Wednesday, June 10, 2009

Expect The Best And Prepare For The Worst

Readers of the English language financial press are pretty much agog at the moment at the sight of two of the worlds best known contemporary intellectuals having a very public and very bitter argument. And the topic of their feud? The size of the US fiscal deficit, and whether having it is deadly, tolerable, or simply a good thing.

There have, of course, been numberous high profile economic disputes before (the one between the then IMF Chief Economist Ken Rogoff and Nobel Economist Joeseph Stiglitz immediately comes to mind ), but the latest embroglio between Harvard historian Niall Fegurson and the world's newest addition to the list of Nobel Laureates, Princeton economist and New York Times columnist Paul Krugman, looks set to break all previous records, at least in terms of audience ratings.

In essence Professor Ferguson is putting forward three arguments: first, the recent sharp rise in US government bond rates is a sure sign that the bond market is “trembling” in the face of the huge bond issuance that is now looming on the horizon; second, such large fiscal deficits are both unnecessary and counterproductive; and, finally, there is every reason to fear they will have a strong inflationary impact.

Krugman, for his part fears deflation not inflation, argues that such large fiscal deficits are necessary, and even desireable in current circumstances, as the private sector pays down its debt, and suggests that the rise in longer term interest rates is due not to inflation fear, but rather to the expectation that Ben Bernanke will raise short term interest rates sooner, rather than later, to avoid just such an outcome. Investors are, on Krugmans view, simply positioning themselves in the face of what they now feel is inevitable.

What both participants are agreed on is that rates on 10 year US treasuries have been rising sharply recently. Yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – hit 3.91 percent on June 8. At one time that would have been considered pretty low. But the financial crisis changed all that: at the end of last year, the yield on the 10-year nond fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

At the heart of the problem is what appears to be a negative feedback loop, since investor expectation that the inflationary pressures which may accompany any economic recovery will lead the Federal Reserve to raise short term rates may well end up delaying that very recovery they so hope for. Ferguson blames the rapid increase in the money supply for creating the situation, while Krugman says that with so much excess capacity in the system inflationary pressure is a long way off at this point.

Meanwhile the Federal Reserve been working overtime to try to bring rates down again. The fundamental reason the Federal reserve started buying Treasury debt in the first place was to lower mortgage rates to revive the moribund housing market. That was starting to work, but the big danger comes from the fact that the interest rate rise is pushing mortgage rates back up again, and this is likely to delay any rebound in the housing market and derail the broader economic recovery in the process.

Unsurprisingly results from Freddie Mac's Primary Mortgage Market Survey, released at the start of June, showed a jump in the 30-year fixed mortgage rate to an average of 5.29% for the week ending June 4, compared with an average rate of 4.91% the week before. That was the highest rate recorded since the week ending Dec. 11, 2008. With Treasury yields rising even higher over the last week, the 30-year mortgage rate is most probably somewhere around the 5.50% at this point.

Ferguson or no Ferguson, it is obvious that the US bond market has gotten ahead of itself in anticipating a return of inflationary pressures. Longer term inflation expectations - or so it is argued by a broad spectrum of monetary economists - may work against the fluid operating of a quantitative easing regime in or on the boundary of a liquidity trap, not because investors fear that a country like the United States is about to become the new Zimbabwe, but precisely because they know it won’t. Indeed, as I frequently find myself saying of late, the United States is not Argentina, gee, it isn’t even Italy, by which I mean that investors know perfectly well how Ben Bernanke and his colleagues over at the Federal Reserve will react to a situation where inflation is perceived as rising above their target range - they will start to raise short term interest rates, and it is this expectation of future increases in short term rates which ironically cause longer term interest rates to rise, in just the way they are doing right now, in what is almost a text book case study in the United States.

The dollar also gained against the yen on speculation the Federal Reserve will raise interest rates later this year, reducing the advantage of borrowing in the U.S. to fund purchases elsewhere. Traders added to bets the central bank will increase its target rate for overnight loans between banks by its November policy meeting, according to futures traded on the Chicago Board of Trade. The contracts show a 66 percent chance of a rate increase by then,compared with 24 percent odds a week ago.

So, far from the position being as Niall imagines it is, with investors demanding enhanced premiums for holding US assets due to their fear of impending inflation, what we have here is a kind of see-saw process, whereby bad economic data, which leads investors to anticipate interest rates being held low in the US for some considerable time, raises risk sentiment and sends them off into riskier emerging market assets (with Big Ben playing sheet anchor) in the process sending the grenback to ever lower levels, while positive economic news makes playing carry with the USD as one of your currency pairs increasingly riskier, and thus leads the punters themselves to retreat, sending the dollar cruising back up again. All of which is very counterproductive, since given the knife edge character of the current US “recovery” all it does is slow things down (since the cheaper USD is good for exports) and ramp up the deflationary pressure.

Right now, the fear in the bond market is that even though the federal budget deficit is likely to moderate as the economy revives, the budget gap might stay around $800 billion for the next decade. The faster the economy can grow, the more the government will be able to boost tax revenues, and the lower the deficit will be. "For the moment, the working assumption is massive deficits as far as the eye can see, and I think that's going to be a problem for the bond market," she says.

The Fed must decide, perhaps as soon as its June 23-24 policy meeting, whether to increase its purchases of Treasury bonds. It is on course to buy $300 billion worth of bonds by September. If investors perceive the Fed’s actions as an effort by the central bank to facilitate bigger deficits, they could conclude inflation is coming and flee Treasurys, pushing interest rates up. Mr. Bernanke’s comments were aimed at thwarting that perception.

Jim Bianco, president of Chicago-based Bianco Research LLC. “The Fed wants to operate in predictable ways,” Bianco said. “They are also trying to not just look arbitrary, which makes people think ‘I can’t ever go to the bathroom because there could be a press release that the Fed changed the buybacks.’ That’s been a real concern: ‘Wow, I just went to the bathroom and lost $2 million dollars.’”

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