Richard Duncan explains Alan Greenspan's conundrum

Richard Duncan, author of "The Dollar Crisis: Causes, Consequences, Cures", has this to say about the fact that long term yields are not going up (in fact, they may be still going down) when the Federal Reserve is rising short term rates:

There is a wide-spread misconception that the United States relies on the savings or other countries to finance its current account deficit. This is incorrect. During recent years, at least, the US current account deficit is financed primarily by money newly created by the central banks of other countries. Newly issued paper money is not the same thing as a county's savings. The companies that earned money by exporting to the US keep their savings. It is only that they keep them in their domestic currencies after having sold the dollars they earned from exporting to their central bank. In fact, the banking systems of the export-oriented economies all across Asia are burdened by too much savings. Excess deposits are increasing more quickly than viable lending opportunities and, consequently, interest rates have fallen to historic lows.

Therefore, it is not a matter of the US using up all the rest of the world's savings to fund its deficit. It is a matter of that deficit being financed by the central banks of the United States' trading partners. And, for their part, Asian central banks, in particular, have consistently demonstrated their ability and willingness to create money in order to finance the US current account deficit. Given that nothing has occurred to call into question their determination to continue doing so, there is no reason to expect that behavior to change any time in the near future. What else, then, could be worrying Chairman Greenspan?

It may be that he is growing concerned that he and his colleagues at the Fed are losing control over interest rates, and, therefore, over the broader economy. The Fed began raising the Federal Funds rate in June 2004. Since then it has increased rates by 25 basis points on eight occasions, by a total of 200 basis points, to 3.0%. Despite that, the market-determined rate on 10 year government bonds has actually fallen over that period by 50 basis points to just above 4.0%. That cannot be what the Fed had hoped for when it began raising rates.

The explanation for this unexpected outcome can be found in the imbalance between the amount of dollars being accumulated by the central banks of the United States' trading partners and the issuance of new US government and agency debt.

Many countries around the world accumulate large stockpiles of dollars as a result of their trade surpluses with the United States. The central banks of most of those countries print their own currency and buy those dollars in order to prevent their currencies from appreciating when the private sector companies that earned the dollars exchange them for the domestic currency on the foreign exchange markets. The central banks then invest the dollars they have acquired into US dollar-denominated debt instruments, preferably US treasury bonds or agency debt, in order to earn a return. If the amount of dollars accumulated by foreign central banks exceeds the amount of new debt being issued by the US government and the US agencies during any particular period, then the central banks will buy existing government and agency debt instead of newly issued debt. By acquiring existing debt, they push up the price and push down the yield. That seems to explain why long bond yields have been falling since mid-2004 even though the Fed has been increasing interest rates at the short end of the yield curve.

If this reasoning is correct, the implications are quite disturbing given current trends in the current account deficit and the budget deficit. If the US current account deficit continues to expand from its level of $666 billion in 2004, as seems likely so long as the dollar remains at existing exchange rates, then the amount of paper dollars that foreign central banks wish to invest in US government debt will continue to expand. Meanwhile, the US budget deficit is widely expected to be lower in FY2005 (approximately $370 billion) than in FY2004 when it was $413 billion. That means that the government will issue less new debt this year than it did last year. Presumably, the same will be true of Fannie Mae and Freddie Mac, in light of the accounting scandals in which they have become embroiled. Under such circumstances, there will not be enough new government and agency debt issued to satisfy the demand of foreign central banks. Consequently, they are likely to buy existing debt instead, which will have the effect of pushing up the price of those bonds and driving their yields down even further...regardless of what the Fed does to the Federal Funds rate.

Mortgage rates are determined by the yield on 10 year treasury bonds in the United States. Therefore, if foreign central bank buying drives down the yield on treasury bonds, it will also push down mortgage rates, which in turn will cause the rate of increase in US property prices, already the fastest in 25 years during 2004 (and the fastest ever in real, inflation- adjusted terms), to accelerate still further. Higher property prices will allow yet more equity extraction which, in turn, will stimulate US consumption further. Additional consumption will pull in more imports and exacerbate the US current account deficit. And, a larger current account deficit will put yet more dollars in the hands of foreign central banks, who, then, will look for still more dollar-denominated assets in which to invest them. At the same time, rising house prices and booming consumption will lift US tax revenues, causing the US budget deficit to shrink much more than currently expected.

In other words, if the US current account continues widening faster than the US budget deficit, it could drive down yields on government bonds and therefore the interest rates on mortgages so low that it creates an asst bubble in the United States that the Fed could not control.

Regardless, then, of whether the US government reduces its budget deficit or not, it would appear that the rapidly expanding US current account deficit has begun to undermine the ability of the Fed to determine the level, or even the direction, of interest rates in the United States. Moreover, if the present trend in the current account deficit is left unchecked, the investment of ever larger amounts of dollar surpluses by foreign central banks into US dollar-denominated assets threatens to produce asset price bubbles and economic overheating in the Untied States over which the Fed would have no power to control. Seen from this perspective, there is little wonder that the Fed has begun to talk down the dollar. These fears may also explain why the United States has recently launched an aggressive campaign to force China to revalue the Yuan.

Finally, it is also worth noting that the extraordinary accumulation of dollar reserves has begun to impact third party countries, as well. When investors diversify out of dollars and into euros, for instance, they then invest those euros in euro-denominated debt instruments and thereby push up bond prices and push down bond yields in Europe. This explains why German government bond yields are currently at a 109 year low. Soon, this could make economic management in Europe more difficult, too.

Such low yields on government bonds in Europe, the US and elsewhere around the world also threaten the solvency of life insurance companies and corporate pension schemes which will be unable to meet the guaranteed returns promised to policy holders and retired workers if interest rates continue falling.

Categories: economy, interest rates, bond market, real estate