Greenspan versus the bond market
June 10, 2005
Last month Standard and Poor’s downgraded General
Motors’ and General Motors Acceptance Corporation’s
debt to junk status. Later in the month Fitch Ratings followed suit.
GM is the largest corporate debt issuer in the United States, with
about $300 billion in outstanding debt -- all of it junk.
If you thought GM is in the business of selling cars,
you might find it interesting that GMAC, which is the financing
arm of GM, accounted for 80% of the group’s total profit last
year. As the recent downgrading of GM’s debt has significantly
increased the cost of capital for the group I wonder where their
profits are going to come from now.
To cope with rising costs and declining sales, General
Motors announced that it plans to eliminate 25,000 manufacturing
jobs over the next three years. Part of the problem, according to
GM, is the rising cost of health care in the US. Health care expenses
add approximately $1,500 to the cost of each GM vehicle. Not surprisingly,
GM is trying to convince the unions to allow it to cut its health
care spending. Equally unsurprising, the unions oppose that idea.
Meanwhile, Federal Reserve Chairman, Alan Greenspan,
believes that the US economy is on “reasonably firm footing”
despite the “uneven character of the expansion over the past
year”, and he has indicated that the US central bank is not
done raising interest rates just yet.
The Fed chairman said that it is “very difficult”
to know what level of interest rates is optimum for the economy
although “we probably will know it when we are there.”
Since June last year the Federal Reserve has raised
its short-term interest rate target from 1% to 3% while at the same
time ten-year Treasury rates have declined from 4.7% to less than
4%. This flattening of the yield curve is what many are calling
the “bond market conundrum”.
Whenever long-term interest rates fall below short-term
interest rates (referred to as an inverted yield curve) there is
a good chance that a recession is ahead. Greenspan, however, does
not believe falling long-term interest rates indicate economic troubles
ahead. Federal Reserve Officials are upbeat on the economic outlook
and Mr. Greenspan stated that even if the yield curve did invert
they would “not automatically assume it will mean what it
meant in the past” -- meaning that he does not think an inverted
yield curve implies the economy will slow down.
The chief economist for Manufacturers Alliance/MAPI,
a public policy group in Arlington Virginia, recently stated that
the rate of manufacturing growth is decelerating virtually across
the world. I look at the US auto industry and note that US auto
sales fell 8% in May compared to a year ago. We know General Motors
will eliminate 25,000 jobs; how many other manufacturing jobs are
at risk?
Back in the Nineties, several currency crises caused
massive international capital flows that distorted exchange rates
and affected various financial sectors including US bonds and stocks
(see “The Greater Depression” in the Commentary Section
of my website: www.paulvaneeden.com, dated January 30, 2004).
Those imbalances caused, and continue to cause, misallocations
of capital that must be reversed before real, sustainable economic
growth will be possible.
I believe we will experience a severe recession while
these imbalances are corrected, and until then the best we can hope
for is to muddle along as we have been doing lately.
Financial survival will require us to act rationally,
not emotionally, and to be careful. The way I am playing it is by
looking for leverage to a falling US dollar exchange rate. The dollar
may look strong right now, but it has severe structural problems.
In the end I think the dollar is going to suffer… a lot. It
is just a matter of time.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
own portfolio and shares his investment ideas with subscribers to his weekly
investment publication. For more information please visit his website (www.paulvaneeden.com)
or contact his publisher at (800) 528-0559 or (602) 252-4477.
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