Great Article - must read...
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ORO (11/30/2000; 13:36:43MT - usagold.com msg#: 42546)
HBM – Rate Inversion
Euro and dollar “currency war” are part of the reasoning behind Fed actions. I proposed that the Euro’s emergence as the debt denominating currency of choice since 1999, would cause the Euro volumes on the international markets to explode while dollars become exceedingly scarce due to a lack of fresh borrowing in dollars abroad. The Euro has moved from 20% of new transnational debt issue in its legacy currencies, to some 75%. The result has been a complete halt to growth in dollar money supply within the international arena. External elements to the international market are drawn upon to supply the missing dollars needed by indebted economies to both pay down debt and pay for oil. These dollars are sought through the sale of exports to US consumers and the elimination of imports from dollar denominated suppliers – hence the poor international sales of the US based multinationals. Europe, in the meantime, has undergone an export boom driven by the excess of Euro on the international markets, as most new debt and maturing dollar debt rollovers are in Euro (being a debt currency it can only be created by new indebtedness).
The distorted pricing of the dollar that has resulted from this is making the exporters to the US extremely aggressive and the low pricing has brought about a boom in US consumer purchases of foreign goods. The volumes are so massive that the freight system, as reflected in the Baltic Freight Index of 11 transcontinental shipping lines, is now at record highs and is more than double the value at 1998. International shippers are straining for capacity and have started to order new ships from places such as Korea and Poland. The restraint of physical trade volumes made possible through technology savings in inventory management and supply chain streamlining, is done – and the last improvements were actually done last year.
Since short-term funds are used to finance inventory, raising them would cause inventory to drop soon after. As the Fed raised interest rates once inventories were starting to build – particularly as spot shortages in a broad array of producer goods (communications chips, construction materials, specialized labor and other items) brought about a tendency to hoard them at exactly the wrong time (when prices are rising) - the holders of inventory were pressed to sell it. This caused a crash in the prices of those producer goods that had accumulated in inventory over the last few months as inventories were slashed and the markets supplied by this dumping. That is the only real economic effect of the rate “tightening” by the Fed. The effects are late to arrive and are temporary. Once inventory is emptied, the long-term supply problems would reappear.
In the meantime, this causes the following – (1) as spot shortages brought prices up and caused speculative inventory buildups and double ordering, the buyers lost profit margins, as sellers gained profit margins. (2) As the Fed raised rates, inventory accumulation dropped and then reversed, (3) The buyers lost capital to drops in the value of their inventory, and the suppliers lost margin and sales volumes as their current supply was competing with their prior supply now exiting inventory. As the stock market values attest, the result has been destruction of profit on both supply and demand sides as the supply chain to the consumer lost profitability, first closer to the consumer, then going backwards through the supply chain. The result is a disincentive to investment in the whole of the goods and services supply chain. This will ultimately result in inventory bottoming out just when the lack of investment restricts supply again. The rate hike today will induce a price rise tomorrow.
The Fed has succeeded in inducing a slow down in prices at the producer level and a price tumble in some items. Oil dishoarding in the refineries both as a response to higher rates and as a response to higher oil prices is the only element, aside from the Strategic Petroleum Reserve “sales”, putting a lid on oil prices.
The apparent success in “fighting inflation”, is therefore a temporary phenomenon. It does, however, make for good copy and international public relations.
The Fed is fighting the demands for liquidity coming from abroad by attempting to curtail supply of dollars to the international markets; this by forcing inventory emptying – much of which is imported. Loan rollovers from old dollar loans to Euro require access to dollars and restricting the supply prevents loans from being switched to Euro loans. This is intended to prevent the loss of future demand for dollars for debt repayment, as the international borrower’s preference for Euro loans is scuttled he will roll-over more of the existing dollar loans.
The Euro group is closing on this by the sale of their dollar reserves. This allows some relief to the dollar debtors, who are then induced to cover the dollar loans and replace them with Euro loans. The ECB absorbs the Euro created by the loans through this same action of selling dollars.
The kicker here is the capital market flows. The low Euro rates, which match the EU corporate profit profile, have made US investments much more attractive and brought back in many of the dollars exported through our incredible trade deficit. The ECB’s lowest rate is still 3.75%, while the equivalent Fed rate is 6%. At the bottom (coinciding with oil prices bottoming in Q2 99), these rates were 1.5% and 4%, respectively. The spread dropped from 2.5% to 2.25%.
Thus short term money is driven to remain in the US, but the US can not maintain the driving force because of the damage to corporate profitability the high short rates are inducing.
Long term spreads have dropped even more heavily, from near 2% to under 0.5% on government paper. That is not much of an inducement to buy. Even an EU bank using overnight funds at 3.75% to hold 10 year treasuries at 5.5% is hard pressed, since the transaction leaves less than a 1.5% spread. Short term funds that the Fed has pushed up will keep inducing flows into the US only so long as profitability here remains superior. Needless to say, the Fed action has collapsed the profit margins of the whole of US industry – services as well as goods – local as well as importing (inventory effects) and exporting (dollar bubble effects) – which is now at the point of reversing the foreign flows into the US as the lack of profitability is reducing both the value of equity and corporate debt.
The inversion of the yield curve itself has the following local effects:
(1) Pushing borrowers to turn short term debt into long term debt through home equity loans and mortgage refinancing.
(2) Preventing banks from using Fed source short term funds instead of market funds – thus absorbing short term money into bank accounts and money funds. There, the funds remain in shorter term debt which is used to finance the purchase of longer term debt. Mortgages and corporate debt are at 2% and 3% spreads to government debt and are 1-2% above Fed rates, thus this is not a restricting factor on longer term borrowing. Had the rate been raised above the market rates (mortgages and corporate debt rates), we could say the Fed was “tightening” – in the sense of restricting borrowing. But it has not done so and shows no intention of doing so.
(3) Because of (2) this has the international effect of preventing bank funds from moving out of the US, and through this effect on the lack of dollars abroad, pushes the dollar up and lowers our import bill. This helps in controlling import prices (and the trade deficit), so that overall consumer price levels are restrained because of this factor.
(4) Lowering rates to undo the inversion will allow bankers to borrow from the Fed to buy treasuries and high grade bonds and whole loans – which would create a “gusher” of liquidity when it comes.
I have noted here before that the banking sector needs heavy injections of permanent funds because its assets have fallen close to or below its liabilities. This will induce bank failures soon if not addressed. The only way the Fed can address this is through the monetization of loans and bonds, which it can’t do with the current Fed funds rate because it leaves too little margin for banks to play while still allowing the money markets to expand longer term borrowing. Banks will have to have a source of funds that is cheaper than market rates in order to make a profit and avoid insolvency. The Fed will lower rates as a result of this imperative to keep the banks alive.
The end of the inventory effects induced by the Fed tightening will soon be completely over on all sides – local inventory, import inventory, oil inventory, retail inventory - are all going to turn direction into fresh accumulation as global volumes of trade have hit against the bottle necks in the following areas: oil supply (capacity is not really strained yet in the Gulf, but it is elsewhere), refining capacity, oil transport capacity, natural gas supply and especially transport, import transportation, production capacity abroad for non-durables and low value durables imported to the US – particularly specialized labor in Korea, Mexico, Singapore, Ireland, etc…, construction materials, heavy engineering project capacity for drilling and shipping equipment, insurance, and much more.
The Fed’s step down on the interest rate brake will end what little inventory dishoarding can still be obtained and would cause a nearly immediate resumption of accumulation – at least for sectors where inventories are at bare bones levels. When this happens, prices will likely move strongly.
The downward shift in profitability is now turning into a reduction capital flows and will turn into flight out of the US if Fed rates remain at these levels. This is because the bulk of foreign money is in bonds, equities, and income producing real assets, not within US banks, so that whatever capital flows can be gained by the spreads in central bank funds will be completely overwhelmed by sale of investments and repatriation of funds out of the US. The supply of dollars this would create can tank the dollar on the international markets even without the Fed lowering rates. |
