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A Most Savage Credit Crunch

While the Fed hiked its rate by a paltry 25 basis points, the bond market used a hammer, raising 10-year Treasury yields by 100 basis points within just two weeks - that is, by nearly a full percentage point.

If the Fed truly and urgently wanted credit restraint, the action in the bond market should have pleased them. We suspect the abrupt surge of long-term rates has shocked them, because the resulting higher mortgage rates have effectually choked the mortgage refinancing bubble, presenting policymakers in the Fed with far more credit tightening than they really want.

All their hawkish talk, we presume, was intended rather to calm the inflation fears in the market by emphasizing the Fed's anti-inflation vigilance, thereby hopefully moderating the rise in longer-term market rates. In any case, the talk about a rate hike was much ado about nothing.

In his London speech, Greenspan cited that "the rise in rates... has induced a dramatic fall in mortgage refinancing." According to the Mortgage Bankers Association (MBA), mortgage-financing activity in the United States in the week ending June 4 was down 68% compared to a year ago. The MBA's Refinancing Index had even plunged by 85% year over year.

Yet the impact of the higher interest rates seems to have been cushioned by a surge in the demand for adjustable rate mortgages (ARMs).

What exactly could or would the Fed accomplish with a quarter-point rate hike? What would that do to the economy and the financial system? In short, it would not be likely to change much, if anything at all. Even the carry trade would still be profitable at this higher rate.

In fact, the existing short-term rate of 1% is ridiculously low for a supposedly booming economy to begin with. But most of the profits derived from this record-low rate go to the financial system, funding its assets in large part by this rate. Manifestly, Wall Street firms, banks and hedge funds could easily cope with a slightly higher federal funds rate. For consumers and non-financial firms, the Fed's 1% rate is pure theory - except for savers.

What truly matters, in particular for financial institutions heavily engaged in carry trade, are changes in the long-term rate, because they directly hit their capital, and that, of course, with high leverage. The rise by 100 basis points reduces the value of 10-year bonds by almost 10%. Given that the carry trade with bonds is generally leveraged at 20:1, or 5% equity, this loss of value in the bond holdings actually wipes out more than the invested capital.

In hindsight, it seems reasonable to say that by maintaining the consumer borrowing and spending binge in the face of plummeting income growth, the mortgage- refinancing bubble has been the U.S. economy's lifeline. Consumer spending posted a new historical record in the sense that it outpaced total economic growth. With an overall increase of $625.8 billion, for the first time in history it exceeded the simultaneous GDP growth, up $581 billion. The consumer achieved this with a debt surge of $1,678.8 billion.

But as explained, this lifeline has been badly damaged. There is no spectacular collapse like that in the stock market of 2000-01. Yet a drastically deflating mortgage- refinancing bubble is sure to have a much greater effect on the economy. What is unfolding there is not just gradual credit restraint. It is a most savage credit crunch with obvious, most dismal consequences for consumer spending and the economy.

All the more, it stuns us how little attention this fact is finding. Just weeks ago, the question of a possible quarter-point rate hike by the Fed provoked an agitated public discussion. Now there appears to be a savage credit crunch in the offing, and nobody seems to even notice.

In our view, the fate of the mortgage refinancing bubble and its further impact on the economy is presently the single-most important issue facing the U.S. economy. All other major GDP components are much too weak to take over as the new locomotive. Consider that nonresidential business investment contributed just 0.30 percentage points to real GDP growth in the first quarter of 2004. Consumer spending remains so predominant that any weakness on its part would instead pull down the other components.

Of the numerous economic data that America's statisticians constantly publish, a single forthcoming number appears absolutely decisive under these circumstances. That is real consumer expenditures in May, in the Personal Income and Outlays report published June 28 (just after this letter has gone to the printer).

As earlier elucidated, the numbers for the first four months of 2004 have been unusually weak. Overall growth was $61.5 billion, or $184.5 billion at annual rate. This compares with an annualized increase in the fourth quarter of 2003 by $388.4 billion and an increase over the whole year by $297.7 billion. To speak of any traction in this economy is absurd. With the mortgage-refinancing bubble seriously jeopardized, more weakness is the only thing we can imagine for consumer spending.

The other bubble that gives us the greatest headache is the highly leveraged carry trade in longer-term bonds. We ask ourselves how this monstrous bubble, having certainly run into several trillion dollars, can ever be unwound without pushing market interest rates substantially upward.

Well, prices of longer-term bonds crashed in April-May. For 10-year bonds, the loss was close to 10%. For the time being, U.S. bonds have stabilized at their lowered level, as unwinding - in other words, selling - has drastically abated or stopped. But it is a deceptive stability. Such a huge bubble that has been built up over two or three years is not liquidated within weeks. For sure, the bulk of the carry trade still hangs over the markets.

The decisive point to see about the carry trade of bonds from a macro perspective is that huge purchases of bonds with borrowed money essentially result in artificially low longer-term interest rates. Normally, such purchases ought to come exclusively from current savings.

While the U.S. economy has near-zero domestic savings, it possesses a financial system that, thanks to its central bank, knows no limit in credit and debt creation. It is a financial system of virtually unlimited "elasticity," one might say.

However, this extraordinary financial elasticity works overwhelmingly in two directions: personal consumption and financial speculation. During the 13 quarters from end 2000 to the first quarter of 2004, private household debt has soared by $2.52 trillion, or 36%, and financial sector debt by $2.9 trillion, or 35%. Jumping from $578.1 billion in 1980 to $11,280.6 billion in the first quarter of 2004, the debt of the financial sector in the United States has skyrocketed from 21% of GDP to 98.4%.

Mr. Greenspan keeps hailing this extraordinary ability of the U.S. financial system for expansion as a sign of superior efficiency. We increasingly wonder about its elasticity in the opposite direction, that is, when it comes to unwinding existing bubbles, regarding the immediate surge of long-term interest rates only as a first taste of things to come.

Building the huge carry-trade bubble of bonds during the past few years has been fun because the yield spread and rising bond prices lured ready buyers en masse. It was a pleasure for sellers and buyers. But we wonder from where the huge buying of bonds will come when selling pressure from the unwinding of this bubble will develop in earnest.

Imagine, America's whole financial system has trillions of dollars in the same boat. But what can possibly trigger heavy selling of this kind? For sure, the Fed is desperate not to upset this boat with the major rate hikes that could do so. If it feels compelled to move in order to satisfy bond vigilantes, it will do no more than minimal, so to speak, rather symbolical rate hikes.

Considering the huge amounts involved in the U.S. carry trade, we think that this bubble has, actually, become far too big to allow for orderly unwinding, by which we mean unwinding with moderate interest effects. Under the conditions created by the Fed, it was easy to create virtually unlimited leveraged buying of bonds on the way up. But there are few willing buyers on the way down.

But to be sure, it is impossible to recreate these conditions. First of all, rate cutting by the Fed has spent its power; second, there will be upward pressure on interest rates from new credit demand; and third, being outrageously overloaded with highly leveraged bond holdings, the financial system will be a very reluctant buyer of new bonds.

All in all, the asset bubbles have over time become far too big to allow for orderly unwinding. With the highly leveraged carry trade in bonds alone running into several trillions of dollars, one has to wonder where and who the necessary potential buyers for these trillions are that would make such extensive deleveraging possible. The fact to see is that the Greenspan Fed has lured the U.S. financial system into a horrible liquidity trap.

This essay was adapted from an article in the July edition of: The Richebächer Letter


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