Re: [A-List] Yield Curve Conundrum

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Inverted yield curve and recession
The "term structure" of interest rates defines the relationship between
short-term and long-term interest rates. The yield curve is a graphic
expression of the interest-rate term structure. Historical data suggest
that a 100-basis-point increase in the Fed Funds rate has been
associated with a 32-basis-point change in the 10-year bond rate in the
same direction. Many convergence trading models based on this ratio are
used by hedge funds.

Of course what was true in the past is not necessarily true in the
future, given that the rules of the fixed-income investment game have
been altered fundamentally by deregulated globalization of money
markets. The failure of long-term dollar rates to rise along with the
short-term rate since late winter 2003 can be explained by the
expectation theory as applied to the term structure of interest rates,
as St Louis Fed president William Poole observed in a speech to the
Money Marketeers in New York last June 14. The market simply does not
expect the Fed to keep the short-term rate high for extended periods
under current conditions. The recent upward trend of short-term rates
set by the Fed is expected by the market to moderate or even reverse
direction as soon as the economy slows. And reacting to the underlying
weakness of deceivingly robust economic indicators, the market
apparently expects the economy to slow, and perhaps soon.

Greg Ip of the Wall Street Journal reported on December 8 that
Greenspan, in a written response to a letter from Republican Congressman
Jim Saxton, chairman of the Joint Economic Committee of Congress, about
the meaning of a "neutral" interest rate, said definitions of "neutral"
vary, as do methods of calculating such rates, and that neutral levels
change with economic conditions.

Thus the concept of a neutral rate, one that is neither above nor below
normal spreads over inflation rates, is made useless by practical
difficulties. This of course is a standard Greenspan position on all
economic concepts as the Wizard of Bubbleland always drives by the seat
of his pragmatic pants, doing the opposite of his obscure periodic
ideological pronouncements.

The Fed raised the Fed Funds rate target to 4.25% in its December 13
meeting, continuing its "measured pace" policy of 13 steps of 25 basis
points each, up from a low of 1% in June 2004. And with the 10-year
yield now at 4.5%, a flat yield curve is imminent and an inversion soon
if the Fed, as expected, continues its current upward interest-rate policy.

The Fed's statement accompanying the December 13 meeting on interest
rates did not include any reference to "accommodative" rates as it had
described earlier hikes. The market appeared to interpret this omission
as the Fed acknowledging that the short-term rate is now at neutral;
that is, on par with historical spread above inflation rate.

Historically, a flat yield curve signals future slow growth and an
inverted yield curve signals future recession. But Greenspan dismissed
the historical pattern by arguing that lenders are now likely to accept
low long-term rates because of their expectation of future low
inflation, and this would stimulate future economic activities. So stop
worrying about the inverted yield curve and learn to love a global
"savings glut".

The Fed also dropped its usual reference to a "measured pace", an
omission that immediately encouraged speculation that it would hereafter
raise rates only intermittently instead of at a gradual steady pace of
small steps of 25 basis points at every Federal Open Market Committee
(FOMC) meeting. Yet the market remains nervous about the Fed's
acknowledgement of the need for "further measured policy firming" that
suggests more rate increases. Greenspan will chair his last meeting this
month. Ben Bernanke, the incoming Fed chairman, will chair his first
rate meeting in March, as the Fed does not hold rate meetings in February.

Yet there is no denying that the debt-driven US economy is afflicted
with overcapacity. And if low inflation, as defined by the Fed, is the
result of stagnant wages, where in the world is the future expansion of
demand going to come from without inflation? The answer is from more
debt collateralized by a further expanding asset-price bubble.

Lower US interest rates also lower the exchange value of the US dollar,
allowing non-dollar investors to bid up dollar asset prices. Asset-price
appreciation is not registered by such economic indicators as inflation,
thus the Fed could continue its below-neutral interest-rate policy to
fuel an expanding bubble without penalty. The US economy has been
delirious for some four years with runaway debt that no one feels any
need to pay back as long as real interest rates remain negative or below
neutral, while no one seems to worry that debtors can ill afford to pay
back debts as soon as real interest rates rise about neutral. With the
short-term rate at 1% and real-estate prices rising by more than 30%
annually, a full price mortgage can be amortized in a little over three
years by market trends.

Offshore dollars not necessarily owned by foreigners
Non-dollar investors in US dollar assets are not necessarily foreigners.
They are anyone with non-dollar revenue, such as US transnational
companies that sell overseas or mutual funds that invest in non-dollar
economies.

The New York Fed estimates that, at year-end 2003, foreign central banks
held $2.1 trillion in dollar-denominated securities, "equivalent to more
than half of marketable Treasury debt outstanding". Yet foreign central
banks do not own these dollars free and clear. They acquired
export-earned dollars in their economies by the governments issuing
sovereign debt denominated in domestic currencies. Much of the dollars
reserve held by foreign central banks come from dollar profits of the
export sector. Such profits are earned mostly by offshore joint-venture
or wholly owned operations of US and other foreign transnational
companies and financial institutions.

These US subsidiaries do not repatriate their off-source earning to
avoid high US taxes. They convert their dollars to domestic sovereign
debt instruments that pay high yields to profit from inter-currency
interest rate arbitrage. Some 60% of Chinese export is traded by
non-Chinese companies, and the ratio is expected to increase as China
further privatizes its state-owned enterprises. The exporting economies
exchange high-yield domestic sovereign debt instruments for US dollars
to buy low-yield US bonds.

Unlike investors, hedge funds do not buy bonds to hold, but to speculate
on the effect of interest-rate trends on bond prices by going long or
short on bonds of different maturity with denomination in different
currencies. They finance their transactions with loans from the repo
(repurchase agreement) market, which trades collateralized short-term
loans at rates that closely track Fed Funds rates. An inverted dollar
yield curve will cause distress for repo players who borrow dollars
short-term to invest in longer-term instruments.

While hedge funds do not set the direction of the market, they do
exacerbate market volatility. The proliferation of hedge funds and the
continuing rise in the amount of money they command through astronomical
leverage allow market trends to be excessively affected by short-term
speculation. Hedging, instead of a strategy for protection, has come to
mean taking on ever higher risk for higher returns.

The inverted dollar yield curve can be read as a signal that market
speculation is betting on a coming global recession by betting against
high short-term dollar rates. Thus traditional term structure is being
made to stand on its head. Instead of an inverted yield curve
forecasting a future recession, market expectation of a future recession
is producing an inverted yield curve, which reinforces the likelihood of
a future recession.

Global savings glut is only a dollar glut
There is another factor that distorts the historical term structure of
interest rates, the denial of which has caused Greenspan to describe a
flat yield curve as a conundrum. Fed chairman-designate Bernanke argued
in a speech last March 29, while still a Fed governor, that a "global
savings glut" has depressed US interest rates since 2000. Echoing this
view, Greenspan testified before Congress on July 20 that this glut is
one of the factors behind the so-called interest rate conundrum, ie,
declining long-term rates despite rising short-term rates. Bernanke
noted that in 2004, the US external deficit stood at $666 billion, or
about 5.75% of US gross domestic product (GDP). Corresponding to that
deficit, US citizens, businesses, and governments on net had to raise
$666 billion from international capital markets. As US capital outflows
in 2004 totaled $818 billion, gross financing needs exceeded $1.4 trillion.

Yet this shows only the flow of funds without identifying the ownership
of such funds. With deregulated global money markets, money can change
location without changing ownership as funds move electronically around
the world in search of the highest returns. What Bernanke did not say
was that a sizable amount of this money belongs to US entities.

Bernanke argued that over the past decade a combination of diverse
forces has created a significant increase in the global supply of
savings, in fact a global savings glut, which helps to explain both the
increase in the US current-account deficit and the relatively low level
of long-term real interest rates in the world today. He asserted that an
important source of the global savings glut has been a remarkable
reversal in the previous flows of credit to developing and
emerging-market economies, a shift that has transformed those economies
from borrowers on international capital markets to large net lenders.

Eurodollar owners not necessarily foreigners
In the United States, domestic saving is currently dangerously low and
falls considerably short of US capital investment. Of necessity, this
shortfall is made up by net borrowing from foreign sources, in essence
by making use of foreigners' savings to finance part of domestic
investment.

The word "foreign" is misleading; it is more accurate to refer to
offshore sources, including eurodollars owned by US corporations,
institutions and individuals. The US current-account deficit equals the
net amount that the United States borrows abroad, and US net offshore
borrowing equals the excess of capital investment over domestic savings,
but not necessarily national savings because many US corporations,
institutions and individuals own substantial offshore or eurodollars.
Still, Bernanke reasoned that the country's current-account deficit
equals the excess of its investment over saving.

In 1985, US gross national saving was 18% of GDP; in 1995, 16%; and in
2004, less than 14%. It seems obvious that despite Bernanke's
predisposed observation, the current-account deficit equals the excess
of US consumption, not investment, over domestic savings. In a
globalized money market, national saving is composed of both domestic
and offshore savings.

Theoretically, investment cannot, as a matter of definition, exceed
savings, a concept aptly expressed by the formula I = S (total
investment equals total savings) framed by economist Irving Fischer
(Nature of Capital and Income, 1906) that every economist learns in the
first day of class in neo-classical macroeconomics. For total investment
to be equal to total savings, the demand for lendable funds must equal
the supply for lendable funds, and this is only possible if the rate of
interest is appropriately defined. If the interest rate were such that
the demand for lendable funds was not equal to the supply of it, then we
would also not have investment equal to savings. Thus the Fed
interest-rate policy is responsible for over- or under-investment in the
US economy.

Foreign countries with dollar trade surpluses with the US increased
reserves by issuing local-currency sovereign debts to withdraw the
trade-surplus dollars in their economies, thereby, according to
Bernanke, mobilizing domestic savings, and then using the dollar
proceeds to buy US Treasury securities and other dollar assets. In
effect, foreign governments have acted as financial intermediaries,
channeling domestic savings away from local uses and into international
capital markets. What Bernanke neglected to say was that much of this
money belonged to off-source subsidiaries of US corporate parents. These
US corporations achieve profitability by cross-border wage and benefit
arbitrage through outsourcing. The net effect of lowering dollar
interest rates by outsourcing also reduces interest income for US
pension funds, dealing a double blow to American workers.

A related strategy has focused on reducing the burden of external debt
by paying them down with the funds from a combination of reduced fiscal
deficits and increased domestic debt issuance. Of necessity, this also
pushed emerging-market economies toward current-account surpluses. The
shifts in current accounts in East Asia and Latin America are evident in
the data for the regions and for individual countries.

Bernanke also asserted that the sharp rise in oil prices has contributed
to the swing toward current-account surpluses among the
non-industrialized nations in the past few years. The current-account
surpluses of oil exporters, notably in the Middle East but also in
countries such as Russia, Nigeria, Indonesia and Venezuela, have risen
as oil revenues have surged. The aggregate current-account surplus of
the Middle East and Africa rose more than $115 billion between 1996 and
2004.

In short, events since the mid-1990s have led to a large change in the
aggregate current-account position of the developing economies, implying
that many developing and emerging-market countries are now large net
lenders rather than net borrowers on international financial markets. In
practice, these countries increased foreign-exchange reserves through
the expedient of issuing sovereign debt to domestic money markets, and
then using the dollar proceeds to buy US Treasury securities and other
dollar assets. Bernanke calls this mobilizing domestic savings.

While Bernanke accurately describes the conditions, he obscures the
causal dynamics. There are few data on the ownership of international
capital and the prospect of hot money that zaps around the globe
electronically being most US-owned is very real. When dollars are moved
from Singapore to New York, there is no information on who owns those
dollars. The so-called global savings glut is hardly the result of
voluntary behavior on the part of foreign central banks. It is the
coercive effect of dollar hegemony that has left the trading partners of
the United States without a choice.

The US trade deficit is denominated in dollars, which can only be
recycled into dollar assets. Local-currency sovereign debts are issued
by foreign treasuries to soak up the current-account surplus dollars.
That foreign central banks end up holding larger dollar reserves can
hardly be viewed as national savings. Foreign central banks merely
exchange domestic sovereign debt for dollars that are US sovereign
credit instruments.

Further, Bernanke ignored the obvious fact that rising dollar-asset
value has distorted the aggregate debt-equity ratio in the global credit
market. As US assets appreciate while Japanese assets depreciate, US
borrowers can carry more debt with the same debt-equity ratio than
Japanese borrowers. This has in fact reduced margin requirements for all
sorts of leverage financing in the US. Banks give not only
full-market-value loans, but full-expected-future-market-value loans in
an ever-rising bull market. History is very clear on the accelerating
damage that margin calls did in the 1929 crash, a fact that apparently
escapes Bernanke, despite his image as a dedicated student of the 1929
crash.

Rising foreign-exchange reserves breed domestic deflation
The exporting economies ship real wealth to the United States in
exchange for fiat dollars that cannot be spent in their own economies
without first being converted into local currencies. If the local
central banks exchange the trade surplus dollars in their economy for
local currencies, local inflation will result from an expansion of the
money supply while the wealth behind the new money has been shipped to
the US.

Thus most foreign governments issue sovereign debt in local currencies
to soak up the dollars in their economies, few of which are owned by
their own citizens and many owned by foreign investors and traders, and
turn them over to their central banks as foreign exchange reserves. The
net effect is deflationary for the exporting economies because sovereign
debt reduces the local-currency money supply.

Local sovereign debt is used to cover the loss of real wealth by export
to the US for dollars. Thus the true financial health of any economy is
measured not by the amount of foreign-exchange reserves held by its
central bank, but the net foreign-exchange reserves after deducting the
outstanding sovereign debt, the dollar equivalent of which is determined
by the exchange rate between the currencies. This is why exchange-rate
revaluation affects not only trade competitiveness, but also
capital-account balance between economies of different currencies.

The glut Bernanke refers to is only a dollar glut that in fact
impoverishes the exporting economies. There is no global savings glut at
all. While the exporting economies continue to suffer from shortage of
capital, having shipped real wealth to the US in exchange for paper that
cannot be used at home, their central banks are creditors holding huge
amounts of dollar-denominated debt instruments. It is not a global
savings glut. It is a global dollar glut caused by the Fed printing
money freely to feed the gargantuan US appetite for debt.

At first glance, the United States has become the world's biggest debtor
nation. Japan and China have become the world's biggest creditor
nations. The US owes Japan more than $2 trillion. At the end of
third-quarter 1998, 33% of US Treasury securities were held by
foreigners, up from just 10% in 1991. Some 30% of foreign-held assets
were US government bonds ($1.5 trillion), and 12% corporate bonds.
Again, the word "foreign" is misleading. It is more accurate to use the
term "offshore", for many of these securities are owned by offshore US
entities. By last June 30, more than 50% of outstanding US Treasuries
($2 trillion) were held by foreign central banks. But the foreign
governments have liabilities to offshore US entities that own their
sovereign debt instruments.

Total US federal debt exceeds $7.6 trillion. Yet Japan desperately needs
US investment and credit. The US economy has been booming for more than
a decade with only two brief recessions, each bailed out by the Fed
injecting massive liquidity into the banking system, while during the
same time the Japanese economy have been sliding downhill in a
deflationary spiral, with its sovereign debt receiving junk ratings. The
same happened to South Korea and will soon happen to China, where the
initial euphoria of dollar addiction will eventually turn to pain.

While there are many well-known factors behind this strange inversion of
basic economic logic, one factor that seems to have escaped the
attention of neo-liberal economists is the US private sector's ability
to use debt to generate returns that not only can comfortably carry the
cost of debt service but also conflate asset values with astronomical
price-earnings (p/e) ratios.
http://www.atimes.com/atimes/Global_Economy/HA11Dj01.html

Anne Williamson wrote:

> Interesting comments imparticular regarding Ivy League advisors'
> 'prejudices' at end of interview - Michael Hudson, your input would
> certainly be of interest regarding the issue mentioned. -A.
>
>
>
>
> Yield Curve Conundrum
> By Chris P. Dialynas
> PIMCO Spotlight, February 2006
>
>
> Q: Incoming U.S. Fed Chairman Ben Bernanke has suggested that today's
> relatively low interest rates are the result of a global savings glut
> that is flowing into U.S. and global bonds. What are your thoughts on
> the "savings glut" theory?
>
> Dialynas: The idea of the savings glut is that there is an abundance
> of savings in the world and that this abundance of savings has caused
> interest rates to drop to low levels globally and for risk premiums on
> financial assets to dissipate, leaving us in a financial environment
> where risk premiums are quite low and real interest rates are quite
> low. The basic tenet underlying the savings glut hypothesis is that
> there is more saving than investment and that savings is
> maldistributed. We know that saving equals investment, so today's
> situation is characterized as actual investment falling short of
> "intended investment". The savings glut is essentially Professor
> Bernanke's, and others', answer to Chairman Greenspan's yield curve
> conundrum.
>
> But to me, the notion that there is a savings glut is an incomplete
> and inadequate theory. The International Monetary Fund recently
> published data on world savings, and what we observe is that world
> savings rates have actually declined from the 1970's to the present
> time (see Chart 1). So the crude notion of a savings glut doesn't seem
> to reconcile the data with the theory because if there is a savings
> glut now then there would have been a much higher savings glut in the
> 1970's, and yet real and nominal rates were high in the late 1970's
> and extremely high in the early 1980's. Ironically, the savings glut
> concept, global aggregate demand shortfall, insufficient consumption
> discussions dominated the economic discussions of the 1930's. The
> 1930's were dominated by global recession, accentuated by extreme
> stress in the U.K. and the emergence of the U.S. economy on a relative
> scale, in sharp contrast to today's global prosperity but similar in
> that the emergence of China is similar to the emergence of the U.S. at
> the beginning of the 20th century.
>
>
>
>
> Q: If the savings glut theory doesn't fit the data, what might explain
> today's interest rate structure?
>
> Dialynas: In thinking about the causes for low rates and low risk
> premiums in bond markets globally, it seems to me that there is
> something else going on that relates to global trade and to global
> capital flows that is somewhat independent of global savings rates and
> more dependent upon the risk of investment in plant and equipment
> relative to financial assets. Certainly savings rates in individual
> countries are important but the quantity of global capital flows and
> abundant access to credit enables global arbitrage of investment
> opportunities.
>
> My basic premise is that investment projects, as we all know, need to
> be evaluated on a risk-adjusted basis and that the risk of investment
> in plant and equipment and capacity has increased for a few reasons.
> One reason is that war and terrorism increase the risk of investment.
> The second reason is the fact that capital cannot freely flow into and
> out of China and even if it could, property laws don't seem to be well
> developed in China and the risk of expropriation by the government
> would appear to be quite high. Additionally, China's government does
> not permit the free flow of investment into the country. Finally, the
> twin deficits and the pension industry problems pose future policy
> risk uncertainty.
>
> In an ideal world, investment capital would flow into China because of
> their vast amount of people and extraordinarily low labor compensation
> rates, and unconstrained global investment would be re-established,
> out of financial assets into plant and equipment in China. Hard
> investment elsewhere would immediately become obsolete if China opened
> fully, including freely floating its currency. So there is, in
> essence, a barrier to optimal investment and investment returns need
> to be calibrated for the higher risk. The failure of the S&P 500
> price-to-earnings multiple expansion at present is indicative of a
> higher risk premium. In Keynesian/Hicks parlance, the
> investment/saving curve in the U.S. is almost vertical and will remain
> that way until changes in China occur. High risk causes the
> investment/saving curve in the U.S. to go to a vertical slope, causing
> investment in plant and equipment to be insensitive to interest rates,
> as you can see in Chart 2, where the "LM" curve indicates equilibrium
> between money demand and money supply.
>
>
>
>
> If China opens, floats its currency, insures property rights,
> etcetera, the investment/saving curve will become horizontal in China
> and remain vertical in the U.S.
>
> Viewed alternatively, and an obvious hypothetical, if U.S. companies
> were able to freely import labor, for as long as they desired, from
> China at Chinese wage rates (including benefits), then the U.S.
> investment/saving curve would flatten and the slope of the
> investment/saving curve in China would steepen. Investment into the
> U.S. would increase substantially and subside in China.
>
> The barrier to investment in China could evaporate tomorrow or that
> barrier may become infinite tomorrow. So the uncertainty associated
> with the war in Iraq, the war on terror and the political/economic
> future of China causes a lack of hard investment by savers and the
> money flows into more liquid assets, such as bonds in industrialized
> countries. As the money flows into bonds, it gets recycled through
> trade and interest rates decline. Moreover, it instills a sense of
> tranquility in the receiver nations such as the U.S. Tranquility
> relieves any impetus for policy action.
>
> This process has continued, unabated, because of the fixed exchange
> rate in China and some quasi-fixing of other exchange rates in the
> Asian region to the Chinese currency, which in essence means other
> Asian exchange rates are fixed to the dollar. This situation has
> obviously led to greater and greater trade imbalances, greater debt in
> the U.S. and a tremendous amount of reserve accumulation for Asian
> countries and oil-producing countries and commodity-rich countries as
> well. The Asian fixed exchange rate is a critical element to the
> imbalances, to the dynamics, and creates the analogy of the U.S.-China
> peg today to the U.K. adherence to the Gold Standard in the 1920's.
>
> The analogy to the huge exports of gold from the U.K. in the 1920's
> and early 1930's is the $2 trillion reserve accumulation by other
> countries during the past few years. In the past few years, there has
> been in excess of a couple trillion dollars of dollar reserve
> accumulation by other countries. As a result, the global economy is,
> and has been, awash with liquidity because of the increased risk of
> investment and fixed exchange rate in China (see Chart 3).
>
> Finally, the increased uncertainty of future U.S. policy associated
> with large fiscal and current account deficits as well as under-funded
> private pension systems also substantially increases investor risk.
> While it may be difficult to conceive of a solution to the deficits, a
> very large number of policy combinations are imaginable, each with a
> very different implication for capital returns.
>
>
>
>
> Q: Let's talk about some of the implications of this excess global
> liquidity. What happens if the barrier to investment in China is removed?
>
> Dialynas: A tremendous inflow of capital into China would occur if
> investment barriers were removed. The inflow of capital would bid up
> the value of the economy, the exchange rate and the price of labor.
> The inflow of capital into this utopian investment regime would result
> in an outflow of capital from industrialized countries and a reduction
> in wages in those countries. The "exploitation" of low-cost Chinese
> labor would enrich western capitalists to the detriment of the Chinese
> holders of production facilities. This process is in progress today-in
> slow motion. The present process, while politically comfortable, is an
> economic disaster. The U.S. will cross over from a "control" economy
> and world leader to a "controlled" economy and world follower. An
> outflow from the U.S. of high quality human capital will occur as this
> process progresses.
>
> Q: If the global economy is awash in liquidity, wouldn't that normally
> lead to inflation?
>
> Dialynas: The inflation has occurred. The inflation is in the housing
> market. The inverse of the current account deficit has been debt
> creation, and debt has accumulated in the consumer side and federal
> component of the economy. So the inflation that we have realized in
> the U.S., the U.K., Australia and other current-account deficit
> countries, but also in some surplus countries like China with
> low-priced labor and undervalued exchange rates, has been huge price
> inflation in the real estate markets. Housing price inflation is, in
> essence, the externality of this global liquidity and fixed exchange
> rate regimes.
>
> Housing price inflation has some very important longer-term
> implications. A housing bubble leads to more investment in housing,
> which contributes to current GDP growth. However, if that investment
> were in plant and equipment of equal magnitude then we would have a
> productive resource with which production could be utilized to repay
> the current account deficit. In the case of a housing bubble and
> construction boom, no such product is available. The economic
> prospects for the national economy will rise and fall with the housing
> market. A pop in the housing bubble may invoke a ruinous downward
> multiplier reduction in the U.S. economy while the debts remain.
> Ultimately, the houses themselves may need to be liquidated to settle
> debts with foreigners.
>
> Q: There has also been inflation in commodity prices, and oil in
> particular. What is the relationship between global liquidity and
> commodity prices? And how do you think about the implications of this
> relationship when trying to forecast global economic growth and other
> factors?
>
> Dialynas: The boom in industrial commodities is another result of the
> abundant global liquidity and that has important implications as well.
> Some of the stock markets in countries that export these commodities
> have had their prices inflate upward quite a bit, especially in the
> Middle East, where the geo-political risk actually fell as a result of
> the U.S. invasion of Iraq. Given the dramatic increase in oil prices,
> there has been a fair amount of wealth transferred from the U.S. (and
> all net consumers of oil, but the U.S. is the largest consumer of oil
> by a large amount) to these oil-producing and many
> industrial-commodity-rich countries, including Russia, Middle East
> countries and South American countries.
>
> For some of these Asian countries, reserve accumulation is a new
> process but reserve accumulation for oil-producing nations is
> something that Middle Eastern countries in particular have been
> accustomed to for decades. The explosion in energy prices is a big
> windfall to oil-rich countries. So, in trying to forecast future risk
> premiums and relative asset valuation, yield curves and inflation
> rates it is important to understand how the future consumption and
> investment behavior of some of these oil-producing countries will
> differ from future consumption and investment by countries in the
> Asian bloc.
>
> It seems to me the Middle Eastern countries will be much more likely
> to consume, and the consumption will probably be tilted toward
> technology--aircraft and military equipment --as well as consumer
> goods, than might be the case if we contrast them with some of the
> Asian countries, where they are more concerned with actually producing
> goods and selling goods, but also desirous of advanced technologies
> --military and otherwise. And if you consider these natural resources,
> such as oil, for example, as inventory that the commodity-producing
> countries are simply drawing down, there is very little risk capital
> investment associated with that process as contrasted with traditional
> spending and investment that is tilted more toward building new
> factories or producing goods.
>
> Another important implication of this idea that commodity-producing
> countries are merely drawing down inventory relates to the fact that
> one of the common prescriptions for curing global imbalances is for
> emerging market residents to become consumers. If we believe the
> inventory-draw-down hypothesis, then this transformation is very
> difficult because the hypothesis implies the emerging market countries
> are the beneficiaries of an economic and financial windfall that could
> end tomorrow.
>
> In fact, those countries are also suffering a hollowing out of their
> production by China and are becoming economically obsolete, which
> should retard consumption rather than encourage it. If they are able
> to liquidate their resource inventories for a very long time, such
> that they become extremely wealthy, and figure out a way to hold the
> wealth in a secured way (if such a notion exists), then this hollowing
> out becomes irrelevant and their consumption can increase. That
> prospect is very distant in my view. They will continue to feed the
> Chinese production machine the best they can, for as long as they can.
> The stronger they become, the greater they can charge for marginal
> commodity production.
>
> Q: What role are the financial markets playing in the global liquidity
> glut?
>
> Dialynas: We know the primary source of the global liquidity glut is
> the extremely stimulative fiscal and monetary policies in the U.S.,
> post-2000, and the transmission of U.S. monetary policy to China,
> Japan and other "fixed exchange rate" regimes via the currency peg.
>
> It may also be the case that some of this global savings glut is the
> result of leverage. With the proliferation of derivative instruments,
> and unregulated swap markets in particular, in conjunction with low
> risk premiums and investors' ingenuity in trying to engineer higher
> absolute rates of return, financial leverage has been one of the
> presumed solutions to low returns. And we see this with the
> proliferation of the hedge fund industry.
>
> The proliferation of derivative instruments and products may be
> offering a very cheap and abundant, but potentially transitory, source
> of funding to the demanders of capital through the leveraging of
> investment risk in conjunction with derivative vehicles. And the flip
> side of this cheap capital is that the suppliers of capital may be,
> and probably are, taking inordinate market risk.
>
> If the market should be confronted with an external shock, we might in
> fact find that capital can be destroyed rather rapidly because of the
> past complacency of the market and the inherent capacity for virtually
> anybody to employ leverage via the derivatives market. In former
> times, the qualifications for leverage were much more onerous and not
> as readily available or custom-made as they are today.
>
> One of the secular risks facing the global economy is the potential
> for an exogenous shock that hits at our tremendously levered capital
> structure, in the U.S. in particular. With leverage at unprecedented
> levels, such a shock would hit both the borrower's ability to service
> the debt and hit the investor's wealth simultaneously as negative
> investment returns prevail.
>
> Q: How would you characterize today's global economy? Is it a
> so-called "Goldilocks" economy, with good growth, low inflation and
> low risk premiums, or is it a situation fraught with risk?
>
> Dialynas: It's both, depending on your time horizon and who you're
> talking to. If growth with low conventional "core" inflation is your
> metric, then it's a Goldilocks world. The question is how long can it
> persist? The Goldilocks people will tell you it can persist for a
> very, very long time. But the problem that I explained earlier, which
> is the problem of a lack of investment because of the very high
> geopolitical risk associated with investment, implies that capital is
> depleted with time. So the potential to repay the debt dissipates with
> time and finally, although we don't know when, Goldilocks runs into
> the Big Bad Wolf and the wolf eats Goldilocks.
>
> Q: We've talked about a lot of variables, but what is the bottom line
> in terms of the outlook for bonds and the shape of the yield curve?
>
> Dialynas: The outlook is very path-dependent. There is this notion
> that the U.S. in particular, but other industrialized countries as
> well, has received a subsidy from the global savers in the form of
> lower rates. The estimates are that rates are 50-100 basis points
> lower than they would otherwise be as a result of this symbiotic
> trading and financing relationship between surplus countries and
> deficit countries and that if something should disrupt this process,
> then rates would go up substantially. On the surface, this seems
> pretty logical, and certainly if things unwound slowly, that would
> probably be the path. As the subsidy dissipated, assuming the capital
> needs were consistent, you would need higher interest rates or a lower
> currency to continue to attract capital, particularly because, as
> we've discussed, the successful transformation of China would result
> in massive outflows of U.S. capital to China.
>
> But if things were disrupted by some sudden surprise event, then it
> seems to me rates would probably decline across the curve, and
> probably more so for short rates than long rates. Economic growth
> would most likely slow substantially and you'd probably go to
> recessionary conditions. It could go either way and that's why trying
> to forecast the investment behavior of those who hold the dollar
> reserves and those who continue to have huge trade surpluses is really
> a very, very important call for us to make.
>
> If you look at the volatility of the market and the price of options
> on currencies, interest rates and stocks, volatility premiums are
> quite low. And a flat yield curve would be indicative of, at least for
> a while, lower volatility premiums.
>
> In terms of the yield curve, part of what we are seeing with the
> flatter yield curve is lower term premiums but it is very hard to
> assign cause and effect because we have a re-regulation of the pension
> system that is resulting in better asset liability management on the
> part of defined benefit pension plans. So we have all of these factors
> with respect to trade flows. But then we have also got this huge stock
> of assets in the pension industry that are horribly mismanaged with
> respect to asset/liability management. Pensions are very short
> duration and regulations are being tightened to make it much more
> costly to be mismatched, and so one of the responses is to better
> match and that means buying more long bonds, resulting in lower rates
> and a flatter yield curve. So it is hard to dissect the inferences
> that one might normally make about the yield curve shape with respect
> to the economic cycle, with respect to trade flow influences and with
> respect to asset liability management.
>
> And finally, in terms of risk premiums, I think it's interesting to
> note that from an economic point of view, other than the growth in
> debt, it seems to me we have been completely insulated from the
> economic hardship we might expect to be normally associated with
> fighting a war and financing a war. So there is a question as to
> whether some of the complacency in the financial markets is not only a
> function of capital flows but also a function of the fact that most
> Americans seem completely unaffected by the fact that we are engaged
> in a serious war.
>
> And it's interesting to wonder whether it makes a difference in risk
> premiums and the financial markets in one regime versus the other, as
> to whether part of what we see with low risk premiums is the situation
> where we are engaged in a war but with good growth, low inflation, and
> low risk premiums even as we finance the war through the debt
> accumulation and the trade flows.
>
> Q: Well Chris, now that Chairman Greenspan has passed the baton to
> Professor Bernanke – any comments?
>
> Dialynas: As you can infer from my comments in this interview, from
> the discussion of "Bretton Woods II" last year and from my lengthy,
> detailed December 2004 paper "Trouble Ahead, Trouble Behind...", I am
> a pessimist who believes the imbalances in the world are grave and
> dangerous. I attribute part of the responsibility to the Federal
> Reserve as their "insurance company/bail-them-out" policy-making
> philosophy skewed incentives, which resulted in the mispricing of risk
> and the misallocation of global capital. The tremendous imbalances
> today are the result of this philosophical viewpoint.
>
> This ad-hoc philosophical viewpoint, to the best of my knowledge, was
> conceived in the 1920's by Federal Reserve economist Charles D. Henry.
> There was much debate at the time about the role of the Fed and
> rules-based policies. The Fed proceeded with its mission using
> conventional methods, recognizing the effect low interest rates had on
> asset values, asset values on consumption and the destabilizing effect
> of asset bubbles.
>
> The Greenspan Fed has rationalized its lenient, expansionary bail-out
> with the "productivity miracle" which, in my view, is mostly a result
> of the labor supply shock of China, India, Russia, Eastern Europe and
> extremely low interest rates.
>
> Thus, there has never been a good rationale for sucking it up and
> absorbing the pain of rebalancing. Rather the policies of multiple
> bailouts were undertaken with a yet-to-be-known underwriter. Professor
> Bernanke of Princeton inherits a global political economy extremely
> unbalanced with no solutions in sight.
>
> The Clinton and Bush administrations, as well as the Greenspan Fed,
> have relied upon any internal and external advisors. Without doubt,
> most of these advisors are of Ivy League vintage. It is particularly
> noteworthy to understand that the endowments of most of those
> universities--endowments that substantially accrue to the benefit of
> the respective professors--are primarily invested in very high-risk
> assets and high-risk strategies (as are numerous other investors in
> their quest for high returns in a low interest rate world). It is,
> consequently, of little surprise that policy advice has tended to
> aggressive stimulus. A disciplined,
> "take-your-medicine/rebalance-the-economy" set of policies would most
> likely be detrimental to the endowments of many of this country's
> leading educational institutions. As long as these institutions
> maintain high-risk portfolios, the policy advice from the ivory towers
> will be highly stimulative based upon new, bizarre economic ideas. The
> global imbalances will grow. Professor Bernanke is a member of this
> fraternity. He is a very thoughtful economist who was an expert guest
> speaker at a PIMCO Secular Forum a few years ago. He was impressive
> then and impressive subsequently. There is an extraordinary challenge
> for a very high-quality person. My concern is his presumed
> pro-reflationary bias.
>
> Q: If now-Chairman Bernanke were to ask you for advice, what would it be?
>
> Dialynas: First, I do not know that I'm qualified to offer advice but
> I would be flattered and wouldn't hesitate. My advice would be simple.
>
> Number one: beware of advice from advisors holding risky portfolios.
> Understand their biases. Who is paying their rent?
>
> And number two: announce that all helicopters have been grounded and
> the pilots dismissed!
>
> I am honored and emphasize these are my opinions and, while well-known
> to my PIMCO colleagues, are not regularly accepted but are
> well-debated to the benefit of our clients. Thank you for this forum.
>
> Q: Thank you, Chris. We look forward to checking back with you in the
> future for updates on how these very important issues are progressing.