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THE INTEREST RATE CONUNDRUM, Part 2
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|Subject: THE INTEREST RATE CONUNDRUM, Part 2 Thu 14 Jun - 23:19|| |
By Henry C K Liu
In today's financial world, a liquidity boom produces rising nominal or face value in return on investment (ROI) with an increasingly hollow economy in two ways:
(1) by devaluing all currencies against real assets and (2) by keeping down
wages and worker benefits around the globe.
Thus while all currencies devalue steadily but not at the same pace, all of
them devalue faster against real assets and slower against labor cost, because wage adjustments tend to lag behind both real and nominal inflation rates. This translates directly into low real valuation for labor, structurally constraining growth of demand to fall behind growth of supply. This in turn leads to an overcapacity economy of declining consumer purchasing power. Neo-classical economists call this the business cycle, which Keynesians assert must be countered with demand management through full employment supported by deficit financing.
The laws of overcapacity
The first law of overcapacity is that it is deflationary (falling market prices
of assets), which in turn requires falling wages to maintain corporate
earnings. The second law of overcapacity is that it discourages new plant
expansion, so that existing capital assets appreciate in market value in
nominal terms as liquidity increases, causing the stock markets to rise even
though their economic value remains stagnant.
But the laws of overcapacity naturally lead to a downward economic spiral that ends in depression. Moreover, socio-political stability requires nominal wages to continue to rise above inflation. Thus the convenient monetarist solution is to allow stealthy but real devaluation of currencies against real assets, but with a slower devaluation rate against the value of labor.
The global regime of declining currency value is one that will lead to a new
form of slavery, despite a rise in living standards from higher labor
productivity and resource utilization as a result of technological progress.
Universal currency devaluation is masked by an exchange-rate regime in which currencies rise and fall unevenly against one another around the benchmark US dollar as the prime reserve currency, while all currencies fall against hard assets in unison but at different rates due to varying local conditions. The uneven rates of currency devaluation present windows of profit opportunity for arbitrageurs in the global foreign-exchange and financial markets. A network of interlocking asset bubbles then grows around the world as a result of dollar hegemony and the emergence of deregulated global currency and financial markets, jumping over national borders, fueled by a general devaluation of all currencies while the trading public is distracted to focus on the relative exchange value of one currency against another.
Thus while both the US dollar and the euro steadily fall, Europeans are
comforted by seeing their currency rise against the dollar in recent years when in fact the euro has merely been temporarily falling at a slower rate than the dollar. As the dollar, the prime benchmark reserve currency for trade and finance, devalues against assets, the exchange-rate regime in the current international finance architecture will eventually drag all currencies down with the dollar, lest the trading partners of the United States find themselves saddled with trade penalties associated with inoperative exchange rates.
A confused public
The general public is further confused by uncertainty about whether a rising
currency is good or bad for them. They are told to rejoice when their currency falls, as the goods they produce will sell in larger quantity because they can be bought with less money by foreigners, even their own income per unit of production will fall and they themselves will be crowded out of restaurants and shops in their own home towns by suddenly richer foreign tourists.
Ironically, while any normal citizen should find the prospect of receiving less
money for the same amount of product he or she produces unappetizing,
policymakers insist that there is no alternative systemically. In the meantime, the rich get richer from declining wages worldwide.
All the economies of the world are competing in global markets by pushing their domestic wages and worker benefits down in search of globalized
"growth". The global market has turned into an arena for universal
voluntary slavery to serve global capital.
Wicksell's ideas obsolete
Swedish economist Johan Gustaf Knut Wicksell's idea of fighting inflation by
pegging interest rates to ROI, operative under industrial capitalism, is
problematic in finance capitalism because of the emergence of structured
finance in which the traditional discounted rate of return for industrial
investment tends to be overwhelmed by astronomical returns from financial
manipulation routinely expected of hedge funds and private-equity firms.
To fight stealth inflation from currency devaluation, Wicksell's notion of
pegging interest rates to ROI in structured finance would set interest rates so high as to make the sky-high rate of 19.93% under former US Federal Reserve chairman Paul Volcker pegged to money supply look tame.
Further, in Wicksell's time (he died in 1926 at the age of 74), there were no
exchange-rate issues as there was no foreign-exchange market, since the reserve currency was based on the gold standard, with other currencies adopting fixed exchange rates against it. Cross-border movement of funds was strictly regulated, and currency accounts between trading nations were settled in gold regularly through adjustment of national accounts in the Bank of International Settlement.
Back then, domestic interest rates had no direct immediate effect on the
exchange value of a country's currency. Today, domestic interest rates do have a bearing on currency exchange rates, albeit increasingly less directly. High domestic interest rates will push a currency's exchange rate upward, hurting a country's current-account balance and worsening domestic inflation, even though this relationship is increasingly obscured by the decoupling of nominal interest rates from the real interest rate and the decoupling of exchange rates between currencies from the real value of all currencies as derivative of a fiat dollar as the main reserve currency.
The lessons of 1987
The 1987 stock-market crash was unleashed by the sudden collapse of the safety dam of portfolio insurance, a hedging strategy made possible by the new option pricing theory advanced by Nobel laureates Robert C Merton and Myron S Scholes.
Institutional investors found it possible to manage risk better by protecting
their portfolios from unexpected losses with positions in stock-index futures. Any fall in stock prices could be compensated by selling futures bought when stock prices were higher.
This strategy, while operative for each individual portfolio, actually caused
the entire market to collapse from the dynamics of automatic herd-selling of
futures. Investors could afford to take greater risks in rising markets because portfolio insurance offered a disciplined way of avoiding risk in declines, albeit only individually. As some portfolio insurers sold and market prices fell precipitously, the computer programs of other insurers then triggered further sales, causing further declines that in turn caused the first group of insurers to sell even more stock and so on, in a high-speed downward spiral. This in turn generated other sell orders from the same sources, and the market experienced a computer-generated meltdown.
The 1987 crash provided clear empirical evidence of the structural flaw in
market fundamentalism, which is the belief that the optimum common welfare is only achievable through a market equilibrium created by the effect of countless individual decisions of all market participants each seeking to maximize his own private gain, and that such market equilibrium should not be distorted by any collective measures in the name of the common good.
Aggregate individual decisions and actions in unorganized unison can and often do turn into systemic crises that are detrimental to the common good. Unregulated free markets can quickly become failed markets. Markets do not simply grow naturally after a spring rain. Markets are artificial constructs designed collectively by key participants who agree to play by certain rules. All markets are planned with the aim of eliminating any characteristic of being free for all operations. The free market is as much a fantasy as free love.
In response to the 1987 crash, the US Federal Reserve under its newly installed chairman, Alan Greenspan, with merely nine weeks in the powerful office, immediately flooded the banking system with new reserves, by having the Fed Open Market Committee (FOMC) buy massive quantities of government securities from the market. He announced the day after the crash that the Fed would "serve as a source of liquidity to support the economic and financial system". Greenspan created US$12 billion of new bank reserves by buying up government securities from the market, the proceeds from which would enter the banking system.
The $12 billion injection of "high-power money" in one day caused the
Fed Funds Rate (FFR) to fall by 75 basis points and halted the financial panic, though it did not cure the financial problem, which caused the US economy to plunge into a recession that persisted for five subsequent years.
High-power money injected into the banking system enables banks to create more bank money through multiple credit-recycling, lending repeatedly the same funds minus the amount of required bank reserves at each turn. At a 10% reserve requirement, $12 billion of new high-power money could generate in theory up to $120 billion of new bank money in the form of recycled bank loans from new deposits from borrowers.
The Brady Commission investigation of the 1987 crash showed that on October 19, 1987, portfolio insurance trades in S&P 500 Index futures and New York Exchange stocks that crashed the market amounted to only $6 billion by a few large traders, out of a market trading total of $42 billion. The Fed's liquidity injection of $120 billion was three times the market trading total and 20 times the trades executed by portfolio insurance.
Yet post-mortem analyses of the 1987 crash suggest that though portfolio
insurance strategies were designed to be interest-rate-neutral, the declining FFR was actually causing financial firms that used these strategies to lose money from exchange-rate effects. The belated awareness of this effect caused many institutions that had not understood the full dynamics of the strategies to shut down their previously highly profitable bond arbitrage units. This move later led to the migratory birth of new, stand-alone hedge funds such as Long Term Capital Management (LTCM), which continued to apply similar highly leveraged strategies for spectacular trading profit of more than 70% returns on equity that eventual led it to the edge of bankruptcy when Russia unexpectedly defaulted on its dollar bonds in the summer of 1998. The Fed had to orchestrate a private-sector creditor bailout of LTCM to limit systemic damage to the financial markets. The net effect was to extend the liquidity bubble further - it migrated from distressed sector to healthy sector.
The 1987 crash reflected a stock-market bubble burst the liquidity cure for
which led to a property bubble that, when it also burst, in turn caused the
savings-and-loan (S&L) crisis.
The Financial Institutions Reform Recovery and Enforcement Act (FIRREA) was enacted by the US Congress in August 1989 to bail out the wayward thrift industry in the S&L crisis by creating the Resolution Trust Corp (RTC) to take over failed savings banks and disposed of their distressed assets at
fire-sale prices. The Federal Reserve reacted to the S&L crisis with a
further massive injection of liquidity into the commercial banking system,
lowering the FFR from its high of 9.86% reached on May 10, 1989, to 3% on
September 4, 1992, making the real rate near zero until February 4, 1994.
It was too late to help president George H W Bush in his bid for a second term in the election of November 1992, but it gave the era of his successor, Bill Clinton, a liquidity boom. Since there were few assets worth investing in a down market plagued by overcapacity, most of the new money went into relatively low-yield bonds. This resulted in a bond bubble by 1993, which then burst in 1994 when the Fed finally started to raise the short-term rate, which reached 6% on February 1, 1995.
By 1994, Greenspan was already riding on the back of a debt tiger from which he could not dismount without being devoured by it. The Dow Jones Industrial Average (DJIA) was below 4,000 in 1994 and rose steadily to a bubble of near 12,000 by 2000, a 300% rise, while Greenspan raised the FFR seven times from 3% to 6% between February 4, 1994, and February 1, 1995, a 100% rise, to try to curb "irrational exuberance" in the stock market, and kept it above 5% until October 15, 1998, after contagion from the 1997 Asian financial crisis hit Wall Street, when the Fed reversed course on interest rates.
By the mid-1990s, excess liquidity had fueled a worldwide equity rally that
found its way into the Asian emerging markets, where it fed an unprecedented bubble of easy money in the form of undervalued currencies pegged to a falling US dollar. When the Asian emerging-market bubble crashed abruptly on July 2, 1997, as the Thai central bank suddenly ran out of foreign-exchange reserves in a matter of days trying to maintain its unsustainable currency peg, followed by the Russian debt crisis in 1998, all the major central banks of the world reacted yet again by pumping even more liquidity into the global banking system, exacerbating a new wave of global decline in currency value.
During this period, the US dollar never rose in real value, although its
exchange rate with Asian currencies rose because those currencies were falling in value faster than the dollar was.
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Confusing money with wealth
Money itself is not wealth, only a generally accepted measuring unit of wealth.
Liquidity, the flooding of the financial system with money, does not
necessarily add wealth. Liquidity accelerates financial transactions that can
create or destroy wealth depending on the terms of exchange.
In the days of industrial capitalism, wealth was created by the creation of
productive hard assets, while in finance capitalism, wealth is created only by
earnings. Whereas wealth is increased by more production in industrial
capitalism, earnings in finance capitalism increase only money income, which
only adds wealth if the purchasing power of money does not decline. When asset
prices rise without real expansion of the purchasing power of earnings, money
is simply devalued, while the nominal value of assets increases as real wealth
remains stagnant or even declines.
Initially, this flood of money that began in 1994 inflated another bond bubble,
which popped viciously in 1999. Then, more liquidity released by the Fed
boosted equity prices further and provided the fuel for the enormous tech-stock
bubble of 1999 and early 2000.
The first three years of the 21st century saw a worldwide equity-market crash
followed by a recession plagued by global overcapacity, over-indebtedness, and
over-leveraging. And the response of central banks was always more liquidity
through low interest rates in relation to return on capital, which helped pump
up the bond bubble in 2003 and supported artificial rallies in housing prices,
equities, commodity prices, higher corporate debt without changing debt/equity
ratios, and mushrooming emerging markets, particularly China. Fools were
calling it a US-led recovery.
A bubble within a bubble
Once the genie of excess liquidity is out of the bottle, it is almost
inevitable that a bigger genie will have to be let out of a bigger bottle to
keep the ongoing bubble from bursting, to avoid the nasty consequences of a
burst bubble for the financial system and the real economy.
Central banks around the world, led by the US Federal Reserve, despite their
pivotal role in helping to create financial bubbles, nevertheless declare that
bubbles cannot be anticipated and nothing can be done to prevent them. But
central bankers comfort markets by claiming magical power to handle the
destructive consequences of bubbles, through a one-note monetary policy of
short-term rate cuts to inject fresh liquidity, to save a bursting bubble by
creating a bigger bubble. With structured finance, bubbles can be created by
endogenous liquidity, and bubbles about to burst are expected by be rescued by
And even if central banks react to asset bubbles by raising short-term interest
rates, the extent of the rate hikes needed to reverse asset prices in times of
exuberance may be so large as to destabilize the real economy worse than a
bubble burst would. This view is supported by the experience Greenspan had in
his battle against "irrational exuberance".
While declaring that central banks cannot prevent bubbles, the Fed has admitted
more than once that it sees as one of the roles of a central bank the support
of the market value of financial assets, however inflated. Instead of being the
guardian against moral hazard, the Fed has become the promoter of moral hazard.
A market anomaly is thus created in which equity prices rise in response to
what normally would be considered bad news for the real economy, such as
falling home sales, because the market then expects the Fed will lower
short-term rates, causing equity prices to rise, even though home mortgage
rates are tied to 10-year Treasuries rates. Conversely, equity prices can fall
in response to what normally would be considered good economic news such as
rising home sales because causes the Fed to raise short-term rates, which
really do not have any direct connection to home finance. This is because the
market knows that in a bubble about to burst, good news of further expansion is
US financial assets have been built not only on debt, but on debt recycled at
high velocity. It is a form of turbo-debt, in which one dollar of debt can act
as equity to finance more than $100 of credit through sequential leveraged
financing and leveraged securitization. Borrowers in turn become lenders, who
themselves lend borrowed money. Massive financial energy is released through
chain reaction of a tiny amount of equity.
Debt is not intrinsically objectionable if it is adequately collateralized by
real assets, and the proceeds are invested to increase real national income
above what is needed to service the debt. But turbo-debt by definition is
generated by practically no equity. And if debt is serviced mostly by the
wealth effect of debt-propelled asset appreciation, a bubble is in the making.
So-called air-ball financing enabled the telecom bubble of the 1990s, when it
was widely used in financing telecommunications expansion in the 1990s.
Air-ball financing involves the use of unrealistically anticipated future
earnings as collateral for financing overinvestments in hope of generating
A housing bubble exists because houses are being financed and refinanced by
full-value mortgages collateralized only by the anticipated continuing rise in
home prices. A liquidity boom generates asset bubbles because liquidity is not
wealth, only an illusion of wealth. And the rise in asset prices beyond the
growth of gross domestic product is really a decline in currency value. A
market rise of 40% against a GDP growth of 3% translates into a currency
depreciation of 37% in a year.
Blurred distinction between debt and equity
The pervasive securitization of debt accompanied by a complex network of
hedging blurs the all-important dividing line between debtor and creditor, and
allows an economy to borrow from itself, not just against its future, but
against its current and less sophisticated debt, not for productive investment
to generate real wealth, but for financial manipulation to achieve virtual
The use of debt as collateral for more sophisticated debt has characteristics
of a bubble. The broad unbundling of risk to maximize transactional surplus
(profit) ultimately leads to the socialization of risk (transferring unit risk into
systemic risk), while the privatization of the resultant profit remains a
sacred prerequisite. This maldistribution of virtual wealth exacerbates both
the risk and the effect of a bubble by making a bubble inside a bubble.
The Bank of International Settlement's Lamfalussy Report defines systemic risk
as "the risk that the illiquidity or failure of one institution, and its
resulting inability to meet its obligations when due, will lead to the
illiquidity or failure of other institutions". The prospect of systemic
risk becomes commonplace when lenders are also borrowers who depend on the
return of the funds they lent to pay for the sums they borrowed.
Risk of illiquidity, not any drop in demand for goods or loans, is the
improvised explosive device (IED) of financial terrorism that puts in harm's
way unsuspecting investors running a relay race on the debt-securitization
Whether or when a bubble will burst depends on the central bank's ability to
extend the bubble's elasticity, which is not unlimited, albeit flexible through
inventive redefinitions of theoretical relationships and the cause-effect
paradigm. To support the market, a central bank needs increasingly to
intervene, which in turn destroys the market.
As is already apparent, the US Federal Reserve is increasingly reduced to an
irrelevant role of rationalizing the virtual finance economy rather than
directing it. It has adopted the role of a cleanup crew rather than the
guardian of public financial health.
Ironically, a cure for a debt bubble can come from a bloodletting through asset
hyperinflation, euphemistically called "unlocking value". In that
scenario, the traditional strategy of holding cash gives no protection, because
real currency value can fall faster than nominal asset-price depreciation. Such
hyperinflation has brought down many governments and socioeconomic systems in
In a financial bubble, the real economy may not be growing, but the monetary
value of financial assets rises, and is defined as growth, not inflation. Thus
we have robust "recoveries" that continue to lose jobs, with the
value of money protected by high unemployment and stagnant income from wages.
Or we can have a recovery with low unemployment with rising nominal income that
is accompanied by a decline in real aggregate income, with wages falling behind
In the finance sector, wealth is created by escalating systemic risk-taking,
known as the "Greenspan put". Inflation and deflation have become two
sides of the same coin that alternate as monetary concerns in a matter of
months, through a highly manipulated global foreign-exchange market that tends
to destabilize real economies via a multitude of conduits such as wealth
effects, balance-sheet effects, and recurring alternates of credit excesses and
crunches and liquidity booms and busts.
Central banks seldom adjust their monetary policies to arrest asset bubbles and
related imbalances and instabilities. The days of the central banker being the
spoiler who takes away the punch bowl when the party gets going are long gone.
Central bankers now bring stronger drinks when the party slows.
While central banks still cling to the mandatory task of fighting inflation,
they never try to reverse inflation by allowing deflation. Thus any battle lost
against insipid inflation is a battle lost forever, with no prospect of ever
regaining lost ground. Therefore among market participants, bulls enjoy the
advantage of having the wind of inflation behind them even in a continuous bear
Inflation targeting becomes labor targeting
In the United States, the Fed has served notice that it is prepared to move toward
inflation targeting to prevent deflation, as suggested by then board member Ben
Bernanke, now Fed chairman.
Prices of assets can only go up but are never allowed to fall, even to adjust
previous irrational exuberance. Trapped by their own doctrinaire fixation,
central banks will continue to provide excess liquidity to support asset-price
bubbles, and to mask the destructiveness of burst bubbles by unleashing new
bubbles with more liquidity, euphemistically known as recoveries.
At the same time, central banks will vehemently fight inflation as measured by
rising wages. Thus central banking operates with a severe institutional bias
In fact, market volatility, another term for shot-term instability, in the
financial sector of the economy has become a major source of profit for
financial institutions. Long-term investors are endangered species in the
financial world; most market participants have become leveraged traders for
short-term profit, even pension funds and university endowment funds. The only
factor of production that maintains any semblance of stability is wages.
The recurring financial crises around the world shared similar characteristics.
Each crisis was largely unanticipated by market analysts and central-bank
economists, with the forward markets providing no indication of the impending
Going into each crisis, complacent traders took on highly leveraged long
positions in currencies, bonds, or spread products that soon came under heavy
speculative counterattack. In each case, traders adopted trading models
constructed from historical paradigms to guide their trading strategies. When a
decisive majority of traders followed similar trading strategies, the market
would overshoot from technical pressure, and conventional wisdom became
disconnected with reality. But once a crisis hit and conventional wisdom was
discredited by facts, traders rushed to liquidate their highly leveraged
positions en masse, hoping for a timely exit before the crowd.
In each instance, the rush to unwind highly leveraged positions accentuated the
magnitude of the currency or fixed-income crises.
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|Subject: Re: THE INTEREST RATE CONUNDRUM, Part 2 Thu 14 Jun - 23:20|| |
Exchange rates and purchasing power parity
Theoretically, exchange rates adjust to achieve purchasing power parity (PPP) between two
currencies. PPP is achieved when a unit of domestic currency can purchase the
same quantity of goods in another economy when converted to foreign currency at
the prevailing exchange rate, to conform to the law of one price.
If PPP holds, then identical baskets of goods should sell for the same price in
each economy after exchange-rate conversion. If they do not, then opportunities
for "risk-free profits" will exist through arbitrage in
foreign-exchange markets that translates into massive flows of funds across
national borders. Eventually, price arbitrage will set a market exchange rate,
or the prices of goods in the two economies will change so that PPP between the
two currencies is re-established. With deregulated global capital markets,
prices of assets also adjust toward convergence of PPP between two currencies
to cause market crashes.
In adjusting, the market tends to overshoot up or down like the swing of a
pendulum until equilibrium sets in. But if the overshoot is boosted each time
by speculative forces, then the swings of the pendulum will never reach
The dollar-exchange-rate overshoots of 1985 and 1995, similar to the 1994
global bear market in bonds, proved to be transitory events. But while the
dollar-crisis episodes represented dramatic overshoots at major turning points
in the dollar's long-term trend of decline, the 1994 global bond market selloff
in hindsight seemed to be simply an interruption of a long-term rally in global
bonds, although substantial losses were incurred during the selloff. This was
because the Fed used a bigger bubble to cushion the collapsing bond bubble,
keeping interest rates low, causing nominal bond prices to rise, while in fact
the real value of bonds might have declined.
The lessons of 1994
It is instructive to analyze the situation in 1994 because the data and dynamics are
by now indisputable.
Going into 1994, many highly leveraged fund managers had taken on huge
long-duration positions in several key markets after riding the 1993 global
bull market in bonds created by historically low interest rates, and thought
that additional hefty returns could be achieved in 1994 by maintaining those
highly leveraged long positions. But they evidently ignored the fact that
leading indicators of global economic activity were already turning up strongly
from the long period of monetary ease accompanied by currency devaluation,
making those long positions extremely vulnerable if there should be a shift in
monetary policy toward tightness, meaning rising interest rates.
The US Federal Reserve's rate hike from its low of 1% that began on June 30,
1994, that eventually reached the current 5.25% on June 29, 2006, was the
catalyst for traders to unwind their highly leveraged long positions,
triggering a major selloff in bond markets around the globe. Global bond yields
rose by 200-300 basis points, or 2-3 percentage points, on average over the
first three quarters of 1994, causing a collapse in bond prices. By the fourth
quarter of 1994, bond yields managed to stabilize and then begin to fall
steadily in 1995, causing a bond-price rebound. By late 1995, bond yields had
returned to their pre-crisis levels.
This pattern of collapse followed by stabilization and then recovery through
stealth inflation was not too dissimilar to the pattern of the dollar's
collapse in early 1995. In both crises, the collapse stagetook place over a three-to-six-month period,
followed by a period of stabilization that lasted about three months and a
recovery period that took place over a three-to-12-month period.
But were these real recoveries, or were they merely the stabilization of uneven
currency devaluation? Could it be that the dollar never did recover, but other
currencies finally caught up with the dollar's collapse? Dollar interest rates
were not rising at a pace demanded by its fall in real purchasing power.
More lessons in 1998
The 1998 credit-spread crisis shares a number of similar features with the 1994
As in the 1994 crisis, fund managers in 1998 once again took on aggressive
highly leveraged long positions, this time in spread products, evidently
believing that credit spreads would continue to narrow. Unfortunately, Russia's
decision on August 26, 1998, to engineer a controlled default on its debt
obligations led to a complete reassessment of credit risk by global investors.
The herd-like rush to exit caused the collapse of the hedge fund LTCM.
Fear that default risk might increase and spread worldwide led to a mad
scramble for liquidity. Quality spreads in the US corporate bond market widened
dramatically and stood at recession levels. Indeed, the yield spread between
Baa corporate bonds and US Treasuries widened to levels not seen since the
1990-91 recession. US corporations became less willing to borrow and therefore
curtailed investment spending, which clearly dampened US growth in subsequent
High-yield spreads are tied to fundamentals such as expected future default
rates. But spreads are also related to market liquidity in ways that are not
yet well understood even by the most seasoned professionals.
Liquidity can disappear quickly
Liquidity, a fundamental concept relating to the quantity of money in monetary
policy, can also be defined in the market as the ability to buy or sell large
quantities of assets quickly and at low discount and cost.
Normally liquid assets can become illiquid in a market meltdown. The vast
majority of equilibrium asset pricing models do not consider the effect of
trading and thus ignore the time and cost of transforming financial assets into
cash or vice versa, particularly in times of distress or exuberance, rational
or irrational. Recent financial crises, however, suggest that, at times, market
conditions can become suddenly severe and liquidity can decline or even
disappear extremely quickly, even overnight or even in the middle of a trading
day. Such liquidity shocks are a potential channel through which asset prices
are influenced, or distorted, by liquidity.
In 1994, the bond market was caught on the wrong side of economic fundamentals
and yanked down with the shifting tide of higher rates at the Fed. But stocks
skated through relatively unscathed, because credit was still available and
investors recognized that the bond market needed an adjustment that more
accurately reflected the central bank's new thinking.
A bond fund's "duration" measures the theoretical impact that one
percentage-point rise in interest rates would have on the net asset value of a
fund. A bond fund with five-year "duration" could be expected to drop
by 5% in value if interest rates rose by 1 percentage point. Conversely, a
1-percentage-point drop in rates would cause a fund with five-year duration to
increase by 5% in value.
To figure total return, changes to net asset value (NAV) should be added or
subtracted from the income generated by the fund. So a bond portfolio with a 3%
yield whose NAV drops 5% would suffer a loss of 2% on a total return basis over
a 12-month period.
Long-term bond funds often have effective durations of at least seven years. In
that case, a rise in long-term interest rates of 2 percentage points over the
next 12 months would cause at least a 14% drop in value. With yields on
long-term Treasury bonds at 5%, such an increase would translate into a loss of
9% or more for fund shareholders - similar to when the Fed tightened monetary
policy in 1994.
To protect against that possibility, investors keep fixed-income money in
short-term corporate bonds, typically with durations of six months or less.
With yields of long bonds below 5%, it would take a 9-percentage-point boost in
short-term interest rates just to push the total return on such funds into the red
over a one-year period. In the current environment of massive overcapacity and
debt, the chances of that happening are about zero. That is why long bonds will
rise as surely as tomorrow's sun.
The lessons of 2003
In July 2003, Federal Reserve officials engaged in damage control after
Greenspan spooked the bond market in congressional testimony by suggesting that
the FFR at 1% might have fallen as low as it would go. Greenspan further
disappointed investors by noting that the Fed was unlikely to engage in
"unconventional" market activities, such as buying long-term
government bonds to drive down long-term rates, which had stayed inverted for
The policy of using interest-rate cuts to pump up demand has been tested to
destruction since 1994. But all policies carry costs. The costs in this case
included most obviously the dangers of pushing down long-term interest rates as
well as short-term to a level that might be unsustainable, and subsequently
reigniting inflationary pressures. In other words, the Federal Reserve was
creating a bond bubble similar to the equity bubble, and then protecting the
equity bubble by creating conditions where that bond bubble would be popped.
But investors that anticipated this scenario were fooled. Long-term rates
stayed low because massive capital inflow came from foreign central banks
operating under dollar hegemony. Bonds rose in 1994 further and faster than at
any stage in the previous four decades, and collapsed in 1996 and again in
Once market participants think the market is turning against bonds through a
rise in interest rates, they are likely to stampede out of bonds, creating a
bond crash similar to the equity crash. Traders hedge their risk exposure in
bonds with compensating positions in interest-rate futures by adopting
immunization strategies by constantly rebalancing price risk with coupon
reinvestment risk, which change in opposite directions.
In the 1950s, the bond market was considered a safe, conservative investment.
At that time a buy-and-hold strategy was sufficient. However, since the 1960s,
inflation has increased, and interest rates have become more volatile. Thus,
with more volatile interest rates, there exists a greater profit potential with
bonds. Also, the Macaulay duration, named after Frederick Macaulay, the
introducer of the concept, being the weighted average maturity of a bond where
the weights are the relative discounted cash flows in each period, came into
use in the 1970s.
Under conditions of a liquidity boom, rising rates lower bond prices as well as
equity prices. That combination is explosive enough, but adding to it the
impotence of rising interest rates to halt the declining value of the dollar,
we have a mixture of deadly financial dynamite that can be detonated by
seemingly unrelated minor developments at unexpected times.
The psychosocial effect of a bond crash on market sentiment is highly damaging.
Market participants and investors have been conditioned to think that lower
returns on bonds are justified by their being less risky than equities. On a
30-year or longer basis, this is a correct view, but not on a three- or
five-year term. Under current market conditions, there exists at least as large
a possibility of 10-year bonds falling by 25% over any 18 months as there is of
shares falling by the same amount. Yet investors in bonds do not have that same
awareness of risk as equity investors, so the consequences could be serious. A
typical portfolio with one-third in bonds will not escape losses in a bear market.
Total return swaps
Total return swaps (TRS) can make short-term dollar loans (liabilities) appear
as portfolio investments. Also, the requirement to meet margin or collateral
calls on derivatives may generate sudden, large foreign-exchange flows that
would not be indicated by the amount of foreign debt and securities in a
nation's balance-of-payments accounts. As a result, the balance-of-payments
accounts no longer serve as well to assess country risk.
Even for the dollar, which is protected by dollar hegemony in which the United
States can print more dollars at will, the long-term consequences of currency
devaluation will cause structural damage to both the economy and investors. In
the event of currency devaluation or a sharp downturn in securities prices,
derivatives such as foreign-exchange forwards and swaps and TRS functioned to
quicken the pace and deepen the impact of the crisis.
Derivatives transactions with emerging-market financial institutions generally
involve strict collateral or margin requirements. Asian firms swapping the TRS
on a local security against LIBOR (London Inter-bank Offer Rate) post US
dollars or Treasury securities as collateral; the rate of collateralization is
estimated at about 20% of the national principal of the swap. If the market
value of the swap position were to decline, then East Asian firms would have to
add to their collateral to bring it up required maintenance level.
Thus a sharp fall in the price of the underlying security, such as would occur
at the beginning of a currency devaluation or broader financial crisis, would
require Asian firms immediately to add dollar assets to their collateral in
proportion to the loss in the present value of their swap position. This would
trigger an immediate outflow of foreign-currency reserves, as local currency
and other assets were exchanged into dollars to meet their collateral
requirements. This would not only quicken the pace of the crisis, it would also
deepen its impact by putting further downward pressure on the exchange rate and
asset prices, thus increasing the losses to the financial sector.
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|Subject: Re: THE INTEREST RATE CONUNDRUM, Part 2 Thu 14 Jun - 23:20|| |
The mergers-and-acquisitions time bomb
In 2006, the dollar volume for merger and acquisition deals was $4 trillion,
which was one-third of US GDP.
Mergers between corporations in theory create value by improving efficiency and
synergy in an overcapacity economy. This is generally achieved by laying off
redundant workers and executives to create a leaner merged company and by
selling off non-core subsidiaries that could be run more profitably by others.
Generally, mergers shrink production and business activities to improve profit
margins and reduce competition. In other words, mergers squeeze financial value
from downsizing the economy.
Acquisitions of public companies by private-equity firms are attempts to create
value by taking public companies private on the theory that public companies
are inherently inefficient because of regulations on corporate governance, such
as the US Sarbine-Oxley Act. By taking public companies private, the new
private owner can restructure the company with greater flexibility out of the
public eye with less disclosure and can resell the restructured company for
high profit within a relatively short time, usually to a public corporate buyer
or through an IPO (initial public offering). The irony is that private-equity
firms are now lining up to sell equity to the public, which is the equivalence
of an anti-prostitution church running a cathouse.
These trends are by definition cyclical, depending of a fragile combination of
abundant cheap money and low price of the target companies and an enabling tax
structure. For example, one of causes of the 1987 crash, aside from the
exchange-rate effects of the Plaza and Louvre Accords, was a threat by the US
House of Representatives Ways and Means Committee to eliminate the tax
deduction for interest expenses incurred in leveraged buyouts. Still another
cause was the 1986 US Tax Act, which while sharply lowering marginal tax rates,
nevertheless raised the capital-gains tax to 28% from 20% and left capital
gains without the protection against inflated gains that indexing would have
provided. This caused investors to sell equities to avoid negative net
after-tax returns and contributed significantly to the 1987 crash.
There were other factors, such as the effect of portfolio insurance on the
futures market, etc. At present, the US federal tax authority, the Internal
Revenue Service (IRS), allows carry fees earned by private-equity firms to be
taxed at a 15% capital-gain rate rather than the 35% ordinary income-tax rate.
A change in that ruling can do havoc to the private-equity sector.
The Wall Street Journal ran a report by William M Bulkeley on June 7 that the
IRS shut a corporate-tax loophole two days after IBM used it on March 29 to
avoid $1.6 billion in US taxes by structuring a $12.5 billion share buyback
through a new subsidiary in the Netherlands. The IRS called the IBM maneuver a
"triangular reorganization", in which the foreign unit spent $1 billion
in cash and $11.5 billion in borrowed funds to buy 188.8 million shares, or 8%
of outstanding, from a group of investment banks what had borrowed the shares
from institutional investors.
The investment banks will buy share in the open market for returning the
borrowed shared over the next nine months and IBM will make whole any losses to
the investment banks if IBM share prices should rise. IBM intends to repay the
loans with earnings from its foreign subsidiaries with tax rates averaging 22%,
substantially below the average US rate of 40%, saving $1.6 billion.
The contradiction, aside from tax avoidance with no business purpose, is that
the transaction gave IBM a reduced incentive to see its share rise in the open
market until the $11.5 billion loans are repaid.
The PPI/CPI spread
Since 2003, the Producer Price Index (PPI) has risen by 16.4% in the US, while
the Consumer Price Index (CPI) is only up 12.5%. This is caused by globalized
trade through cross-border wage arbitrage keeping consumer prices down. CPI is
heavily weighted toward import prices while PPI is weighted toward export
prices. Import prices fall while export prices rise when the dollar rises
against foreign currencies.
Even though exchange rate is only a part of the reasons for the US trade
deficit, Congress has fixated on the idea of forcing China to revalue its
currency upward against the dollar. But a falling dollar causes China's central
bank to demand compensatory higher dollar interest rates for the US sovereign
debt it buys, which in turn slows the US economy.
A higher short-term rate is important in its inflationary effect on CPI because
it drives the rates for much of consumer credit, such as credit-card loans and
auto loans, as well as adjustable home mortgages. The long 10-year bond rate
drives fixed mortgage rates only at the time the mortgage is taken, but rising
long-term rates will depress the price of outstanding long bonds to compensate
for the gap in yields.
A falling dollar will artificially lift overseas profits of US transnational
corporations and in turn lift equity prices while the US domestic economy
stagnates or declines.
Among the objections against globalization, including income inequality and
abuse of workers' rights and the environment, the most serious has been the
devastating recurring destruction brought on by currency-induced financial
crises in developing countries. In the past decade, globalization has also
depressed wages in the advanced economies.
But now the destructiveness of financial globalization is beginning to be
undeniable. Even pro-globalized-trade economists now are forced to acknowledge
cross-border capital flows as the Fifth Horseman of the Apocalypse of financial
globalization through no-holds-barred deregulation and liberalization in
structured finance that leaves large segments of the world's population in all
countries in financial ruins.
The comparative advantage of "free trade" has long been neutralized
by a dysfunctional international finance architecture that devastates the poor
and weak in all economies, rich or poor. Amid this growing resistance, the
United States is trying to pry open financial markets faster everywhere,
particularly in China.
Central banks distort domestic prices
In today's globalized financial markets, the central bank in every nation
distorts all prices in the local economy to prevent economic adaptation to
changing world prices in key commodities, such as oil.
Domestic interest rates are forced to rise during a recession to prevent
capital flight. This is true regardless of whether the currency is
free-floating or pegged to the US dollar. The only difference is that the
penalties manifest themselves in different forms, via asset depreciation for
floating currencies and via a drain in foreign reserves in pegged currencies.
As noted earlier, dollar hegemony uses currency crisis as the widely deployed
IED in finance terrorism against domestic development in all countries, rich
Ironically, while the advanced economies are plagued with overcapacity from
stagnation and disparity of income, there is rising evidence that low-wage
production in East and South Asia, which in the past decade has been the main
factor in containing global inflation, is going through a sea change to build
pressure for global inflation. While unemployment is still serious all over
Asia, including booming economies such as China and India, existing plants in
the export sectors of these countries are running near full capacity. This is
because foreign investment goes only into projects that yield extraordinary
returns from low wages in the export sector, while unemployment continues to
rise in the domestic sectors.
Social and political pressures in reaction to income disparity are giving labor
everywhere a stronger voice in demanding more equal distribution of the
benefits of globalized trade, in the form of living wages and more liberal
benefits and protection of workers' rights. Thus while both China and India are
still burdened with oversupply of human resources with a glut of
underemployment or high unemployment, plant capacity in their export sectors
can grow only at higher costs to meet consumer demand in their export markets
for low-cost goods. This is because the excess labor is in the rural interior,
where there are no plants and where the cost of building them and the
transportation network to serve the export sector are not economically viable.
And the plants along the coastal regions are experiencing a labor shortage
because more migrant workers cannot be accommodated for lack of low-cost
But higher costs in China will result in higher prices for Chinese exports and
reduced US demand for goods until US wages rise, which is registered as
inflation. As a result, central banks of the world are increasingly anxious
about structural inflation, forcing them to tighten monetary policy by raising
The Goldilocks era of a happy combination of high growth, low inflation and low
interest rates may be coming to an end. Fed chairman Ben Bernanke told a
bankers' conference in South Africa on June 5 that rising wages and
environmental costs in China will have an upward effect on US inflation. The
International Monetary Fund has calculated that low-wage imports from China
have reduced US inflation by 1 percentage point. Many economic projections
expect global growth will no longer contain inflation. Rather, further global
growth will translate into inflationary pressures.
With cost-pushed inflation bringing higher interest rates in a cycle of slowing
economy and weaker earnings caused by a housing bust in the United States,
rising wages that still fail to keep up with real inflation from currency
devaluation, dwindling consumer demand from income disparity, and trade
friction threatening to turn into protectionist measures, cheap money can
evaporate quickly, to put a sudden stop to the recent merger-and-acquisition
frenzy by private-equity firms, and turn completed deals into bankruptcy
While each of these developments may not by itself be serious enough to bring
the US economy to a halt, a confluence of all such interrelated developments
could produce a whirlpool effect that sucks everything down a black hole of
vanishing virtual money.
Income is all
The fountainhead of this financial whirlpool is in the conundrum that rising
interest rates are impotent in reversing the decline of the purchasing power of
the dollar. What is needed is a redefinition of economic growth, to be measured
by rising purchasing power of wages rather than by nominal GDP increases. And
that path is through closing the disparity of income and wealth in every
economy, rich and poor, among people and between economies.
The timeless adage in economics that income is all holds even more true today.
Copyright 2007 Asia Times Online Ltd.
All rights reserved.
|Subject: Re: THE INTEREST RATE CONUNDRUM, Part 2 || |
THE INTEREST RATE CONUNDRUM, Part 2