IT'S THE BUBBLES, DUMMY
by Dr. Kurt Richebächer
The further fate of America's consumer borrowing and
spending binge is of major concern at this juncture. Last
year, in particular, it was the key prop to the U.S.
economy. If it definitively falters, the recovery will
surely derail.
The creation of a huge carry trade in bonds was crucial in
lowering mortgage rates. Consequently, a massive mortgage
refinancing bubble was provoked, characterized by massive
home equity extraction. This freshly created equity
provided the funds for simultaneous bubbles in housing and
stocks. Soaring pseudo wealth was then offered as
collateral to facilitate the borrowing binge.
All of a sudden, sliding asset prices have hammered these
highly leveraged asset and credit bubbles. Ironically, the
trigger was pulled by a string of strong economic data.
Fretting about higher inflation and a possible hike in
short-term rates, heavily leveraged investors started
cautionary liquidations. But given the leverage, more and
more selling was bound to follow. In short, investors had
simply become too optimistic, giddy from the artificially
low interest rates.
There can be no question that, in time, badly performing
financial markets will take their toll on general
sentiment. The change in sentiment always comes after the
markets have already declined dramatically - falls that
most people are not prepared for. A recently published OECD
report spells pure optimism about the world economic
prospects and thus provides a warning that markets may be
about to fall.
In its March Quarterly Review, under the title 'Appetite
for Risk Lifts Markets,' the Bank for International
Settlements in Basel, Switzerland, reports, "Financial
markets around the world rallied into the new year, adding
to the impressive gains recorded in 2003. Improvements in
global growth prospects and corporate finances, coupled
with a robust appetite for risk, underpinned increases in
equity and credit prices. Not even further revelations of
corporate malfeasance seemed to unsettle investors." We
hasten to add that the Bank has been highly critical of
this development.
As we have already said, the sudden rise in long-term U.S.
rates, which started in mid-March, was not caused by bad
news, but by unexpectedly good news. For us, it is an
unbelievable irony that the strong employment gains were so
coveted by the Fed yet, at the same time, ultimately proved
to be the needle that pricked the bond bubble.
To quote Ramsay King on this point: "It will be an irony of
biblical proportion if dubious employment gains spook the
markets, which then impairs the economy, which in turn
costs Bush the election. That irony would be compounded if
there was any political maneuvering or pressure to produce
great but unwarranted employment numbers."
For us, and for Mr. King, it is a great irony that the
prevailing perception of a strongly rebounding U.S.
economy, which caused interest rates to rise so suddenly,
is so badly flawed in the first place. Consumer spending
has effectively slumped during the first quarter. What's
more, the recent impairment of the mortgage refinancing
bubble is a compelling reason to assume that the consumer-
spending slump will continue to get worse.
Thanks to all these bubbles, the American consumer borrowed
a mind-boggling $879.9 billion last year, having borrowed
$775.7 billion the year before. However, most of the
borrowed money went into housing and stock purchases,
fueling the rise in their prices, rather than into living
expenses.
Pursuing the discussion about the outlook for stock
markets, it strikes us that the question of potential
buyers and their finances is never touched upon. In the
late 1990s, the necessary funding came primarily from
American and foreign corporations through huge stock
buybacks and frenzied merger and acquisition activity.
Private households just jumped on the running bandwagon.
Since 2000, all buying on these accounts has vanished. Last
year, private households stepped in as the standalone
buyer. With poor income growth and virtually no savings at
their disposal, their stock buying implicitly depended on
heavy borrowing from the mortgage-refinancing boom. But
having largely depleted this source of funds, we see a
grossly overvalued stock market without any potential
buyers.
During the past two to three years, the U.S. economy and
its financial system obtained an unusually high dose of
monetary and fiscal stimulus. Yet it was really the
interplay of three bubbles ˜ in bonds, housing, and
mortgage refinancing ˜ that enabled the consumer to sustain
such an elevated level of spending. Meanwhile employment
and income growth fell precipitously.
Manifestly, these policies, having involved heavy rigging
of markets, were a palliative that prevented disaster for
the U.S. economy in the short run. But instead of
redressing the economic and financial imbalances from the
prior boom, these policies propelled the imbalances to new
extremes. After all, the U.S. economy is now, in many ways,
in worse shape than ever before.
There has been some involuntary unwinding of the global
reflation trades. Yet we have still only seen the tip of
the iceberg. It is our view that the leverage used in the
carry trading of bonds, in particular, has grown to such an
absurd scale that orderly deleveraging is now impossible.
To point out the obvious: The asset and credit bubbles that
have been inflating consumer spending ˜ bonds, stocks,
mortgage refinancing ˜ are plainly deflating. The property
bubble will soon follow for lack of funding. In short, we
see savage deflation for the asset markets, but stagflation
for the economy - and it is so obvious that no one can see
it. This will soon change.
Regards,
Dr. Kurt Richebächer |
