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:, 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 ( or contact his publisher at (800) 528-0559 or (602) 252-4477.


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