The Love Us Overseas!

Making Sense

Remember all the talk of foreign investors abandoning the U.S. dollar, that there will be few buyers for U.S. debt? Fears have not come to fruition, at least not yet. TIC data (foreign investor purchases of U.S. securities) indicate that foreign investors were in hot and heavy last November.

November data indicate a net inflow of foreign investment into U.S. securities of $39.0 billion. This is up from a prior revised $15.1B (up from $7,5B). Remember how investors, especially foreign investors, where going to specifically avoid the long end of the curve due to inflation concerns due to widening U.S. deficits and inflationary Fed policy? Well it appears as though someone forgot to tell foreign investors. Last November, the net inflow of foreign capital into long-dated U.S. debt was $85.1B. This was more than double the street estimate of $40.0B and a prior revised $28.9B (up from $27.6B). Remember, QE2 was launched in November, Rather than deterring foreign buyers, they were encouraged (for both investment and currency exchange reasons) to invest in dollars.

Thus far Fed policy has not led to much-feared higher inflation. Although long-term interest rates rebounded dramatically from their lows, they have stabilized near current levels as trades put on ahead of QE2 were unwound. However, some experts believe that inflation in the U.S. may be just over the horizon and is cropping up overseas now.

Stanford professor, Ronald McKinnon writes in today’s Wall Street Journal that Fed policy is helping to cause overseas inflation and that it is only a matter of time before the inflation wave arrives on our shores. Mr. McKinnon writes:

“What do the years 1971, 2003 and 2010 have in common? In each year, low U.S. interest rates and the expectation of dollar depreciation led to massive "hot" money outflows from the U.S. and world-wide inflation. And in all three cases, foreign central banks intervened heavily to buy dollars to prevent their currencies from appreciating.”
“When central banks issue base money to buy dollars, domestic interest rates are forced down and domestic inflationary pressure is generated. Primary commodity prices go up quickly because speculators can easily bid for long positions in organized commodity futures markets when interest rates are low.”
However, what may be different this time is the ability or willingness of consumers to borrow and spend. During the last such time of extremely “easy” Fed policy consumers were able to borrow and spend, often irresponsibly. The inability or unwillingness of consumers to borrow and spend may hold down so-called core inflation. That could alleviate the inflationary pressures on commodities. Mr. McKinnon warns that a second round of stagflation could lie ahead. Whether or not a repeat of the 1970s is in the cards remains to be seen. It all depends on actions and reactions of policy makers and consumers. However, Mr. McKinnon delivers a good synopsis of Paul Volcker’s success in defeating stagflation and responses by foreign central bankers. He also delivers a good synopsis of the most recent economic bubble. He writes:

“The Greenspan-Bernanke interest rate shock of 2003-04, followed by a weakening dollar into the first half of 2008, created the bubble economy. Primary commodity prices began rising significantly in 2003-04, then flattened out before spiking in 2007 into the first half of 2008.”
“But the biggest bubble was in real estate, both commercial and residential. With low mortgage rates and no restraining regulation on mortgage quality, average U.S. home prices rose more than 50% from the beginning of 2003 to the middle of 2006. This led to an unsustainable building boom—with echoes around the world in countries such as the U.K, Spain and Ireland. The bubbles in primary commodity prices collapsed mainly in the second half of 2008. But the residue of bad debts, particularly ongoing mortgage defaults, led to the banking crisis and global downturn of 2008-09.”
Mr. McKinnon is spot on, but he leaves out one fact. Long-term rates did not rise as was expected. Remember Mr. Greenspan’s so-called conundrum (when he claimed he did not fully understand why long-term rates were not rising as expected). The problem was that although private investors were leaving the dollar, many foreign investors (especially central banks and exporters) were buying U.S. treasuries to keep borrowing costs low, prevent the dollar from weakening further and to keep U.S. consumers spending.

Mr. McKinnon is correct that there are similarities between now and 2003. However there is one great difference: credit. The housing market remains impaired because only those with strong credit profiles can obtain loans and mortgages. Although credit maybe loosening, it is unlikely, not to mention unwise, to extend credit to those who cannot repay their debts. Without easy credit (or an industry rising to take the place of a once-robust housing market), core inflation could remain tame, unemployment fairly high and higher food and energy prices could dampen consumer spending. Who knows, maybe there is a commodity bubble?

One last note: This is earnings season. We have already seen two large banks report. Both reported lower-than-expected trading and capital markets earnings. With greater regulations coming on line, banks will need to maximize revenue from other areas. One such area is traditional banking. The current steep yield curve permits banks to generate significant revenues by borrowing on the short end of the curve at very low rates (LIBOR, etc.) and invest on the long end of the curve (10+ years out). For the recovery to continue, banks need to be able to lend profitably. This means a steep yield curve. Look for Fed policies to keep the yield curve steep. Next week’s FOMC meeting promises to be a non-event. Today’s NAHB Housing Market Index report indicates that progress remains slow.