Here is another guy who thinks debt actually matters, he has thought so for a long time and has been wrong for exactly the same period. What he hasn't figured out yet is that it only matters if it is recognized by those who count....until then it is just noise.
Global: The Mother of All Carry Trades
Stephen Roach (New York)
Everyone does it — borrow short and invest long. With the overnight lending rate well below the inflation rate, the cost of money is essentially “free” in real terms. All it takes is reinvestment anywhere else along the yield curve to make a positive return from the spread, or carry, trade. By holding the nominal federal funds rate at a 40-year low of 1%, the Federal Reserve has aided and abetted a multiplicity of carry trades — from those in the Treasury market, to high-yield and emerging-market debt, to credit instruments and mortgage securities. It’s the rage. You can’t afford to miss the carry trade — until, of course, the Fed takes away the proverbial punch bowl.
The American consumer has put on the biggest carry trade of them all. In a job- and income-short recovery, consumers have defied the fundamentals of consolidation and kept on spending. Consumption has soared to a record 71% of GDP in the past two and a half years, well in excess of the 67% share of the 1990s; moreover, during just the past year, the Y-o-Y growth rate of real consumption expenditures accelerated sharply from 2.3% in 1Q03 to 4.3% in 1Q04. Income short consumers have turned, instead, to two exogenous sources of purchasing power — a steady stream of tax cuts and the extraction of equity from their favorite asset, the home.
The asset-based impetus to consumer spending is nothing more than a huge carry trade. Taking advantage of rock-bottom interest rates, American homeowners have embarked on a record mortgage-refinancing bonanza. By some estimates, the equity extraction that has resulted from this frenzy exceeded $550 billion in 2003, or more than 6.5% of disposable personal income. I should note that this estimate is based on the simple difference between the change in mortgage debt and net investment in residential housing — a gauge that Dick Berner has criticized as a macro-analytical tool (see his August 1, 2003 essay, “Why the ‘Refi’ Bust Won’t Cripple Consumer Spending”). Notwithstanding his critique, Dick concedes that refis have been an important source of consumer purchasing power in recent years. And with good reason: The temptation of low interest rates and ever-rising property values simply proved irresistible to income-short US households. This was a sure-fire way to make ends meet in tough times.
The only catch in this sure thing is the means by which it occurs — debt. The American consumer has never — repeat, never — gone on a debt binge the likes of which has occurred in recent years. Household sector debt now exceeds 85% of GDP — an all-time high and about 20 percentage points higher than the ratio a decade ago. The common refrain to this complaint is that consumer debt ratios have always risen over time as households have become wise in the ways of sophisticated balance sheet management. Moreover, there are many who argue that consumers are being entirely rational in turning to debt in a low interest rate climate; after all, goes the logic, with rates at 40-year lows, it seems inconceivable that debt service could ever become onerous.
Think again. Debt service measures published by the Federal Reserve are already flashing warning signs. The Fed now has two official gauges of household debt burdens — a narrow measure of mortgage and installment debt payments and a broader measure of financial obligations, which also includes auto lease payments, residential rents, and homeowners’ insurance and property tax payments. Even with interest rates at 40-year lows, both of these debt burden proxies are in the upper decile of historical experience. The reason: the sheer magnitude of the stock of outstanding indebtedness.
But the “rational” consumer is widely thought to have the fallback position of what the trade calls a “long duration liability structure” — a preponderance of fixed rate indebtedness that supposedly locks in low interest rates for a longer period of time and thereby shields the indebted from the upside of the rate cycle. Think again here as well. In recent months, there has been an ominous surge in the demand for adjustable-rate mortgages (ARMs). In May 2004, the ARMs share of the dollar volume of new mortgage originations rose to 50%, up sharply from the 20% average that had prevailed from 2001 through mid-2003. This recent rush to ARMs leaves overly indebted American consumers increasingly exposed to the upside of the interest rate cycle at just the point when the Fed is about to embark on the march to policy normalization. In other words, the American consumer has upped the ante on the carry trade at precisely the wrong point in the rate cycle. And they call that rational?
There’s one final twist to this puzzle — the possibility that carry trades lead to asset bubbles. In perpetual search of the easy returns that steep yield curves seem to guarantee and, in today’s case, returns that can be financed freely at rock-bottom short-term interest rates, investors have rushed into a host of long duration assets. In other words, the lure of the carry trade is so compelling, it creates artificial demand for “carryable” assets that has the potential to turn normal asset price appreciation into bubble-like proportions.
In my view, that’s now a perfectly legitimate concern in what is arguably America’s most important asset market — residential housing. Just-released government data on nationwide house prices are flashing distinct warning signs of just such a possibility (see Dick Berner’s, “Bubble Trouble?” in today’s Forum for a more sanguine assessment of this aspect of the problem). The so-called OFHEO (Office of Federal Housing Enterprise Oversight) US house price index has now increased at a 9.8% average annual rate over the past two quarters, one of the strongest two-quarter increases on record and enough to take the index up 7.7% above its year-earlier level in 1Q04. While that’s not in outright bubble territory just yet, there are some increasingly worrisome signs of such a possibility in some of America’s most important housing markets. That’s especially the case in California, which contains approximately 20% of the nation’s housing stock by value; according to the latest OFHEO sample, home prices in the Golden State stood 13.9% above their year-earlier level in 1Q04. In the tri-state New York area, Y-o-Y house price inflation averaged 10% in the most recent period. And these numbers, of course, pale in comparison to what you hear on the bi-coastal cocktail circuit.
The problem with asset bubbles in an overly indebted economy is that they are a recipe for disaster. Think back a mere four years ago — bubbles always pop. But the real threat is the popping of the levered bubble. Therein lies the biggest risk of all for today’s overly-indebted, income- and saving-short American consumers. If they lose the asset-based underpinning of the carry trade, it could finally be game over.
I will be the first to concede that this is Old Macro — in other words, it’s based on a theory that has been dead wrong for the past year and a half. But in retrospect, it doesn’t take a rocket scientist to figure out why consumers have kept spending. It’s Washington, stupid — the most powerful combination of monetary and fiscal stimulus in modern history. Consumers have been well trained to pounce on such opportunities. Ever since they discovered the sheer ecstasy of the wealth effect in the late 1990s, American households have refused to live within their means, as those means are delineated by what they earn on their jobs. Instead, consumers have repeatedly gone to the Fountain of Youth and, courtesy of an overly generous central bank, freely monetized purchasing power from an increasingly over-valued asset. This strategy has worked so brilliantly in recent years that American consumers have now thrown all caution to the wind and opted for floating-rate liabilities at precisely the wrong time — just when the interest rate cycle is about to turn.
History tells us that carry trades end when central bank tightening cycles begin. The Fed knows full well what’s at risk in the biggest carry trade of them all. Little wonder the US central bank wants to be “measured” in normalizing its policy rate. In my jaundiced view, it will take nothing short of a miracle to extricate the self-indulgent American consumer from this mess.
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