TIPPING POINTS: leading to a fall

Economists are calling it a “soft patch,” a temporary slowdown in economic growth. This reflects a regression from earlier euphemisms of a “Goldilocks” economy. I’m sure before long the “soft patch” will turn into a “soft landing.” However, I’ve yet to see a “soft landing” in my 30 years in the investment business. Soft landings are as rare as the dodo bird. It is surprising to see this term resurface every time we are about to head into a recession. Perhaps economists think it has a more palatable sound than recession and depression, which are more frightening terms to investors.

What we can say with a certain degree of confidence is that the Fed will keep raising interest rates until they arrive at a "neutral rate," i.e. an interest rate that is neither stimulative nor contractive for the economy. Reality is something different. The Fed can never truly arrive at a neutral rate. They habitually raise rates until something breaks—usually either in the economy or the markets, but in most cases it's both. The days in which the Fed could fine-tune the economy ended several decades ago with the emergence of the financial economy. Today, even more money is injected into the economy and the investment markets outside the traditional banking sector. Last year the US economy added $2,718 billion in debt. However, the broadest measure of the money supply (M3) expanded by only $587.5 billion. For those who are relieved that money supply growth has slowed down, as shown in the table below, take no comfort. Credit expansion in the US is rampant as reflected in last year's total credit expansion of $2,718 billion.

As the above table illustrates, credit is expanding at double-digit rates as reflected in commercial loans and commercial credit growth over the last 3, 6, and 12 months. Foreign central bank purchases of Treasuries have also helped to expand credit here in the US. While the monetary base grew by only $33 billion, Federal Reserve Credit and Foreign central bank purchases of Treasuries grew by $42 billion and $207 billion respectively. Credit expansion in the US is hyperinflating. Outstanding debt in the US has grown by 38% over the last four years to $36.2 trillion, an increase of over $10 trillion in the last four years. Last year alone consumer borrowing expanded by $1,017.9 billion, up from $839.4 billion the prior year.[1] New mortgage borrowing surged 87% to $884.9 billion as more Americans bought McMansions in the suburbs. The whole US economy is turning into a hedge fund with national savings of only $133 billion against national borrowing of $2,718, a 20-1 leverage factor.

The 'flation Debate Continues

Along with the redundant talk over the current “soft patch” in the economy, we have benign talk of inflation. The investment markets believe that the Fed will keep inflation contained through its successive rate hikes and there is more talk about deflation in the air. Never before have I seen such abuse of language as it pertains to inflation and deflation. Total credit expansion of $2,718 billion is inflationary not deflationary. A $10 trillion increase of total credit to $36.2 trillion is inflationary. Derivative growth of $50 trillion is inflationary. It is why commodity prices are rising around the globe. It is why the US trade deficits are worsening, and it is why McMansion prices keep going up in the suburbs. The National Association of Realtors reported this week that median prices for previously occupied homes rose at double-digit rates in 66 out of 136 metropolitan areas that it surveys. In Florida, California, Nevada, and New Jersey prices have risen 46%, 33%, 29%, and 23% respectively. This is asset inflation not a bull market.

Source: Wall Street Journal, 05/16/2005

The confusion today over what constitutes inflation stems from the fact that most analysts only recognize one form of inflation, which is rising prices in an economy. Rising asset prices—whether in the financial markets, in stocks or bonds, or in the real economy with real estate or lower mortgages—is not viewed as inflation. Analysts prefer the term "bull markets." Short-term interest rates below the inflation rate, P/E multiples over 20 on the S&P 500 and as high as 44 on the Nasdaq, dividend yields of 1-2% on the S&P 500 and the Nasdaq, and long-term interest rates of 4.11 to 4.47% on the 10-year note and 30-year bond are not considered to reflect inflationary tendencies. Inflation has and always will be a monetary phenomenon. Simply put, it is too much money chasing too few goods. In the asset markets, it is too much money chasing too few assets, so the prices of those assets rise. In the real economy, it is too much money chasing too few goods, so the prices of goods rise as we now see in most commodities. A rising and expanding trade deficit is another form of inflation. It is excess demand that is made up by foreign imports. Without those imports, inflation would be a whole lot higher in the US. The burgeoning trade deficit is what has moderated price increases in the US.

Even when it comes to stated inflation rates, as reflected in the CPI and PPI, most experts believe these essentially fictional numbers. Most inflation gauges are highly manipulated by hedonics and by skewing what is measured. One analyst recently exhibited his own ignorance of the CPI by extolling deflation with an example citing the drop in CPI between 2001 and 2003. As I wrote in “Let's Get Fictional,” the drop in the CPI from 2001-2003 was due to the combination of lower rents and lower used car prices. Had the government shown the increase in new car prices and new home prices in the CPI, everyone would have been talking about inflation instead of deflation.

Even with skewing the data, signs of inflation are everywhere from higher food and energy prices, which are routinely excluded, to the rise in import prices or more recently the rise in the PPI. This recent rise has been downplayed by the financial press as a lagging indicator. They expect that as the Fed continues to raise interest rates and as the economy slows down, the growth rate in inflation will subside.

The Yield Curve Is Flattening

There are doubts that the Fed will continue to be vigilant. Much of what happens in the credit markets is beyond the Fed’s control. The Fed needs to put a stop to the credit inflation it engineered by dropping interest rates to half-century lows. But will it? Can it?

Spreads began narrowing considerably over the last year right after the Fed began its latest rate raising cycle. As shown in the yield curve on the right [See Barron's 05/09/05], the curve is flattening and is in danger of inverting, which signals an approaching recession. The spread between the 2-year and 10-year note has narrowed to 50 basis points. It could narrow even further if the Fed raises rates another quarter of a point as is expected at its June meeting.

There are a number of issues, which the United States faces today. Each one looms larger as the year progresses. Whether it will be one or a combination of issues that tip the balance is hard to say. But I believe the following tipping points should be red flags to the investor as we head closer to the cliff, leading to a fall...

1. Leveraged Carry Trade
2. Growing Trade Deficit
3. U. S. Consumer Debt
4. Banking Crisis
5. Reliance on Foreign Investment6. The Rogue Wave

Tipping Point: Leveraged Carry Trade

A narrowing of spreads to less than 25 basis points is indicative of an approaching recession. Moreover, as spreads continue to narrow with each new Fed rate hike, the Fed risks collapsing the “carry trade,” which is dependent on widening credit spreads. Note the risk curve below. As credit spreads have narrowed, hedge funds and other speculators have had to go further out on the risk curve in order to maintain a positive spread. The “carry trade” may have started out with Treasuries, but it has moved further out on the risk scale towards the fat tail.

After Treasuries, the carry trade moved on to investment grade corporates, then it was junk bonds, and then emerging market debt. Now it has moved into structured credit. If spreads disappear or the yield curve inverts, it could unwind the carry trade, forcing hedge funds and other leveraged players to unwind their positions. This would entail dumping junk and emerging markets positions or even worse—unwinding structured credit products, which are highly illiquid.The problem with many of these derivative products is that they are of the OTC variety and are highly illiquid. Liquidity comes into a trade when it is created and becomes popular. Liquidity dries up when it is unwound. In extreme cases, as with LTCM in 1998, the market can simply freeze with no buyers. Most structured credit products such as CDS (credit default swaps) or CDO (collateralized debt obligations) are not exchange-traded products, which have a liquid market. Nobody really knows how all of this will play out when the carry trade unwinds. Many of the hedges in place may not work. The best example of this is the portfolio insurance that failed in 1987 or the recent paired trade in GM. The short in GM stock was supposed to hedge the long in GM bonds and preferreds. Instead both sides of the trade lost money.

The derivative market is a ticking time bomb. According to the Bank for International Settlements (BIS), trading in interest rate, stock index, and currency contracts on organized exchanges fell by 3% to $279 trillion in Q1. It is expected that OTC trading is equal to, if not larger, than this. These are big numbers.

Source: BIS Quarterly Review March 2005

The Genesis of "Risk Contagion"

This derivative market continues to expand and the amount of leverage in the world’s financial system also continues to expand exponentially with breakthroughs in financial engineering. The financial economy has grown to be so much larger than the real economy, which is a reflection of the true rate of inflation. The real economy is where widgets are made, factories are built, oil is found, minerals are mined, plumbing is fixed, children are educated, and the sick are healed.

On top of the real economy lies the financial economy made up of bank and central bank credit, mortgage securitization and derivatives. This is where the real outlet for inflation has taken its course. It is a world of excesses — excesses in credit, excesses in speculation, and excesses in risk-taking. This is where the real danger of risk contagion will have its genesis.

With today’s global financial markets being interconnected, the risk of a brush fire in one market—like corporate bonds—can quickly spread to other markets, such as junk bonds, emerging market debt, or structured credit. The linkages between these markets may lead to systemic risk in world financial markets according to Stephen Roach of Morgan Stanley. Roach believes that most of these markets are priced for minimum risk, a dangerous background for a tightening monetary cycle. Many of today’s leveraged players in this market are making bets on complex strategies involving debt, equities, and currencies. Everyone is trying to squeeze out the last penny or nickel in a trade. The problem for many of these hedge funds is that their hedging assumptions are unproven. They may not work. The GM trade is a recent example. When everybody uses the same strategy, liquidity becomes an issue when that trade needs to be exited. Many hedge funds have used similar strategies as the GM trade with convertible bonds. The difficulty is that they can’t exit their position without driving down the market, which could widen their losses. Exiting a losing position becomes more important when a fund is leveraged. But what happens when you can’t exit the trade, or if by doing so, you destroy your capital? In the end, it proves the danger of leverage, which can amplify gains on the upside as well as magnify losses on the downside. Right now most hedge funds are losing money. The leveraged carry trade is one of the tipping points the Fed faces as it raises short-term rates and contracts borrowing margins.

Tipping Point: Growing Trade Deficit

Another tipping point is the trade deficit. It keeps growing and it's getting larger as each month ticks by. The trade deficit for this year will eclipse the record $617.07 billion posted for all of 2004. The trade deficit for the first quarter of this year came in at $174.06 billion, more than $30 billion than the same quarter as last year. This year the US trade imbalance could climb well above $700 billion.

Regional Pattern of the
US Merchandise Trade Deficit


This growing trade imbalance has occurred against the backdrop of a falling dollar. The dollar has fallen 30 percent since July of 2001. Yet the trade deficit has steadily widened. It is apparent that there is something going on here besides a weaker dollar. The problem for the US is the fact that the majority of its trade deficit is with Asia where currencies are either pegged or controlled.

Last year the US trade deficit with China was $124.9 billion. As this table illustrates, our trade imbalance has shifted from Japan and Europe in the 80’s to China and emerging Asian markets in this century.

Central Bank Intervention

Normally, in a free trading market, the dollar would have depreciated against the currencies of countries that were incurring surpluses against the US. However, there has been massive intervention by Asian central banks that have interfered with market adjustments. The Chinese yuan is pegged to the dollar despite large surpluses and the yen is kept from appreciating by Japanese central bank intervention. This is reflected in the rising balance of foreign-held Treasuries at the Fed, which have grown to $1,399 billion, up $207 billion in the last twelve months. In the absence of these purchases, the dollar would have been lower, the stock market would have fallen, interest rates would be higher, and domestic demand would be weaker. Put simply: market mechanisms are not allowed to work. The consequence has been an asset bubble in the US and even larger trade imbalances.

The US Treasury in its semi-annual report to Congress on exchange rates and trade stopped short of accusing China of currency manipulation and said it expected revaluation within six months. The report is creating a hardening line in Congress and the White House. The Treasury report criticized China’s policy as a danger to itself, its neighbors and the global economy. Senator Charles Schumer, a Democrat from New York, has introduced a bill that would impose a 27.5% tariff on all Chinese goods, if they refuse to revalue. [See China Assails U.S. Textile Quotas]

Loss of Manufacturing Cost Advantage
Chinese revaluation of its currency may help the US trade deficit, but I doubt if it will make a major difference. The problem for the US is that the economy of today is not the economy of the 1980s. Our manufacturing base was much stronger back then. When the dollar devalued in 1985-87, the US was able to export its way out of its imbalances. In the 80’s, US exports grew by 5.4% a year and after 1987 they grew by over 10% a year in the following five years. That is because US competition was mainly with industrialized countries where we had a cost advantage. Today the US must compete against emerging nations where we no longer have a cost advantage.

Loss of Manufacturing Base
In addition to no longer enjoying a manufacturing cost advantage, our manufacturing base is much smaller today with much greater import penetration in all major categories of personal and industrial consumption. Foreign-made goods now make up 38% of all durable goods, 54.5% of autos, 56% of computers and office equipment, 57% of semiconductors and office equipment, 57% of communication equipment, 71% of consumer electronics, 78% of apparel, and 99% of all footwear.

The Bank Credit Analyst, May 2005 The problems, as the above statistics attest, confirm that many of these industries have been lost to imports. Factories have shut down or moved offshore and those that remain have difficulties in competing with low-cost, Chinese-made goods. It is doubtful that a 27.5% tariff will bring these industries back to the US. The only industry in which the US maintains a lead is in technology. Even there our lead is slipping as other nations graduate more scientists and engineers and increase their R&D. Our technology industry is outsourcing like other manufacturing industries, because it is cheaper to build a new factory and hire a software engineer in China than it is in Silicon Valley.

Many experts are hoping that our service-oriented economy can help the US trade imbalance. There is no good news here. The US trade surplus peaked back in 1996. It has gone downhill since then. Last year our surplus in services was $66 billion—down $20 billion from 1996. It is unlikely that trade in services will ever replace the deficit in manufacturing. Imports into this country are 50% higher than exports. Export growth, though improving, is growing at 11% versus import growth of 17%. US exports would have to grow nearly twice as fast as imports in order to balance our trade. With a declining manufacturing base and increasing import penetration, this imbalance will only get worse.

Structural Imbalance
The US trade imbalance is structural not temporal. One structural problem is our deficit in energy. The US must import more than 60% of its energy needs. As US production declines by 5-6% a year and the price of energy rises due to tight supplies and competing demands, energy imbalances will become a permanent part of the US trade imbalance. The US consumes 25% of the world’s oil and has no "Plan B" as the world approaches peak oil. Furthermore, the average price paid for imported oil has been hedged with an average price of $36. As these hedges mature, America’s import energy bill will rise.

The fact that the US trade imbalance is structural means there will be no easy fix—no easy way out. A lower dollar is not going to make it go away. However, a lower US dollar, which is inevitable once foreign intervention wanes, means even further problems for the US. A lower dollar means higher inflation as the cost of imports rises as it did last month. Prices for imported goods rose 0.8% in April. That was down from 2% the previous month.

Year-over-year import prices have risen 8.1%. As the dollar falls and as foreign intervention cools, interest rates here in the US will begin their inexorable rise. This will be bad news for the stock and bond markets, the US economy, and the next tipping point: the US consumer.

Tipping Point: US Consumer Debt

In economic terms, the American consumer has acted as buyer of last resort. Last year American consumers borrowed $1,017.9 billion, up from $839.4 billion the previous year. Since the year 2000, consumer indebtedness increased by $3,246.2 billion compared to an increase of consumer income of $1,440 billion. Most of this increase has come from mortgage debt. Last year new borrowings on mortgages were $884.9 billion, representing 87% of total debt borrowings.[2] Outstanding consumer debt more than doubled to over $10 trillion between 1992 and 2004. While consumer balance sheets continue to be laden with debt, there are very few signs of savings. Last year savings in the US was only $133 billion, roughly a third of what it was in 1995 when savings was $306 billion. In 1995 the US added $4 of debt for every $1 in savings. Last year that figure expanded to over $20 of debt for every $1 of savings. In effect, the American economy has turned into one giant hedge fund.

The New ATM: Home Equity Loans
With over $36.2 trillion in outstanding debt, a rise in interest rates can impact the economy in many ways. For the consumer it means higher rates on credit cards, installment loans, increases in variable rate mortgages and home equity loans. The middle class and the poor in this country are turning into indentured servants piling on debt as never before. There is a growing gap in this country between the rich and the poor. Thanks to taxes and inflation, most Americans—out of necessity—need to borrow to make ends meet. Paying the monthly bills with credit cards has now become routine. When those credit card bills add up, if they own a home, equity is extracted to pay down the balances. In most cases, the cycle is repeated.

Debt is now looked upon by most households as an additional form of disposable income. Home equity extraction is what has kept up consumption in this country at above-normal levels. According to Federal Reserve data, US households owed $881 billion in home equity loans at the end of 2004, up from $492 billion in 2000. This represents an increase of 80%. Last year home equity extraction increased by 29%. It is becoming clear that the housing bubble and the equity extraction it reinforces is what is keeping retail sales pumped.

The problem for most Americans is that taxes and inflation are taking their toll on most households. Income gains aren’t keeping up with inflation, which is grossly understated as a result of hedonics. This has lead to more households turning to debt to pay for a lifestyle their incomes can’t support. The median family income has risen only 11% after adjusting for inflation since 1990. At the same time, median household spending has jumped 30% and outstanding household debt has jumped 80%.[3]

Extending Leases
From mortgage loans and home equity loans to installment debt and credit card debt, Americans are up to their eyeballs in debt. Up to now the homeowner has dodged the debt bullet with the decline in interest rates and the bubble-like appreciation of housing. However, cracks in the debt bubble are starting to surface. Most consumers who own cars are upside down in their leases. The auto industry calls it "negative equity," owing more than the car is worth. Half of the car buyers under the age of 40 are upside down in their leases and that figure rises to 56% for Generation Y buyers. Many buyers are stretching out their car payments over 8 years from the typical 3-5 year period in order to reduce their payments.

The problems don’t end with car loans. They get worse when it comes to housing. Most new home sales have been financed with interest-only loans, adjustable rate mortgages, and negative amortization loans. Very few buyers are interested in building or putting equity into their home purchases. The trend is to buy as big a home as debt and income will allow. Last year two-thirds of all mortgage originations were adjustable-rate or interest-only loans. In California home prices are sizzling. As a result only 18% of California households qualify to buy the average price home. Those who can afford to buy are taking out adjustable or interest-only loans in order to qualify. Interest-only loans made up over 60% of all new mortgages here in California during the first quarter, up from 47% in 2004. This trend in creative financing is allowing buyers to trade up and buy much more home than they can reasonably afford. Moreover, at a time when the Fed is engaged in ratcheting up interest rates, the homeowner is buying long and borrowing short—a lethal combination, if rates continue to rise.


What has forestalled the debt collapse is rising housing, which makes the debt burdens seem less ominous. Last year home prices rose 10% nationally with many hot locations of the country rising 30-46%. Not only are Americans buying bigger and more expensive homes, they are also on a trend of buying second and third homes. Last year 23% of all homes purchased were for investment and a further 13% were vacation homes. Concerns are now mounting at the Fed—the originator of the bubble. Mr. Bubbles himself, Alan Greenspan, has made more references to real estate showing bubble-like qualities. He hasn’t uttered the “I” (irrational) word yet, but his speech comes close to admitting that certain areas of the market are exhibiting bubble-like qualities. Mr. Greenspan isn’t worried because, according to the Fed, household equity has grown to $9.62 trillion, up 13% in the last year. It should be pointed out that Fed officials weren’t worried over the stock market in 2000 either. The subsequent years after the crash erased nearly half of the market's value.
Fed officials are hoping that this event won’t be repeated in the housing market. Yet each new rate hike brings us closer to the edge of the cliff. There may be a lot of equity in homes, but this equity is distorted by those who have paid cash or have paid off their mortgages. Thanks to creative financing and the reduction in lending standards, there have been a lot more marginal buyers who have come into this housing market—first time buyers who have no or very little equity, buyers who can barely qualify, and buyers who are adding more debt through negative amortization or through equity extraction. The marginal buyer, the reduction of lending standards, and our need to finance the deficits with foreign money are bringing us ever closer to the next tipping point—a banking crisis.

Tipping Point: Banking Crisis Ahead

Lower Lending Standards
US banking regulators issued a warning to lenders on Monday to tighten up their lending standards. Bankers may be repeating the same mistakes of the last housing bubble of the late 80’s. Lending standards have fallen dramatically. Unlike the last housing bubble of the late 80’s, very little equity is there to cushion the lender. The proliferation of negative amortization and interest-only loans leave lenders with no cushion. The influx of marginal buyers is also putting lenders at risk. Even in the case where homes have appreciated, homeowners are monetizing that appreciation through home equity loans. Bankers are lending up to 100% of the value of a home. In many areas banks and finance companies have lent up to 125% of a home's value.

Banking regulators are worried over several industry trends that could lead to a crisis. The plethora of interest-only payment packages, no documentation loans, and higher loan-to-value and debt-to-income ratios are making regulators fretful. With homeowners owing $881 billion in home equity loans—and with no interest rate cap—regulators are concerned rising interest rates make these loans open ended.

It's Not Just The Banks Anymore
Real estate loans cut across a wide swath of financial institutions. Close to 55% of home equity loans are held by commercial banks, 14% by thrifts, and 7% by credit unions. The balance is held by finance companies that have in many instances made equity loans in excess of a home's value. Despite the rise in interest rates, the bubble in mortgages and real estate, lending continues to expand. According to the Mortgage Bankers Association (MBA), mortgage originations are expected to total $2.5 trillion this year.

Unlike the last real estate cycle, this time around buyers aren’t interested in building equity. The trend is to buy as expensive a home as the lender will allow. Many experts believe that this trend in ARMs and non-traditional loans reflects the end of a housing cycle. These non-traditional loans leave the homeowner and the lender in a high risk situation. If we are approaching the end of the cycle, then falling prices could come next. If that happens, homeowners with negative ARMs or interest-only loans will wind up owing more than the value of their loan. Even if home prices don’t fall off a cliff or just remain stagnant, many borrowers could be squeezed by rising interest rates.

Regulators are worried enough to issue new guidlines to banks to tighten lending standards by requiring them to do more in depth analysis of the borrower's income, debt levels, and their ability to meet mortgage payments. Up until now lenders have relied more on FICO scores to determine loan qualification. With nodoc loans the banks may have no idea what a borrower’s true repayment capabilities really are. For lenders, the real risk is that there is very little equity to cushion the lender in the case of foreclosure. Another risk is that so many of today’s mortgages are either interest-only or they are ARMs—or worse: negative ARMs. The MBA has pointed to another risk for borrowers and lenders, which is the fact that over half of today’s ARMs are traditional ARMs with the initial interest rate fixed for less than three years. The borrower gets a lower initial interest rate for taking on the added risk of rising interest rates. As home prices have soared, buyers have had to resort to higher risk loans in order to qualify. Up until recently, most ARMs were hybrid ARMs, which fixed the rate of interest for 3-5 years. The initial interest rate was much higher than the open-ended ARM, which is being used more frequently today in order to get buyers to qualify. What makes this market so risky, according to some analysts, is that buyers are leveraging up, adding multiple layers of leverage—interest-only loans, negative amortization, and nodoc loans to home equity loans—pile one layer of leverage on to another. Even if a buyer puts down the minimum down payment to buy a home, they can quickly turn around and extract that equity out through a home equity loan so that they have zero equity in a property.

Zero percent equity in a home leaves lenders extremely vulnerable. It is the zero equity borrower who is most likely to walk away from an obligation when their income is no longer able to handle rising mortgage payments. Creative finance has brought a lot of marginal buyers into the housing market during this housing cycle. Unlike the last cycle where 20% down fixed rate mortgages were the norm, this time no money down, variable rate mortgages or interest-rate-only loans have become the norm. The whole mortgage-finance structure is based on the premise that housing prices will always go up. For lenders making home equity loans up to 100% of the value of the home, it is assumed that rising housing prices will eventually create an equity cushion. This makes the banking and finance sector extremely vulnerable to a downturn in the economy as a result of rising interest rates. If we aren’t at the edge of the cliff, we are certainly close. As the Fed continues to raise interest rates, they bring the whole mortgage-finance industry and the leveraged homeowner closer to the brink of a crisis. It is one more tipping point.

Tipping Point: Reliance on Foreign Investment

America’s reliance on foreign savings to finance its twin deficits is another tipping point. Total foreign holdings of T-bills, notes and bonds have risen to $1.977 trillion representing more than 44% of our outstanding public debt. Each month this country needs to finance close to $60 billion just to pay for its consumption of foreign goods. Up until recently foreigners, especially Asian central banks, have been willing lenders. But trade friction is at the top of Washington’s agenda. Pressure is being brought to bear on China to immediately revalue its currency or risk tariffs imposed on its exports to the US. Yet China and Japan are two of America’s largest creditors. Lately their appetite for US debt has been waning. Both Japan and China bought less than $5 billion in Treasury securities between January and February. In March both countries were net sellers. In fact foreign central banks sold a net $15 billion in March compared with net purchases of $11.3 billion in February. Norway was the biggest seller dumping $17 billion of US Treasuries. This is the first time since August of 2003 that central banks have been net sellers.

Private foreign investors have stepped up their buying to fill the void. Otherwise interest rates would be rising by now. The big buying has come from Caribbean banking centers—the home of hot money and hedge funds. Caribbean banks increased their holdings of Treasuries in March from $104.7 billion to $137.2 billion. During the first quarter of this year there has been a definite slowing trend in foreign purchases of US securities. Another apparent trend is that whenever private sector investors show up on the "buy" radar, central banks have used the opportunity to offload more of their Treasury holdings. The combined net buying of US securities dropped to $45.7 billion in March, down by nearly half from the previous two months. Buying was down across all categories from Treasuries to stocks. Stock purchases fell in March from $7.5 billion in February to $1.7 billion in March. It is no coincidence that the stock markets fell in March and in April.

American politicians may think twice about angering our largest creditors. With one of the lowest saving rate among industrial economies, the US is totally dependent on foreign savings to finance our economy from consumption to investments. Chinese and Japanese buying is what keeps interest rates low in this country. They also act as a moderating influence over inflation rates by financing our deficits. Without that money, the Fed would have to print a lot more money. A revaluation of the Chinese currency would surely cause interest rates to rise in this country along with inflation rates. It is estimated by some analysts that if Asian central bank buying of Treasuries was cut in half, interest rates on home mortgages would rise by as much as two percentage points. If that was to happen, the impact on housing would be severe. Imagine what the impact would be on the banking industry.

Tipping Point: The Rogue Wave

The US is playing a dangerous game with our creditors. As one commentator recently opined, “Be careful of what you wish for. You may just get it and not like what it brings.” What could trigger a sell off or a strike in buying by foreigners? Economic weakness is one. Many foreign institutions keep buying US securities, believing in the strength in the US economy. With leading economic indicators falling for four consecutive months that strength appears to be subsiding. Another possible tipping point could be a financial crisis with a large financial institution or hedge fund leading to a crisis in the securities markets. With the economy and our financial markets so highly leveraged, there are ample opportunities for mishaps. There are plenty of rogue waves lurking in the financial system. We just don’t know when and how big they will be when they surface. The housing sector and mortgage-finance markets seem to be the most vulnerable. It is the area where hot money has gravitated. Even foreign central banks have increased their risk exposure in this area. According to Grant’s Interest Rate Observer foreign central bank purchases of Fannies, Freddies, and Ginnies rose at an annual rate of 59.6% during the first quarter. Grant's quoted State Street Bank, a manager of $57 billion of central bank money. According to State Street, “The great majority of our clients are looking to push their investment boundary further out along the risk spectrum.”[4] Let's hope that foreign institutions keep buying. They are all that stands between higher interest rates in the US, a collapse in our financial markets, bankruptcy, and a recession or depression.

Summary

As the Fed rate hikes continue, risk to the financial system increases because all markets are interlinked. Systemic risks to the financial system have increased and may converge. A misplaced bet in structured credit could backfire—causing interest rates to rise. Narrowing credit spreads could cause the carry trade to unwind—forcing leveraged players to dump their bond holdings—leading to a jump in interest rates. A trade war could create friction in the credit markets—forcing central banks to dump their Treasury holdings or go on strike with new buying. A rise in interest rates could make mortgage payments untenable for overburdened households—triggering bankruptcy. Increased bankruptcies would bring more homes on the market—increasing supply and causing home prices to fall. Falling home prices would increase homeowners and lenders risk as equity evaporates. Each tipping point could lead to the next as they are all connected in a daisy chain.

What is clear is that this rate cycle is different. The Fed has very little room to maneuver nor can it afford to make a mistake. The economy is more leverage today than back in 1999. Outstanding debt has grown by $10 trillion since the last time the Fed raised interest rates. The leverage in the financial system has grown exponentially with derivatives and the carry trade. The homeowner has gone deeper into debt, the government is running large budget deficits, and the trade deficit is the worst it has been in this country’s history with no sign of improving. We have no margin of safety. Things will have to workout perfectly in order to avoid a crisis. Will we be that lucky?

Jim Puplava

References
Special thanks for chart courtesy: Barron's, BCA Research, BIS, Bloomberg, Grant's, Wall Street Journal

[1] Richebächer Letter, May 2005, p.6.
[2] Ibid, p.6.
[3] Lagging Behind the Wealthy, Many Use Debt to Catch Up, WSJ, May 17, 2005.
[4] Grants Interest Rate Observer, May 6, volume 23, no 9, p. 6-7.

© 2005 James J. Puplava

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