One of the few upsides of the patently silly negative watch announcement for US Treasury bonds was that it elicited colorful and instructive commentary (see our view, along with Mark Thoma’s and Barry Ritholtz’s at the New York Times’ Room for Debate). Some sightings:
Reporters should be given 40 lashes when they tell us that some specific event explains a movement in stock prices. The reality is that the reporter does not know what caused a movement in stock prices, all they can do is speculate….
It is a bit hard to believe that investors sold off U.S. stocks because they became fearful in the wake of the S&P report, but then suddenly wanted to buy dollars and also were willing to hold Treasury bonds at a lower yield. Unless we think that investors in stock are a totally distinct group from the people who trade currencies and invest in bonds, the NYT’s explanation of the plunge in stock prices makes no sense.
A more plausible explanation is that bad earnings reports, most importantly from Bank of America on Friday and from Citigroup on Monday, made investors more pessimistic about the near-term prospect for profits.
It is also worth noting that S&P has a horrible track record for judging credit worthiness. It rated hundreds of billions of dollars of subprime backed securities as investment grade. It also gave Lehman, Bear Stearns, and Enron top ratings right up until their collapse. Furthermore, no one was publicly fired for these extraordinary failures. Investors are aware that S&P’s judgement does not mean very much.
From Dave Lindorff:
At least one economist burst out laughing on hearing about the S&P announcement. “They did what?” exclaimed James Galbraith, a professor of economics at the University of Texas in Austin, who formerly served as executive director of the Congressional Joint Economic Committee. “This is remarkable! It certainly will confirm the suspicions of those who have questioned S&P’s competence after its performance on the mortgage debacle.”
From Marshall Auerback:
In November 1998, the day after the Japanese government announced a large-scale fiscal stimulus to its ailing economy, Moody’s Investors Service began the first of a series of downgradings of the Japanese government’s yen-denominated bonds, by taking the Aaa (triple A) rating away. The next major Moody’s downgrade occurred on September 8, 2000. Then, in December 2001, Moody’s further downgraded the Japan government’s yen-denominated bond rating to Aa3 from Aa2. On May 31, 2002, Moody’s Investors Service cut Japan’s long-term credit rating by a further two grades to A2, or below that given to Botswana, Chile and Hungary. Well, over a decade later and this has had no discernable impact on Japan’s ability to borrow at the rate the Bank of Japan sets, NOT the ratings agencies or the “bond market vigilantes”.
And in case you are still worried that China will quit buying our bonds and interest rates will therefore shoot to the moon, Michael Pettis dispatched that issue last week:
I don’t think a decline in the amount of capital recycled by China, whether through the PBoC or through other institutions, will likely lead to higher US interest rates at all….
The reason I say this is because if we accept this argument, then it seems to me that we are also saying that one way for the US to reduce interest rates is to allow its current account deficit to explode to significantly higher levels. Why? Remember that foreigners don’t fund fiscal deficits. They fund current account deficits, and they do so automatically. As long as the US runs a current account deficit, in other words, it will receive exactly the same amount of net capital inflows as the size of its current account deficit. So if the US current-account deficit doubles, for example, net foreign inflows will double too.
Will that cause US interest rates to decline? Yes, if US borrowing, especially US government borrowing, stays the same. But will it? Probably not. If the US current account surplus rises because of a surge in US investment, then I would argue that the increase in the amount of savings the US imports is matched by an equivalent increase in the need for savings, and so the impact on US rates is likely to be minimal. Of course if soaring US investment (and with it soaring jobs) cause Americans to feel richer and so increase their consumption, interest rates might even rise.
What if the rise in the US current account deficit is caused not by an increase in US investment but rather by a reduction in foreign (e.g. Chinese) consumption, as might have happened in the past decade? In that case the diverting of demand from the US to China should cause a rise in US unemployment and a reduction in US growth. Washington would try to counteract the diverted demand and rising unemployment with an increase in the fiscal deficit, just as it is doing now, or the Fed might try to counteract it by keeping rates low and encouraging a surge in consumer financing, as happened before 2007. Either way US debt levels would surge.
In that case what would happen to US interest rates? If the increase in the fiscal deficit or consumer borrowing was large enough, rates are as likely to rise as to fall. And remember that rising unemployment should reduce the household savings rate, which would counteract to some extent the increased amount of global savings the US is importing through its current account deficit.
I guess this is just a long way of saying that an increase in the US current account deficit can be contractionary for the economy, and if it results in declining interest rates, we should be clear about why. It is not because the US is lucky enough to have eager foreigners lending it money. It is because a rising current account surplus can slow the economy and weak growth is likely to be associated with low interest rates…
And the reverse is true. If China’s current account surplus declines, there are, very broadly, two ways this can affect the US. On the one hand the surplus can simply be transferred to another country. For example if China’s current account surplus declines because it decides to stockpile larger amounts of commodities at higher prices, it will simply shift the need to recycle its current account surplus to a commodity exporter – say Brazil.
In that case the total US current account deficit is unchanged, and by definition the net capital the US imports is also unchanged. Brazil will do what China was doing – buy US government bonds directly or indirectly.
On the other hand a rise in Chinese consumption could cause both the Chinese current account surplus and the US current account deficit to decline. In that case of course China would buy fewer US dollar assets and so fewer US government bonds…
But in that case the reduction in the US current account deficit would be expansionary for the economy in a way similar to an increase in the fiscal deficit. Both are expansionary. So the impact on the current account would probably be offset by a reduction in fiscal spending