disaster the day the music stopped.
And now it has stopped. The most indebted nation on earth had already announced rescue measures to the value of some US$4 trillion before even this latest stimulus package from the new administration was announced. Such numbers could never even be contemplated a decade ago. In 1998, hedge fund Long Term Capital Management went down owing US$6bn – a number considered so large at the time economists feared the world might end. How does US$6bn stack up today? I think I saw Tim Geithner drop a US$6bn coin on the way up Capitol Hill and not even bother to pick it up.
When the US government began “rescuing” the financial system in March last year, beginning with an orchestrated bail-out of Bear Stearns, the Chinese economy was still raging on and was expected to keep doing so. Even Europe was not expected to suffer much from what was then mostly seen as an isolated US crisis, and Japan was showing signs of improvement after decades in the doldrums as well. There were thus, in theory, plenty of potential lenders to the US in the form of buyers of US bonds.
There were questions asked about whether China, in particular, might diversify away from US dollars having seen its investments being shot to pieces. China was supposedly angry. But we all knew that China really didn’t have much choice, and nor did anyone else. The US economy was still by far the biggest on earth and the US dollar was still the reserve currency as a result.
Legend has it that failed 1980s entrepreneur Alan Bond once went to Westpac and asked for a hundred thousand dollars, which the bank cautiously handed over. It was a lot of money in the day. Having missed every payment, Bond then went back to Westpac and asked for another hundred thousand dollars. The bank asked: “Why would we lend you another hundred thousand if you have made no attempt to pay any of the first hundred thousand back?” to which Bond replied: “Because if you don’t lend me another hundred thousand you’ll never see the first hundred thousand again”.
Westpac lent him the money.
Whenever there were warning cries that China, and maybe even Japan and Germany, would stop buying US bonds if the government was going to keep printing money they were quickly scuppered by assertions that none of them had any real choice. Where else do you put your money? And were the US economy to fail, wouldn’t we all fail as a result?
This particular argument has now, however, become somewhat redundant. If the US government has any fear that no one will want to buy its bonds it matters little whether it’s a case of acrimonious refusal or not. It is now a case of: “Buy them with what?”
The London Daily Telegraph’s Ambrose Evans-Pritchard notes that China’s export industry has now collapsed. China had amassed some US$7.6 trillion of foreign reserves and had been recycling into US bonds at the rate of about US$1 trillion a year. Now the country has become a net seller of bonds instead, having dumped US$190bn worth over the last three months.
Japanese exports fell 35% in December and industrial production fell 9.6%. The Japanese economy is now contracting at a rate of 12%.
German factory orders fell 25% year-on-year in December.
Japan, Germany and China were the manufacturing exporters to the world. The US was the greatest importer. The US could afford to import because export receipts would come back in the form of US bond investment. Had there been no Global Financial Crisis but the US had just decided to stop indiscriminate importing anyway, the US current account deficit would have begun to narrow. Indeed, as the credit crisis began to play out, US spending dropped and the deficit did begin to narrow. With global export-import now ground to a halt the US current account deficit can narrow alright but the fiscal deficit has disappeared into blue sky. The US is printing trillions of dollars in paper money which it assumes will be “backed” by domestic and foreign buying of US bonds.
If not, then the US will be facing, as Evans-Pritchard puts it, an “Argentine fate”.
The “Argentine fate” is one of hyperinflation. At present, the US has clearly entered a period of deflation. Core prices (even without that of oil) fell 2% in the US in the fourth quarter. Several iconic US companies have announced pay cuts. The biggest problem with deflation is that while prices and wages fall, nominal debt does not. It thus takes more goods sold and more paid hours to service the same amount of debt. Look at it from the other side of the equation, holding prices and wages fixed, to see that “real” debt increases under deflation. That means printing more money just to keep up. A downward spiral thus ensues to the point where the rampant printing of money surpasses all else and the value of that money collapses.
Inflation is the bond investor’s greatest enemy.
The US ten-year bond is, as Evans-Pritchard suggests – the world’s benchmark cost of capital. If you buy a government bond you are expecting a stream of coupon payments for the life of that bond. However the value of those coupon payments will erode over time in periods of inflation. Each coupon will be worth less in that year’s dollar terms. The higher the level of prevailing inflation, the less those coupons are worth in today’s dollars. Hence the less that bond is worth to the investor. The bond price falls.
In order to counter inflation the investor requires a higher yield to maturity for that bond, which will be a function of the price paid for the bond and the discounted coupon stream. If a bond is offering insufficient yield to counter the value erosion caused by inflation, it is not a valued investment. Dividend-paying stocks become more attractive as an investment, or even gold becomes a safer alternative as it will at least preserve wealth if not pay any yield. Bonds are sold when inflation is too high.
The global credit crunch became a global financial crisis in September last when Lehman Bros went down. This sparked a panicked “flight to quality”. The two favoured candidates for any flight to quality are always gold and the reserve currency. Gold has fluctuated but generally it has risen in price, while a rush into US Treasury securities has pushed yields down across the curve (demand for bonds pushes prices up and thus required yields down). The one month T-bill traded as low as zero yield. The ten-year T-bond yield dropped below 3%. This is comforting for the US Treasury, and the US Federal Reserve, for it means that plenty of people are happy to “lend” the US money. They are happy to do so despite the Fed having dropped the cash rate (which influences all rates) to zero in an attempt to drop the cost of borrowing and stop the US economy sliding.
The yield on the US one-month T-bill has slowly begun to tick up again, and is now trading around 0.25%. This is considered a good sign for the stock market because it implies panicked investors who transferred their money into the sanctuary of the Treasury security cave, rather than lose more of it in the scary outside world of stocks and commodities, have begun to poke their heads out of the cave entrance once more. Some have decided the worst may be over and now is a good time to start buying other assets again. The yield on the US ten-year T-bond has also risen from around 2% to around 3% since Christmas. With the net dividend yield on the S&P 500 now something like 6% there are clearly those investors who feel it’s time to sell out of bonds and get back into stocks.
But it is also a likely response to a belief that the US printing press will ultimately lead to deflation turning back into inflation, and high levels of inflation at that. Every extra greenback printed undermines the value of the US dollar, meaning interest paid on the money lent to the US government, and the principal itself, are worth less and less. Imagine playing a game of Monopoly with your family but in this case Dad has unlimited access to the bank, which is itself unlimited. The rent you collect from Dad for your hotels on Mayfair becomes a meaningless token, for you know you can never win the game while Dad’s money supply has no bounds. Why play?
Fearing a failure of investors globally to support the US dollar via bond purchases, the Fed suggested before Christmas that apart from supporting the corporate bond market, and the mortgage security market, it would also itself buy US Treasury bonds. While such a transaction seems dangerously circular, there is a hackneyed phrase on Wall Street which is “Don’t fight the Fed”. When this hint was initially dropped in a monetary policy statement, buyers rushed into US T-bonds to stay ahead of the Fed. Ten-year yields remained under 3%. But while the hint is still active and the threat still looms, the Fed has not yet actually stepped into the market. Bond investors have begun to lose faith, and yields have drifted higher.
Yet we all know that were we to allow the US economy to fail our life as we know it will change dramatically. The question is: If we save the US economy again this time, at what point down the track will it be beyond saving? And besides, this is a global financial crisis. Who has the money?
What’s more, just as a fear of recession will lead to recession because worried consumers will stop spending money, a fear of US dollar hyperinflation should lead to hyperinflation if worried investors stop lending money to the US government.
As an aside, Evans-Pritchard once again raises the issue as to whether the European Union and the European Monetary Unit (the euro) can survive the GFC. It was noteworthy that while just about every country in the world has continued madly cutting interest rates, the European Central Bank elected to stay put last week at 2%. One might consider this a positive sign – one which suggests there is no further need at present to provide the European economy with further monetary stimulus. But such assumptions hide a certain reality, Evans-Pritchard notes.
The Fed, or any other central bank, is able to reduce interest rates by injecting funds into the system. That money is funded by issuing bonds. The EU has no bond. The EU is a disparate collection of economies which each continue to issue their own bonds. There are economically stronger members, like Germany and France, and economically weaker members, like Spain and Greece. To continue to drop the ECB cash rate further is to imply that a eurozone bond issue will eventually be needed. If that happened it would effectively mean, for example, that the frugal taxpayers of Germany would be funding the profligate consumers in Spain. One finds it hard to imagine such a move going down well. Is the ECB out of ammunition?
