The title of this article (provided by the page editors of the Telegraph) is a tad more sensationalistic than it need to be, but the basic observation holds: the Fed has gone so far in debasing the dollar that it is starting to see serious pushback from foreign investors.
This is a serious matter. The US runs a massive current account deficit which has until recently been uncomplainingly funded by nice foreigners who for the most part have bought Treasuries. But as Brad Setser has noted, starting with Treasury International Capital reports last year (August in particular was a shocker) private demand overseas for our securities has pretty much evaporated, making our continued high consumption levels dependent on the cooperation of central banks in China, Japan, and the Gulf states.
Worse, those countries (save Japan, which is still studying the issue) are increasingly deploying their foreign exchange reserves via sovereign wealth funds. Their return targets are higher, which means the cost of capital will go up as they take a greater and greater share of surplus recycling.
But no SWF is keen on the US right now, particularly with so many high profile Wall Street deals turning rapidly into turkeys (and that’s before you allow for the FX losses, Eeek). Requests from the financial community for more dough are being rebuffed.
And remember, the people in charge have much more reputational risk than institutional investors, who are under pressure to beat benchmarks. These players, by contrast, are loss averse. The US going into recession and the dollar falling each would be reason to avoid accumulating US assets right now; the two in combination makes the decision a no-brainer. And these investors are pretty certain to be conservative, meaning for the most part they won’t look at opportunities till a bottom has clearly been reached.
The author of the piece, Ambrose Evans-Pritchard, goes further and argues that a deflationary scenario is likely and that commodity prices (ex agriculture) will go into retreat in the not-too-distant future. This is plausible. First, the Fed’s actions so far have been ineffective, and worse, they have produced unintended, counterproductive outcomes.
Bernanke has assumed that the US can create as much liquidity as it needs to in order to prevent deflation. But he’s presupposed that America can act in isolation. Our huge current account deficit means there are limits to how far we can go with the printing press operation, and we seem to be breeching them now.
In addition, Bernanke has commented approvingly on the Fed’s success in reflating in 1933 and 1934. Huh? That was AFTER the banking system had imploded and deposit insurance (the FDIC) was implemented in 1933. That example does not establish that Fed action earlier in the post-1929 crisis would have produced different outcomes (the real question is would monetary easing have prevented bank failures that led to the collapse of money supply). Similarly, many economists argue that had the Japanese cut interest rates faster, they could have prevented their deflation. But even if true (and I’ve heard others who were there at the time argue that the utter incompetence of the Japanese banks and the inability of the authorities to shut them down was at least as big a culprit), Japan had a very high savings rate, which meant it could deal with its crisis internally. We don’t have that luxury.
Moreover, monetary easing will be ineffective if cash hoarding becomes common. Banks are hoarding liquidity; that’s what the Fed has been trying to combat, with only intermittent and short-lived success. And worse, I am hearing tales of individuals starting to hold large cash reserves. It may just be that I have an unrepresentative sample, but let’s hope this does not become a trend.
Finally, no ad hominem attacks on the Telegraph and Evans-Pritchard (and in general). They come predictably when I post his articles. They are tedious and do not advance the discussion. If you don’t agree with his argument or his data, I’m all ears.
From the Telegraph:
As feared, foreign bond holders have begun to exercise a collective vote of no confidence in the devaluation policies of the US government. The Federal Reserve faces a potential veto of its rescue measures.
Asian, Mid East and European investors stood aside at last week’s auction of 10-year US Treasury notes. “It was a disaster,” said Ray Attrill from 4castweb. “We may be close to the point where the uglier consequences of benign neglect towards the currency are revealed.”
The share of foreign buyers (“indirect bidders”) plummeted to 5.8pc, from an average 25pc over the last eight weeks. On the Richter Scale of unfolding dramas, this matches the death of Bear Stearns.
Rightly or wrongly, a view has taken hold that Washington is cynically debasing the coinage, hoping to export its day of reckoning through beggar-thy-neighbour policies.
It is not my view. I believe the forces of debt deflation now engulfing America – and soon half the world – are so powerful that nobody will be worrying about inflation a year hence.
Yes, the Fed caused this mess by setting the price of credit too low for too long, feeding the cancer of debt dependency. But we are in the eye of the storm now. This is not a time for priggery.
The Fed’s emergency actions are imperative. Last week’s collapse of confidence in the creditworthiness of Fannie Mae and Freddie Mac was life-threatening. These agencies underpin 60pc of the $11,000bn market for US home loans.
With the “financial accelerator” kicking into top gear – downwards – we may need everything that Ben Bernanke can offer.
“The situation is getting worse, and the risks are that it could get very bad,” said Martin Feldstein, head of the National Bureau of Economic Research. “There’s no doubt that this year and next year are going to be very difficult.”
Even monetary policy à l’outrance may not be enough to halt the spiral. Former US Treasury secretary Lawrence Summers says the Fed’s shower of liquidity cannot cure a bankruptcy crisis caused by a tidal wave of property defaults.
“It is like fighting a virus with antibiotics,” he said.
We can no longer exclude a partial nationalisation of the American banking system, modelled on the Nordic rescue in the early 1990s.
But even if you think the Fed has no choice other than to take dramatic action, the critics are also right in warning that this comes at a serious cost and it may backfire.
The imminent risk is that global flight from US Treasury and agency debt drives up long-term rates, the key funding instrument for mortgages and corporations. The effect could outweigh Fed easing.
Overall credit conditions could tighten into a slump (like 1930). It’s the stuff of bad dreams.
Is this the moment when America finally discovers the meaning of the Faustian pact it signed so blithely with Asian creditors?
As the Wall Street Journal wrote this weekend, the entire country is facing a “margin call”. The US has come to depend on $800bn inflows of cheap foreign capital each year to cover shopping bills. They may have to pay a much stiffer rent.
As of June 2007, foreigners owned $6,007bn of long-term US debt. (Equal to 66pc of the entire US federal debt). The biggest holdings by country are, in billions: Japan (901), China (870), UK (475), Luxembourg (424), Cayman Islands (422), Belgium (369), Ireland (176), Germany (155), Switzerland (140), Bermuda (133), Netherlands (123), Korea (118), Russia (109), Taiwan (107), Canada (106), Brazil (103). Who is jumping ship?
The Chinese have quickened the pace of yuan appreciation to choke off 8.7pc inflation, slowing US bond purchases. Petrodollar funds, working through UK off-shore accounts, are clearly dumping dollars amid rumours that Gulf states – overheating wildly – are about to break their dollar pegs. But mostly likely, the twin crash in the dollar and US agency debt reflects a broad exodus by global wealth managers, afraid that America is spinning out of control. Sauve qui peut.
The bond debacle last week tallies with the crash in the dollar index to an all-time low of 71.58, down 14.6pc in a year. The greenback is nearing parity with the Swiss franc – shocking for those who remember when it was 4.375 francs in 1970. Against the euro it has hit $1.57, from $0.82 in 2000. Against the yen it has smashed through Y100. Spare a thought for Toyota. It loses $350m in revenues for every one yen move. That is an $8.75bn hit since June. Tokyo’s Nikkei index is crumbling. Less understood, it is also causing a self-reinforcing spiral of credit shrinkage throughout the global system.
Japanese investors and foreign funds are having to close their yen “carry trade” positions. A chunk of the $1,400bn trade built up over six years has been viciously unwound in weeks. The harder the dollar falls, the further this must go.
It is unsettling to watch the world’s reserve currency disintegrate. Commodities from gold to oil and wheat are taking on the role of safe-haven “currencies”. The monetary order is becoming unhinged.
I doubt the dollar can fall much further. What is it to fall against? The spreading credit contagion will cause large parts of the globe to downgrade in hot pursuit – starting with Europe.
Few noticed last week that the Italian treasury auction was also a flop. The bids collapsed. For the first time since the launch of EMU, Italy failed to sell a full batch of state bonds.
The euro blasted higher anyway, driven by hot money flows. The funds are beguiled by Germany’s “Exportwunder”, for now. It cannot last. The demented level of $1.57 will not be tolerated by French, Italian and Spanish politicians. The Latin property bubbles are deflating fast.
The race to the bottom must soon begin. Half the world will be slashing rates this year to stave off credit contraction. The dollar will have a lot of company. Small comfort.
John Hussman, who is no where as negative about outlook as Evans-Prichard (he thinks we will have a “typical,” meaning 30% fall in average stock prices) also has doubts about the intermediate-term prospect for commodities:
Finally, on the commodities front, the CRB (a broad index of commodities prices) has hit fresh highs in recent days, but Friday’s weak employment report has spurred questions about the sustainability of the runup in commodities. If you look at long-term commodity charts, you’ll quickly become convinced of one thing – commodity prices are cyclical. They don’t necessarily overlap economic cycles, but it is dangerous to believe that the cyclical dynamics of commodities prices have been forever changed by China and India. The price levels may very well be higher in the future than they were in the past, but cyclicality is something that should be expected in both commodities and the stock prices of companies that produce them.
It is accurate intuition that commodities are generally stronger in economic expansions than they are in contractions, but that intuition can fail when U.S. real interest rates are negative. At those times, the heavy downward pressure on the U.S. dollar tends to be supportive for commodities. Given that commodities have already had an extremely strong run, it would be overly speculative to take positions here on the expectation that the run will continue, but the evidence suggests that we should expect a serious break only when the rate of inflation breaks.
As a simple way to capture the pattern, we can define the economy as “strong” or “weak” depending on whether the ISM Purchasing Managers Index is above or below 50. We can capture real interest rate pressures by noting whether the latest year-over-year CPI inflation rate is above or below the 10-year Treasury yield. This is not a true “real” interest rate measure, but it generally captures periods where recent inflation is high or accelerating and bond yields are not particularly supportive of the U.S. dollar. Using the recent CPI inflation rate (overall, not core) also introduces a “trend following” component, since rising food and energy prices will push up that year-over-year rate as well.
Most of the past half-century has been associated with an ISM above 50 and a CPI inflation rate below the 10-year Treasury yield. During these periods, the CRB index has increased at a modest average rate of about 4.3% annually. When the ISM has been below 50, with CPI inflation below 10-year Treasury yields, the CRB has declined at an average rate of -5.4% annually. So there is certainly evidence to suggest that commodity prices are vulnerable during periods of economic weakness.
When CPI inflation is running higher than 10-year Treasury yields, the pattern is different. This doesn’t happen often, but the return differences are large enough to be statistically significant despite the small sample size. During these periods of downward real interest rate pressure, the CRB has advanced at an average rate of 10.0% annually when the ISM has been above 50, and 39.6% annually when the ISM has been below 50. This result has been largely due to downward pressure on the value of the U.S. dollar.
In short, my impression is that the commodities run, though increasingly extended and dangerous, may have a final push due to further weakness in the U.S. dollar. Most likely, as we approach the second half of 2008, rising credit problems will reduce monetary velocity enough to finally put a lid on the rate of inflation. At the point where the year-over-year CPI rate drops below 10-year Treasury yields, most of the damage to the U.S. dollar will likely have been done (even if the economy weakens further), and that’s probably when commodities will become poor speculations.