-->An Open Mouth / The Daily Reckoning
Ouzilly, France
Tuesday, 29 July 2003
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*** The curse of good fortune...
*** Stock market retreats. Gold up, dollar up... but bonds
in a shiny new bear market...
*** Too bad you live among the French... and more!
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For an entire generation, Americans have been the happy
beneficiaries of a unique monetary system... in which the
world's bussers and schleppers took American dollar bills
in return for their work. The more dollars we
exported... the more they bussed and schlepped to get them.
It was a little like the discovery of gold in America by
the Spanish in the 16th century. All of a sudden, the
Spaniards were the richest people in the world - for they
had the world's money!
Money came in from the New World; it was as if the Spanish
had a printing press in the basement and could print up as
many dollars as they wanted. Even the word 'dollar' comes
from that period, as Spanish money was known the world
over. As the money supply increased in Spain, the first
effect was inflation. Prices rose. But the second effect
was the one that hurt. Rather than develop their own
economy, the Spanish exported their dollars in exchange for
the goods they wanted.
The Spanish thought they were rich. And, for a while, they
lived rich. They were the 'world's mouth,' the leading
consumers of the 16th century.
But soon the money ran out. And its overseas adventures
became cost-centers, rather than sources of booty. And then
the Spanish discovered something important: the easy money
had been a curse; it deprived Spain of the development
needed to become a prosperous country.
After the Spanish Armada was defeated by the English in
1588, Spain fell into a slump. It was the 'sick man of
Europe' for the next 4 centuries.
And now it is America that is cursed by good fortune. It
has become 'the world's mouth.'
As long as it has a printing press in its basement,
Americans believe, they will never go hungry.
We will see, dear reader; we will see.
Over to you, Eric...
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Eric Fry, our man-on-the-scene in New York:
- The bond market meltdown continued yesterday, driving the
10-year Treasury note yield to 4.29% from 4.17% on Friday.
Suddenly, government bonds are"toxic waste" in an
investment portfolio.
- Triggering yesterday's selloff - according to the pundits
- was the disconcerting news that the U.S. government plans
to auction vast quantities of government bonds between now
and the end of the year. Specifically, the government says
it will borrow a record $230 billion in the third and
fourth quarters in order to plug part of its gaping, half-
a-trillion dollar budget shortfall. The $126 billion that
Uncle Sam plans to borrow in the fourth quarter is the
highest ever for any quarter, topping the $111 billion
borrowed in the first quarter.
- The looming Treasury auctions - while shockingly large -
are"old news", as are most of the other excellent reasons
to sell bonds. One excellent reason, for example, is the
palpable threat of resurgent inflation. Another reason is
the Federal Reserve's unequivocal commitment to destroying
the dollar..."if need be". (The greatest threat to the
dollar's continuing supremacy, says James Grant, editor of
Grant's Interest Rate Observer,"is not the cost of war, or
looming federal social outlays, or even the arrogance of a
unilateral U.S. interest-rate policy. It is rather the
conceit that a paper currency can be managed by the seat of
the pants of a committee of government employees.")
Yesterday, the bureaucratically managed greenback jumped
half a percent against the euro to $1.149.
- Meanwhile, the stock market retreated a bit, as the Dow
dipped 18 points to 9,267 and the Nasdaq added five points
to 1,735. Reflecting the financial market's newfound
volatility, gold rallied $2.10 yesterday to $364.90 an
ounce, building on last week's $15 dollar-per-ounce
advance. Gold prices have rallied almost $30 an ounce since
their low of $340.80 on July 17. What does the precious
metal know? Does it know that the dollar is overvalued? Or
maybe it knows that most U.S. financial assets are
overvalued - the dollar as well as U.S. stocks and bonds.
- Concerning the overvalued bond market, the mystery is not
that bond yields are soaring, but that they ever dropped so
low in the first place. It's not every day that you see
phrases like"soaring federal deficits" and"lowest
interest rates since 1956" in the same sentence. But that's
exactly what we grew accustomed to seeing as recently as
two months ago, before the epic bond bubble sprung a leak.
- It's true that bond yields have spiked dramatically over
the last month and a half, but they could still jump much,
much higher. Remember that the 10-year Treasury yielded
almost 7% back in January of 2000 and that the average
yield on the 10-year during the 1990s was 6.69%. Net-net,
we suspect the bond market's shiny new bear market will be
hurtling down the road for many years to come...
- When appearing before Congress last week, Chairman
Greenspan crowed about how his policies enabled to the
consumer to continue spending money he doesn't have on
things he doesn't need, thereby taking on even more debt he
doesn't have a prayer of paying off.
-"On the liability side of the balance sheet," the
chairman noted,"despite the significant increase in debt
encouraged by higher asset values, lower interest rates
have facilitated a restructuring of existing debt.
Households have taken advantage of new lows in mortgage
interest rates to refinance debt on more favorable terms,
to lengthen debt maturity, and, in many cases, to extract
equity from their homes to pay down other higher-cost debt.
Debt service burdens, accordingly, have declined."
- The flip side of all this wonderful debt accumulation is
that rising interest rates, especially rapidly rising
interest rates, constrict around household balance sheets
like a hangman's noose. The weight of heavy debts will snap
the neck of some balance sheets immediately, while merely
suffocating others slowly and painfully. Already, rising
interest rates have begun to restrict the flow of household
cash flow to the"extremities" like debt service and
discretionary spending.
- Is it any wonder that bankruptcies are soaring, despite
the lowest interest rates in a generation? There were
31,408 bankruptcy filings in the U.S. last week - up 9.9%
from a year ago. Now that rates are soaring again, we
wouldn't be surprised to see bankruptcies soar as well,
even with the"recovering" economy that Greenspan predicts.
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Back in Ouzilly...
*** We are hosting a conference. With no time to write, we
pass along this letter from a dear reader:
"First, full disclosure - I like the country of France very
much. But I disdain the way the French treat Americans.
"On the American Hospital. My experience several years ago
was dismal with this institution. Fortunately it turned out
not to be a life threatening situation.
"On the dollar standard. I've traveled a lot to Europe and
some to the far East. Several years ago, after Mongolia was
free of the USSR, I visited the outer reaches of that
country. I was very surprised to find that the traders that
did cross-border business with the various bordering
"istan" republics had wads of US$100 bills. It was"the"
means of exchange.
"We determined that many of them had never seen an American
before, but they knew the value of our money. Many
financial institutions had machines that would read a U.S.
bill and determine instantly if it was counterfeit. I'd
never before seen such a machine in any other country.
Still haven't.
"We encountered a young Canadian girl traveling alone with
Canadian $s and British pounds, who could not find any
place to accept or convert them. She was desperate. We
traded some for her to help out.
"A couple of years ago I verified that the situation was
the same with the traders. Still using US$100 bills for
exchange. When these guys switch to another medium for
exchange, I'll believe there is a crack in the dollar
standard.
"A final observation. I often encounter French citizens at
political or educational social events that are complaining
about some situation here in America. On numerous occasions
I've offered to pay their way back to France with a first-
class airline ticket on the carrier or their choice. Only
two stipulations.
1. They must leave by noon tomorrow.
2. They must not return for a minimum of 10 years.
To date I have not had an acceptance.
"To end. I like your content. I'm sorry you chose to live
among the French."
*** Editor's comment: At the Daily Reckoning headquarters,
we like the cheese, the wine, the architecture. Paris is a
beautiful city and hardly a day goes by that we don't
appreciate it. We like the way things are put together in
France. When we need to repaint a door, for example, we
like the way it lifts easily off its hinges. We like laying
up stone walls, too, and like having them around us. We
also like the fact that there are few mosquitoes and few
traffic cops. As for the people, we find the average
Frenchman every bit as lunkheaded as the average American,
German, or Lithuanian. We have no prejudices.
We also hear the blackmarketeers in Russia are now asking
for euros.
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The Daily Reckoning PRESENTS: Thus far, the current Fed
chief's"wily gamesmanship" has seen him through the
bursting of one bubble - the late '90s stock market mania -
relatively unscathed. But just how far can his words reach?
The good doctor reports, below...
AN OPEN MOUTH
By Kurt Richebächer
The people who expect a double dip or worse in the United
States certainly represent a small minority. Among
policymakers and economists in America, it is a virtual
consensus view that the Great Depression of the 1930s as
well as Japan's present, protracted economic quagmire have
their decisive cause in one crucial policy mistake: both
central banks were much too slow in lowering their interest
rates when the economies began to weaken.
All this really boils down to one key question: When do
central banks make their decisive mistake? Is it during the
boom and the bubble? Or is it in their aftermath?
Convinced he had learned from history, Mr. Greenspan
slashed the Fed's federal funds rate with unprecedented
speed from 6.5% to just 1%. Establishing thereby a steeply
sloped yield curve, his aggressive rate cuts had sweeping
effects also on long-term rates, as investors and
speculators stampeded into highly leveraged purchases of
higher-yielding longer-term bonds.
In principle, central banks have but two instruments at
their disposal to influence money and credit growth with
the ultimate aim to curtail or to stimulate economic
activity: adjustments in bank reserves through open market
operations; and adjustments in its key short-term rate or
rates.
Yet there is still a third, unconventional instrument of
which central bankers have made very different or no use of
at all. It has sometimes been called a central bank's open-
mouth policy. Mr. Greenspan is definitely the world's one
central banker who has practiced this extraordinary tool
with unusual abundance and aggressiveness. He, apparently,
regards it as perfectly legitimate for a central banker to
bend expectations in the economy and the markets in a
direction he wants.
During America's boom and bubble years, Greenspan was
effectively the most prominent and also the most pronounced
New Era Apostle. In various speeches, he developed
arguments or"theories" plainly rationalizing and fanning
the euphoria in the stock market.
In his famous Boca Raton, Fla., speech on Oct. 28, 1999,
just a few months before the stock market's crash, he
suggested that the unprecedented equity valuations seemed
to be the appropriate response of investors to the
economy's advanced information technology:
"The rise in the availability of real-time information has
reduced the uncertainties and thereby lowered the variances
that we employ to guide portfolio decisions. At least part
of the observed fall in equity premiums in our economy and
others over the past years does not appear to be the result
of ephemeral changes in perceptions. It is presumably the
result of a permanent technology-driven increase in
information availability, which by definition reduces
uncertainty and therefore risk premiums. The decline is
most evident in equity risk premiums.
"But how long can we expect this remarkable period of
innovation to continue? Many, if not most, of you will
argue it is still in its early stages. Lou Gerstner (IBM)
testified before Congress a few months ago that we are only
five years into a thirty-year cycle of technological
change. I have no reason to dispute that."
Having learned nothing from his past blunders, Mr.
Greenspan is at it again. To quote Fed mandarin Vincent
Reinhart:"The Federal Reserve has always appreciated the
importance of correctly aligning market expectations."
Putting it rather more bluntly, the Fed endeavors"to
manipulate market expectations in the direction that the
Fed desires."
During the late 1990s, Mr. Greenspan was keen to foster the
stock market bubble by aggressively manipulating both
market rates and market perceptions. After the equity crash
of 2000, he has become keen to foster the three new bubbles
he kindled in fighting the burst of the stock market bubble
- the house price bubble, the mortgage refinancing bubble
and the bond bubble.
Together, these bubbles are plainly indispensable for
maintaining some zip in consumer spending.
But among the three bubbles, one is of crucial importance
because it drives the other two. That is the (now hard-
pressed) bond bubble. Refinancing activity tends to pick up
significantly whenever mortgage rates drop below previous
lows. Importantly, Treasury yields guide the movements of
mortgage rates. In essence, it was the sharp drop of
Treasury yields over the past two years that led the
simultaneous, steep decline of mortgage rates. The recent,
renewed sharp drop in Treasury yields gave mortgage
refinancing another strong boost.
Within barely six weeks, 10-year Treasury yields plunged
from close to 4% to close to 3%. In sympathy, mortgage
rates fell to 5.21%, the lowest rate in more than four
decades.
The astonishing thing about this sudden decline in market
interest rates was that it happened at a time when the
stock market was, on the contrary, being carried upward by
spreading hopes for the economy's imminent recovery. What
happened to make this new, sharp decline of longer-term
interest rates possible?
In its May 29 editorial, The Wall Street Journal praised
the Fed chairman for his wily gamesmanship."Merely by
talking about deflation, he's made the markets anticipate
easier money; long-term interest rates have fallen
accordingly, helping to keep housing prices afloat and to
spur one more round of home mortgage-refinancing. This in
turn feeds consumer confidence and helps keep the post-
bubble economy growing. As a monetary gambit, uttering the
word deflation has so far been a great tactical success. We
suppose that's worth the price of scaring people about an
economic threat that isn't very likely."
In short, being assured by Mr. Greenspan and other Fed
members that there would be no interest rate hike as far as
the eye can see, investors and speculators, desperately
hungry for big profits, stampeded into heavily leveraged
bond purchases, giving through the sliding yield a new
strong boost to mortgage refinancing.
Closer to the truth: In the guise of worrying about the
evil of deflation, Mr. Greenspan signaled to the
marketplace his determination to accommodate unlimited
leveraged bond purchases. Investors and speculators
complied with enthusiasm, giving long-term rates another
sharp downward tick. Implicitly, in a country with negative
national savings, any decline in market interest rates can
only come from financial leveraging.
In this way, the last bit of restraint on financial
leverage and speculative excess in the markets was
effectively removed. Endless liquidity is available for the
taking by the speculating financial community. The obvious
result is a credit and bond bubble that meanwhile has
vastly outpaced the excesses of the equity bubble.
The fundamental dilemma today is that - by every method
available - the Greenspan Fed and Wall Street are making
desperate efforts to sustain unsustainable bubbles. Of
these, the belabored bond bubble is now our greatest fear.
Its influences have pervaded the whole economy and the
whole financial system, and its bursting may have
apocalyptic consequences.
Regards,
Kurt Richebächer
for the Daily Reckoning
P.S. Nobody questions the need for action. But it should be
clear that easy money can only be the cure for tight money,
not for any other causes depressing the economy. For us,
the real and disturbing story about the U.S. economy is
that with all its imbalances it has reached the stage where
it requires permanent, massive monetary and fiscal stimulus
to garner just a tepid economic response - and to prevent
the various bubbles from deflating. All this is definitely
not prone to create a healthy economy being capable of
self-sustaining growth.
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