This is the second part of the article “Where is my recession?“. We’ve stopped at examining the bull arguments that the worst for the economy is likely to be over. The first argument is that the interest rates are well below the level at the start of the previous recessions.
4. Interest rates
The Feds are as aggressive in lowering interest rates as never before.
Stop. We can already stop and argue at this point. Look at the chart (click to zoom):
Blue is effective Fed funds rate set by bids at the daily TOMO auctions, green is the 4-week T-bill, red is the official rate. It looks to me that the rates are set by the market and Feds can only push or pull the rates away from the market value but not set them outright.
Why this happens? I think there is a supply and demand for instruments of various risk. In the middle of 2007 is was apparent that the interest rates for the risky assets are mispriced, i.e. treasuries are giving better risk/reward than the collapsing commercial paper market. Bernanke rubber-stamped this by his new rates.
So how low interest rates work? The amount of money the Feds are lending outright from their coffers is limited. If you count the difference between 5.25% and 2% on that amount you will find that Feds are not giving much of savings, the money are coming from somewhere else. So what are the main sponsors when the interest rates go down? They are the savers, and the most conservative ones:
- Pension funds, conservative mutual funds, 401k funds
- Insurance corporations (they run the T-bonds bull market when the claims go up, it’s convenient)
- Money market funds
- Foreign central banks
Low interest rates are forcing savers to sponsor the risk takers or agree to just provide funds to the government. They are fighting risk-aversion and essentially just rob Peter to pay Paul.
But fortunately the conservative investors are not only domestic, they are coming from abroad as well. The current account deficit that was about $800 bln last year and is projected to be $700 bln this year is measuring the inflow of foreign capital. The investors are: foreign central banks, sovereign wealth funds and private investors. The main targets of those investments are: treasuries, agency papers made by GSEs), mortgage-backed securities, corporate securities and the stock market.
To get the sense of the risk appetite toward US corporate sector please look at this chart:
The stock market is probably not doing much better, the market of non-agency MBS completely collapsed.
So, at this point, the inflow of the foreign capital is mostly directed into Treasuries and GSE papers, i.e. US public debt, backed by government. But at the same time the average interest return paid for those instruments is well below last year mix, when private sector was healthy and paid well.
5. Socialization of the private economy
Let see again what is happening. The US treasury deficit was running under $200 bln in 2007 and this year is projected to balloon to $500 bln. A bulk of this deficit will be funded from abroad. The non-GSE mortgage securitization market collapsed, over 90% of new papers are sold by Fannie Mae and Freddie Mac and guaranteed by US government. Again, a good chunk will come from abroad.
If we take the whole US economy as one big entity it lives at the constant expansion of debt, at the rate $700-$800 bln (of course the picture is much more complicated but its off-topic). In the past years that deficit was funded by a mix of government and private debt at different levels of return. Today foreign purchases at the private debt market are contracting and foreign investors are mostly sending money to US government at subpar returns. The advantage of private debt is that it can be defaulted or restructured but the public debt will weight on us for generations.
I see it like a trap. The US is forced to socialize its economy in order to put brakes on the otherwise sharp slowdown. The downside of that is the slow destruction of the capitalist economy we were so proud of, we resemble more and more the old Soviet Union
4 Comments
Today action in treasury bonds (TLH) was very bad again. They are barely above 200 DMA.
The Feds need to scare the market into treasuries tomorrow, once more.
They’ll fall into the pit they are digging!
“Low interest rates are forcing savers to sponsor the risk takers or agree to just provide funds to the government. They are fighting risk-aversion and essentially just rob Peter to pay Paul.”
With such low returns some savers are being forced to be risk takers.
Roxy,
You make a good point here:
“…and foreign investors are mostly sending money to US government at subpar returns.”
It is these subpar returns that I think will eventually reach a tipping point where once foreigners factor in a decline in the dollar that they are actually receiving a negative return. The foreign savers have to contend with the currency exchange rate. If a European investor had converted his Euros into dollars and bought treasury paper, he would have an outright loss of capital over the last eight years. This is why I believe we are only seeing FCBs purchasing dollars in order to stabilize the exchange rate. As a result of these purchases by FCBs in order to achieve full employment, many nations are sharing in the inflation that the FED/Treasury is flooding the world with. If our trading nations seek to limit inflation in their own countries and reduce treasury purchases, our dollar will continue to fall and at some point this will either result in a drop in the American standard of living, and eventually a substantial rise in interest rates. This seems to me to clearly be the path that we traveled in the late 70’s/early 80’s.
One Trackback/Pingback
[…] This is the location of my new blog, it’s titled “The yellow brick road” and I’m opening with a new installment of “Where is my recession?” serial. […]
Post a Comment