Bond Market Blowout
By Mike Whitney
Last week's ructions in the bond market, leave little doubt that the financial crisis has entered a new and more lethal phase. Of particular concern is the spike in long-term Treasuries which are used to set interest rates on mortgages and other loans. On Thursday, the average rate for a 30-year fixed loan jumped from 5.03% to 5.44% in just two days. The sudden move put the mortgage market in a panic and stopped the refinancing of billions of dollars in loans. The yields on Treasuries are going up because investors see hopeful signs of recovery in the economy and are moving into riskier investments. More money is moving into equities which is why the stock markets have been surging lately. (The Federal Reserve's multi-trillion dollar monetary stimulus has played a large part, as well.) The bottom line is that investors are looking for better returns than the paltry yields on government debt. That will make it harder for the Fed to sell up to $3 trillion in Treasuries in the next year to finance Obama's proposed economic recovery plan. For now, foreign central banks are still buying enough short-term Treasuries to cover the current account deficit, but that could change in a flash, especially given Fed chief Bernanke's propensity to print more money at the drop of a hat. That's making foreign holders of dollar-based assets more jittery than ever.
Bernanke is in a bit of a pickle. He needs to sell boatloads of US debt, but if he raises interest rates; he'll kill the recovery and send the stock market reeling. What to do? Eventually the Fed chief will arrive at the conclusion that there's only two ways out of a credit bust of this magnitude; either raise rates and crush the economy or print more money and face a funding crisis. Either way, there's a world of hurt ahead.
Here's how economists Christian Broda, Piero Ghezzi and Eduardo Levy-Yeyati sum it up in their report "The New Global Balance: Financial de-globalisation, savings drain, and the US Dollar":
"In a new financial landscape in which leverage is limited by worldwide regulation, and where the gradual digestion of toxic assets will weigh on bank’s balance sheets for some time, limiting the availability of credit, the US will face tougher terms to finance its external imbalance. In our view, these tougher terms, together with the sharp increase in US household savings, could have gone a long way towards unwinding the global imbalances in a non-traumatic way. However, that would have entailed passive fiscal and monetary policies and a politically unpalatable economic contraction. Instead, a massive fiscal stimulus partially financed directly by the Fed through the purchase of Treasuries should ultimately lead to a reversal of the dollar bonanza. Perfectly at odds with the global imbalance premonitions of the early 2000s, the dollar’s weakness will likely be the best gauge of the turnaround of the global crisis." ("The new global balance: Financial de-globalisation, savings drain, and the US dollar", Christian Broda, Piero Ghezzi and Eduardo Levy-Yeyati)
The factors which strengthened the dollar earlier in the crisis have now run their course. Treasuries no longer attract "flight-to-safety" investors, because most people don't think that another Lehman Bros-type meltdown is likely. Investors are shifting to emerging markets, corporate bonds and securities. Commodities are on the upswing because speculators think that Fed's quantitative easing (QE) will end in hyperinflation. More important, cross-border flows have either stopped entirely or been significantly reduced due to the need for fiscal stimulus at home to counter falling demand and rising unemployment. In 2006, 65% of global surplus capital flowed to US markets. No more. Now the US will have to fight tooth-and-nail for a smaller and smaller share of the same pool. It will be uphill all the way.
The US economy is facing other headwinds, too; like a banking system that is hobbled by hundreds of billions in non performing loans and toxic assets, and a wholesale credit system that's still in a deep coma. The Fed and Treasury had plenty of time to take insolvent institutions into government conservatorship and restructure their debt (as they have with General Motors), but have chosen to pursue the same failed approach of providing unlimited funding via the Fed's lending facilities to any institution with a license and a begging bowl. Now time is running out and nothing has been done to address the underlying problems. Bernanke clings to the misguided notion that he can firehose the financial system with liquidity and the troubles will instantly vanish, but that's just more wishful thinking. Insolvency can't be fixed by adding more debt, that just puts off the inevitable day of reckoning and increases the likelihood of a run on the dollar.
Here's how the World Bank put it in their 2002 analysis titled, "Managing the Real and Fiscal Costs of Banking Crises," which examined similar banking crises over the last half century:
"Accommodating measures such as open-ended liquidity support, blanket deposit guarantees, regulatory forbearance, repeated recapitalizations and debtor bailouts appear to increase significantly the costs of banking crises. Did these accommodating policies achieve faster economic recovery? We failed to uncover evidence that they did. Indeed, they seem to have prolonged crises because recovery took longer."
Bernanke's no fool; he knows his strategy won't work. He's just following orders from the banking establishment. Remember, the IMF has a long history of recapitalizing or winding-down failed banks. It's not rocket science. There are tried-and-true methods for resolving underwater financial institutions and they are rigorously followed. The IMF would never give the banks a blank check and simply hope-for-the-best like Bernanke and pal, Geithner. They've created a situation where the banks will be a drain on public resources for years to come, diverting capital from productive sectors of the economy and choking off credit expansion. Credit derivatives expert Satyajit Das pinpoints the real problem in an article posted on his blogsite:
"Mancur Olson, the American economist, in his books (The Logic of Collective Action and The Rise and Decline of Nations), speculated that small distributional coalitions tend to form over time in developed nations and influence policies in their favor through intensive, well funded lobbying. The policies result in benefits for the coalitions and its members but large costs borne by the rest of population. Over time, the incentive structure means that more distributional coalitions accumulate burdening and ultimately paralysing the economic system causing inevitable and irretrievable economic decline.
Government attempts to deal with the problems of the financial system, especially in the U.S.A., Great Britain and other countries, may illustrate Olson’s thesis. Active well funded lobbying efforts and “regulatory capture” is impeding necessary actions to make needed changes in the financial system. For example, the Centre of Public Integrity reported that the expenditure on lobbying and political contribution of the top 25 sub-prime mortgage originators, most linked to large U.S. banks, was around $380 million (the Economist (9 May 2009).(The finance government Complex & The End of US economic Dominance", Satyajit Das's blog)
The institutional bias of the Fed is obvious in every decision they make. Consider the fact that the Fed has provided over $12.8 trillion in loans and other commitments to shore up wobbly financial institutions while the two-year fiscal stimulus for 320 million Americans is a paltry $787 billion. Its goose liver and Cabernet for the bank mandarins and breadcrumbs for the working stiff. Unlike General Motors--where bondholders and workers sustained huge losses and were forced to dramatically slash the size of their business---the banks and brokerage houses have been given carte blanche and are free to use their loans any way they choose, including commodities speculation which has driven the price of oil from $33.98 per barrel on Feb 12 to more than $68 per bbl. today. The taxpayer is literally paying for the rope to hang himself. And Wall Street is only too happy to oblige.
Despite the Fed's best efforts, the oversized financial system will have to shrink to meet the new reality of falling demand and persistent high unemployment. Household deleveraging is ongoing cutting into discretionary spending and changing attitudes towards saving. That means corporate profits will falter while and layoffs continue for the foreseeable future. The economy will probably bump along the bottom for a decade or so before household balance sheets are patched up enough to stage a comeback. The Fed's job is to hasten the recovery by forcing weak players to write-down their losses or declare bankruptcy so their dodgy assets can be put up for auction. That gives the system a chance rebuild on a solid "debt-free" foundation. Bernanke's plan just puts off the pain by keeping asset prices artificially high so losses aren't realized. It's pointless. Author and economist Henry C.K. Liu explains the implications of the Fed's actions like this:
"When financial institutions deleverage with free money from the central bank, the creditors receive the money while the Fed assumes the toxic liability by expanding its balance sheet. Deleverage reduces financial costs while increasing cash flow to allow zombie financial institutions to return to nominal profitability with unearned income and while laying off workers to cut operational cost. Thus we have financial profit inflation with price deflation in a shrinking economy.
What we will have going forward is not Wiemar Republic-type price hyperinflation, but a financial profit inflation in which zombie financial institutions turn nominally profitable in a collapsing economy. The danger is that this unearned nominal financial profit is mistaken as a sign of economic recovery, inducing the public to invest what remaining wealth they still hold, only to lose more of it at the next market meltdown, which will come when the profit bubble bursts. ("Liquidity drowns meaning of 'inflation", by Henry C. K. Liu Asia Times)
"What we have is...financial profit inflation in which zombie financial institutions turn nominally profitable in a collapsing economy." Has anyone given a more lucid description of the wacky goings-on in today's market than that?
Bernanke has shown that he'll do whatever he can to avoid simple price discovery on the illiquid, hard-to-value assets which are at the heart of the crisis. He's underwritten the entire financial system and shifted 100% of the liability for losses onto the taxpayer. He's also managed to keep the banks in private hands, although the cost has been substantial. The so-called "free market" exists only in theory now. The truth is that without the Fed's support, the financial system would collapse in an instant. The transition to state capitalism has taken place without public hearings or input. The line that distiguishes the banks from the government has disappeared.
For $10 trillion, Bernanke could have guaranteed every mortgage in the country, thereby stopping the decline in housing prices, the deluge of foreclosures, and the deep cutbacks in consumer spending. Such a move would have defrosted the secondary market (where mortgage-backed securities (MBS) are traded) because investors would know that the collateral was backed by "the full faith and credit" of the US government. Instead, millions of homeowners have been forced from their homes and onto the streets while Wall Street kingpins debate whether they should be allowed to issue themselves fat bonuses from the TARP funds.
DOOMSDAY FOR THE GREENBACK?
Last week's sudden rise in Treasury yields indicates that Bernanke is nearing the end of the line. The benchmark 10-year T-bill zoomed to a 6-month high of 3.75 percent. Investors want better returns for lending their money to Uncle Sam. That means that funding the multi-trillion dollar deficits will get harder and harder. Bernanke can purchase more long-bonds and keep interest rates low, but investors will see that he's monetizing the debt and head for the exits. Or he can raise rates to attract foreign capital and risk putting the struggling economy into a death spiral. Either way, the consequences will be dire.