Saturday, December 26, 2009

Economics 26/12/2009: Interest rates direction - US, Europe and China

One near-certainty that awaits us in 2010 is the return of the higher cost of borrowing. The growth killer pill o higher interest rates will pass into the system before countries like Ireland get to experience growth. And a double-dip, or an extremely prolonged slog at the bottom of a U will be looming for the US and Europe.

Here is how I know: the forces keeping pressures on the policymakers to keep rates low are declining, while the forces that will push rates higher are already in the making.

Two drivers helped to push US and global rates down since 2007. These are the US Fed’s financial crisis busting injections of liquidity and the Chinese desire to keep yuan pegged to the dollar on the way down. The former fuels the liquidity trap in the US, while the latter fuels the circular pump that converts dollar surpluses on trade and investment side into dollar-denominated paper recycling cash back to Uncle Sam.

US drivers

In effect, the Fed has created a massive and unsustainable demand for US Treasuries via:

  • Direct purchase of US bonds (over the last two months this amounted to some 22% of the entire pool of newly minted US debt – some US$65 billion, driving the yield to near zero once again. The Fed bought some US$300bn worth of longer-term Treasuries at the end of October), and
  • Indirect purchases of US debt via primary dealers and via its balance sheet operations (between January 2008 and December 2009 assets on Fed’s balance sheet grew some 142% to a whooping US$2,240 billion, or more than 16.7% of the entire US GDP).

Now, do the maths: over the last two years, the Fed bought into over US$300 billion in Treasuries purchased directly, some US$600 billion more went into indirect purchasing of Treasuries and the balance of roughly US$1,300 billion is sitting in the illiquid and largely non-performing assets such as US$901 billion worth of MBSs. The Fed has US$350 billion more of toxic stuff to buy before reaching its target by the end of Q1 2009. There after, unwinding of liquidity supports will be on order. And this process has already started with the Fed scaling back some 10 asset purchasing programmes.

Aptly, the hosting of the spending party is shifting from the Fed to FedG, or the Federal Government. Per Bloomberg, the amount the Fed and US agencies have lent, spent or guaranteed has fallen 15% to $8.2 trillion between September and mid December, “the lowest in a year”. The FedG spending on infrastructure, tax breaks and other fiscal measures accounts for 52% of the new total, up from 39% in March 2009. So far, the Government spent some US$4,200 billion – or 30% of the US economic output – in 2009. And last week, the US Congress approved a further increase in the Federal debt ceiling – raising it by US$290 billion to US$12,400 billion.

One problem is that this substitution of the Fed with the Federal Government is the sign of the end of the road nearing for massive money creation exercise in the US. While the Fed can print money as long as there is no significant inflation (in the US terms – anything below 4% per annum in the short term will probably be acceptable with current levels of unemployment), the Federales will have to tax their way out of the deficit hole one day. Inflation is a manageable thing, though for now: US consumer prices were up 1.8% yoy in November – well below the 2.6% annual average recorded over the 2000-2009 period.

But the fiscal hole is a formidable one – the US has managed to run 14 consecutive months of budget deficits since December 2007. The only positive on this front is that the Government still holds on to about 50% of the entire stimulus package allocated earlier in 2009 – some US$787 billion in unspent funding. Don’t bank on Democrats-controlled executive and legislature not burning through that in 2010.

Another problem is that reselling the toxic securities pilled up in Fed’s vaults back into the economy will risk draining liquidity out of the system. The Fed might think that’s ok in the short term, since the US banks are now less prone to tap into Fed’s window for liquidity: the Fed stated that since mid-August 2009 there has been no new borrowing at the Term Securities Lending Facility, while Primary Dealer Credit Facility had seen no clients since mid-May 2009. The Asset-Backed Commercial Paper Money Market has been inoperative since May 2009. These programmes, plus the Commercial Paper Funding Facility, the Primary Dealer Credit Facility and other are now set for a phase-out starting with February 2010. And the Fed is set to shorten maturity profile of its primary credit loans from 90 days to 28 days as of January 14, 2010. TALF (Term Asset-Backed Securities Loan Facility) will close on June 1, 2010. More? The Money market Investor Funding Facility (MMIFF) was discontinued on October 30.

China's conundrum

Obviously, the Fed could have swapped these fine ‘assets’ for Treasuries and sold the Treasuries on to the Chinese in a financial scheme that would have allowed it to retain dollar supply intact. Alas, things are much less promising for such a transaction today than they were a couple of years back.

Chart below (from here) shows just how dynamic China’s refusal to buy more into the US assets has been in recent months.
And the next two charts confirm the same,
except the last one is an even scarier thing. It shows that even as the Chinese FX reserves were rising, their willingness to buy US Treasuries has been falling. Might it be the case that China has decided to recycle US dollars earned from the trade surpluses back into the global economy? Buying gold or even Euro?

Why not? The latter two operations offer Chinese a happy trip to a devaluation room – push supply of dollars globally up and the value of the dollar goes down. With it, the value of yuan, improving further Chinese exports competitiveness.

The side benefit to this for China is that their anti-dollar rhetoric backed by gold and euro buying also pushes the country reputation as a ‘counterweight to the US hegemony’. Naive Europeans keen on showing euro’s strengths are loving that not seeing that China has no love for the EU or for the euro, just an addiction to cheap yuan. Europeans are not even at the frontline as observers, obsessed with ‘strong euro = alternative reserve currency’ pipe dream.

This beggar-the-US position pays off for China in so many ways with such handsome returns that I am amazed no one so far has pointed out to the internal consistency of what the Chinese are doing through the concerted efforts of their monetary, exports and diplomatic/political pillars.

One spanner in the wheels is that the Chinese trade surplus vis-à-vis the US and Europe is now shrinking, and shrinking rapidly. According to China's General Administration of Customs, country exports in 10 months to November 1, 2009 dropped by 20.5% yoy and 14.8% vis-à-vis the US. Its terms of trade (the export price relative to imports) have fallen over 5%. China’s exports to the EU have fallen even faster – down 18.7% in value in the first 10 months of 2009, opening up a gap in its euro earnings relative to dollars.

This gap implies that any rebalancing of the FX reserves into euros away from the dollar will require direct purchases of euros and selling of dollar reserves. Now, China holds some US$2,270 billion worth of FX reserves – some 33% of this in US dollars, marking a 19% rise in the proportion of FX reserves allocated to dollars within the last 12 months. And China holds some US$791 billion worth of US Treasuries.

So this is another marker suggesting the reduction of China’s appetite for dollar-denominated assets going forward.

As US-China trade deficit shrinks from US$268 billion in 2008 to US$188.5 billion in 2009 China will have four powerful reasons not to buy much more of US Treasuries:

  • Falling supply of dollars and even faster falling supply of euros;
  • Falling appetite for Treasuries;
  • Falling returns to both dollars and Treasuries, and
  • Rising demand for gold and euro, both requiring sales of dollar-denominated assets and cash.

Summing it up

With record deficit in works for 2010, the supply of Treasuries is bound to go up – some US$1,300 billion will be pumped into the global markets next year alone, plus some US$2,000 maturing will have to be rolled over.

Meanwhile, the demand from the Fed is gone almost completely and the demand from China is dramatically cut back, if not turned negative. Last week, Morgan Stanley boys estimated that by June 2010, potential excess supply of newly minted Treasuries over demand will be US$598 billion or 33% of the new issuance for the year.

Prices are likely to collapse and yields to rise. The US has no other option, but to push yields even higher in order to rid itself of the surplus Treasuries. Overshooting of the rates will follow.

Now, considering the amount of paper already issued during the crisis, we are looking at a bond prices cycle of some 20-30 years (traditional cycle is 18-26 years). In other words, the era of low rates is now over. Firmly.

While back in the Euroland, elves and fairies are…

Oh, well, inhabiting the imaginary universe where the Grand Plan for world monetary domination requires strong euro (even if at the expense of dead exporters) boys in Frankfurt are happy with the dollar and sterling slide. To them, the game is about turning the euro into a worldwide reserve currency – the stuff held by everyone, from grey and black economy’s ‘entrepreneurs’ (why else would a monetary union with anemic income growth need a 1,000 euro note for?) to legitimate sovereigns. This requires stability of value and, as a side-effect, low inflation. It also requires systemic undermining of European exports competitiveness and, as a side effect, higher unemployment.

In the land of elves and fairies, even with a prospect of continued weaknesses in the financial system still looming over the euro area banks (which have so far failed to pass the 50% mark of expected writedowns), the ECB is already on the tightening path. Earlier this month the ECB raised long-term cost of borrowing under its 12-month lending programme and told the markets it will cease lending under this maturity at the end of Q1 2010.

These measures will have a double whammy effect on euro area interest rates – first, pushing the rates directly by forcing the banks back into the direct interbank lending markets, and second – by forcing the banks to rely on milking their borrowers through higher rates and fees and charges to raise funds to repair their balancesheets.

The global changes – particularly those discussed above – will aid the ECB intentions. As the US raises rates, the euro is bound to ease off relative to the US dollar, opening up some more room for interest rates rising in the euro area. As China switches into buying euro to displace its dollar holdings, and cuts purchases of the US Treasuries, euro will be pushed up in value against other currencies, leading to a deterioration in the EU trade balance. Higher rates will help here too, offsetting falling trade surplus with rising capital account position.

In other words, the ECB is an accidental co-traveler on the road to the higher interest rates. A New Brave World that awaits us in the near future is likely to be the one with high, very high cost of capital.
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