-->A Most Savage Credit Crunch

The Daily Reckoning

Milford, Nova Scotia

Tuesday, July 06, 2004

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*** U.S. wages losing ground...while inflation gains...

*** A pretty Penny...the streets are paved with...copper!

*** F***! American movies...George Gilder...the Giant Hedge
Fund and more!

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Oh reader, dear reader...

Once again, we stopped dead in our tracks and gasped for
air. The whole thing is a fraud we keep yelling. American
capitalism - like its democracy - has become corrupt,
degenerate, and enfeebled. But we are a lone voice lost in
a vast wilderness of up-to-the-minute information and
crackpot optimism.

And yet, there is the evidence, right there on the front
page."U.S. wages losing ground," says the Rocky Mountain
News. The story is simple enough - simple enough even for
an economist to understand. Wages rose 2.2% in the 12
months to the end of May. Inflation - CPI inflation, the
kind that makes things more expensive for the people
earning wage income - rose 3.1%.

We will do the math later. For the moment, we will just
note that 2.2% is nearly 1% less than 3.1%. Ergo, the
American wage-earner...the great broad back upon which the
entire world economy now rests...got poorer.

Doesn't anyone think it a little odd? We mean, this was a
'recovery' year. In every previous recovery, wages rose
sharply. In this 'recovery' they are going down.

Of course, the inference is obvious: this recovery is like
no previous recovery. It is like a duck that can't swim...a
giraffe without a long neck...a democrat with a brain or a
tax-collector with a heart. In short, it is not what it
pretends to be. It is not a recovery at all.

What's more, the U.S. economy is supposed to be the most
dynamic in the world. It is supposed to be making both the
proletariat and the capitalists rich. But neither group is
getting rich. Investors have gotten no capital gains for
the last 6 years. And dividends? Don't make us laugh.

And the great American jobs machine stalled out 3 decades
ago. Since then, the typical wage-earning man has seen
almost no swelling in his pay envelope. More recently, the
Bush administration has watched over the loss of 1.5
million jobs. The job loss in manufacturing was much
greater - 2.9 million. But enough greeters at Wal-Mart were
hired to offset about half of them.

William Niskanen, an economist whose name was heard often
during the Reagan years, guesses that falling real wages
will be a fact of life in America for the next 5 to 10
years. What happens after that, he didn't say.

On the second day of our visit to America we left it. We
took the ferry to Canada... more 'A Family of Euro-Snobs
Rediscovers America,' below...after the news:

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Tom Dyson, from the Monumental City, reminiscing on the 4th
of July...

- Your editor noticed a coin on the floor of the bar. It
was at the foot of a beautiful woman. We were celebrating
our independence and enjoying the firework display in the
inner harbor area of Baltimore. A dirty, beer-soaked floor
wasn't going to stop your editor from picking up the coin;
it was a quarter.

- We always pick up coins from the street. It's not that we
have either expensive tastes or insufficient funds, we
don't. And nor are we tight-fisted...it's more a force of
habit and superstition.

- The attractive woman noticed your editor scratching
around on the floor for the coin."Why did you do that?"
she asked, in no uncertain terms, as your editor stood up
beside her. She couldn't understand why one would pick up a
coin. We couldn't understand why one wouldn't.

-"I'm saving up," your Baltimore-based British editor
lied."I have both expensive tastes and insufficient
funds."

- Here in the U.S.A., we find ourselves stooping down to
the pavement frequently. In fact, so many pennies litter
the streets that sometimes we don't even have time to pick
them all up. Rarely can we make it from one corner to the
next without pausing to pick up a piece of the government's
copper. It never used to be like that.

- The reason is straightforward; give the world's most
wasteful people the world's most rapidly inflating currency
and you'll get streets paved with copper...they used to be
paved with gold.

- But the era of cheap money is over. And we think it
unlikely the Federal Reserve is tempted to reinstate it
just yet. Mr. Greenspan waited four years to move rates up,
rather than down. The Great Enabler will need to see a
whole slew of terrible date before reversing course now.

- Last Wednesday, the Fed's short-term rate rose to 1.25%
from 1% - the famous 'emergency' level in search of an
emergency. But what's this? On Friday, the emergency showed
up - two days too late - when the U.S. Labor Department
reported that fewer than half the expected jobs were added
in June. Only 112,000 payroll jobs showed up versus the
250,000 anticipated. April and May's figures were revised
down too. In total, the world's largest single economy
produced 173,000 fewer new jobs this spring than was hoped.

- But this is the problem. Using rock-bottom interest rates
when the economy is supposedly growing and all the news and
sentiment is positive is a very dangerous tactic. Good news
inevitably changes to bad, and when it does, there won't be
any tonic left. The Fed has backed itself into a tight
corner. What transpires from here will be very
interesting...especially if you own large chunks of U.S.
equities.

- Even as Wall Street traders hurried into their sports
jackets and headed out the door for the long Independence
Day weekend, they pushed the Dow down 51 points on Friday.
It closed at 10,282 - some 89 points off for the week. Tech
investors got whacked too, as the sell-off knocked the
Nasdaq down another 0.5%...on top of Thursday's 1.6%
fall...to end Friday at 2,006 - nearly 20 points off for
the week.

- The U.S. markets were closed yesterday for the holiday
weekend. As a result, trade in Europe was thin...the
bourses scarcely budged. The dollar was steady too after
Friday's currency-carnage, as was gold. After the jobs
report came out on Friday, the dollar dropped over a cent
and a half against both the euro and the pound. The dollar
now floats around $1.23 and $1.83 respectively. Gold
remains just shy of $400 and was virtually unchanged in
yesterday's trade.

- Sooner or later, Mr. Market is going to notice all the
pennies lying around. But he won't pick them up, not Mr.
Market; he'll dump them for gold. As for your editor, well,
he'll probably keep picking them up - the attractive woman
in the bar gave him her phone number...

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Bill Bonner, back in Nova Scotia...

*** From the Economist:

"The greenback has begun to slide again, while gold has
staged a comeback to $400 an ounce. Since mid-May, the
dollar has fallen by 4% on a trade-weighted basis. On the
face of it, this seems peculiar. The dollar has started to
fall again even as the chatter about interest-rate rises
has got louder. Naively, you might expect a currency whose
interest rates are about to rise to go up, not down. One
explanation why the reverse has been the case is that the
Fed has been late in stamping on inflationary pressures, so
real interest rates, rates adjusted for inflation, are
falling even as nominal rates are expected to rise. There
might, however, be another explanation: that rising rates
will make an already awful current-account deficit worse
still, and that markets are again starting to realise that
the only way in which this can be corrected in the long-
term is by a sharply lower dollar."

America has become a 'giant hedge fund,' says Jim O'Neill,
chief economist at Goldman Sachs. Even though the dollar
fell from its high of Feb. '02, the trade deficit got
worse. That's not supposed to happen. A falling dollar was
supposed to make foreign-made goods more expensive.
Americans were supposed to buy fewer of them. The trade
deficit was supposed to shrink.

Instead, the trade deficit hit a new record of nearly $50
billion in the month of April. Why? Because America is such
a great place to invest, say Gilder and Kudlow. Don't worry
about it!

But Americans themselves find that it is better to invest
outside the U.S. While the Dow goes nowhere...and U.S.
bonds provide the lowest yields in four decades, foreign
markets give American investors a chance to make some
money. In the first quarter, for example, foreign direct
investment into the U.S. provided a return on investment of
only 5.5%. Investment by American firms outside the U.S. on
the other hand returned more than twice as much - 11.7%.

This encourages large American investors to act like hedge
funds - they borrow at low U.S. rates and put the money
overseas for higher returns. And thus has the whole country
comes to resemble a risk-taking hedge fund, without the
hedge. Americans, consumers as well as investors, borrow
short at Greenspan's giveaway rates and using the loot to
buy foreign investments as well as foreign-made goods. And
the whole shebang is underwritten by central bankers - Mr.
Greenspan on one hand, with his 'emergency' low rates...and
foreign central bankers on the other, who recycle their
countries' trade surpluses buy buying U.S. Treasury debt.

Again, we stop in our tracks and gasp for air. Sell the
dollar. Buy gold. Who knows how this 'giant hedge fund' is
going to do...but we don't want to have our money in it
when it does it.

***"Kerry is a mediocrity. He is a typical senator who
votes for the moment. He isn't a statesman."

"...if Kerry is elected, the doctrinaire Republicans will
sell stocks for a day or two, but then the market will go
up considerably."

- Seth Glickenhaus, the 90-year-old proprietor of
Glickenhaus & Co., the $1 billion Manhattan-based money
management firm, in a Barron's interview, June 7, 2004.

*** Homeland Bound

"F***!"

"It's unbelievable," said Elizabeth. She had spent much of
the 8 hours of flight time between Paris and Newark
catching up on American movies.

"It's amazing how coarse and vulgar these movies are. I
don't think I've heard the f-word so many times in my
entire life. I don't remember people saying the word so
casually. And in the movies, it's not the bad guys who use
the word, it's the good guys. They use it as if to mean
that they are serious - they don't have time to be polite
or delicate.

"In that one movie I watched, I don't remember the name,
but it was about some police who were trying to figure out
what had happened to a girl who had been kidnapped from
Harvard. She was the president's daughter, or something.
And it looked like an evil band of terrorists were behind
it. But the police beat people up and killed several bad
guys...and said 'f***' to one another all the time. It was
as if they thought their work was so important, they
couldn't be bothered to be nice."

"Well, maybe the word has lost its meaning," her husband
suggested."The language has evolved. It just doesn't have
the same shock value you remember from your childhood. It's
no longer a verb. It's just punctuation. You know, people
say...'So good to see you. F***. Have a nice day. F***."

"That's what I thought, but then I saw another movie in
which a woman said she had 'f***ed' someone last night. I
was shocked. This was on a family airplane. But no one
seemed to take offense."

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The Daily Reckoning PRESENTS:"Greenspan has lured America
into a horrible liquidity trap." Says The Good Doctor. From
this point, an orderly unwinding is simply not possible.
The explanation follows...


A MOST SAVAGE CREDIT CRUNCH
by Dr. Kurt Richebächer

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.


Regards,

Dr. Kurt Richebächer
for The Daily Reckoning