Opinion: Mortgage holders and recovery will be hit by US govt. bonds
5th Jun 09, 1:56pm
By Neville Bennett Bond vigilantes dominated last week, adding 60 basis points to the yield on US 10-year bonds. If this trend continues, it will hurt all business and mortgage holders and protract the slump. I will examine why the yield curve is changing so radically, and then explain it. I will also draw upon expert historical analysis that quantifies the slow growth of credit after crunches. What is happening? An immediate catalyst of the yield spike was extremely soft demand for the US Treasury's auction of US$26 bn issuance last week. This is partly because investors are concerned about maintaining the real value, while the US prints money in quantitive easing (QE). Dealers actually tried to sell more bonds than the Federal Reserve was wiling to buy. That spooked the traders, who now criticize QE. The Obama/Brown policy of creating money is questioned. Several hedge fund managers, for example, believe that this will do more harm than good. At a recent hedge fund conference, as reported by Reuters, many speakers thought it better to take endure pain now to clear the path for recovery. This is, of course, the view of the Austrian school. I believe the Japanese deflation persisted because they did not permit a real crash in 1990. The argument is that current government strategy is to restore the 2006 situation by propping up failing banks and re-inflating asset prices. Hedge funds resent President Obama branding them as "speculators" (nothing hurts more than the truth!) when they hesitated before supporting his plan to support Chrysler. Many prefer "cold turkey", rather than more stimuli. The US government is viewed as a ponzy selling new bonds to pay existing investors, thereby maintaining solvency and credit ratings. The US budget deficit has grown to 13% of GDP without including the trillions of dollars in liabilities in potential losses guaranteed under the Government bail-out. US banks remain undercapitalized despite the sham of the stress tests. Bond traders, who are always alert to economic conditions, are worried but IMF predictions that the US economy will contract by 2.8% this year (probably an under-estimation) and burgeoning unemployment. Almost 10% of US mortgages are now in arreas, up from 8% in March. The delinquency rate is at its highest in 40 years since records were kept, 1 in 8 American households are late paying their mortgage or have been foreclosed. As some mortgages are linked to bond yields, these households will be aghast that 30-year wholesale rates surged last week by 4% to 4.74%. Everyone is chastened by General Motors failure. Why yields are increasing? Everyone knows that business and banks everywhere are rushing to recapitalize. Bank lending is not enough or is deemed unreliable. Corporates are issuing rights issues right-left-and-centre, as well as issuing credit notes. New Zealand investors have been wooed by most banks recently, including Rabo and BNZ. This is a world-wide phenomenon. Investors are very worried about losses. A large proportion of US corporates who issued BBB rated bonds have been re-rated to junk. Many junk bonds are failing. Even sovereign credit is under pressure. Great Britain's cherished triple A rating is under threat. So are 8 of the 35 companies awarded triple A in 1999. A diminishing pool of Triple A is putting many pension funds in a difficult position of chasing a diminishing resource; a serious problem as they are obliged to hold top-notch assets. If the USA's rating is also challenged, as some expect, many investors will be in a harrowing plight. The Federal Reserve, according to New York Times, is spending more that US$1 trillion to keep interest rates low. Increasingly it looks as futile as when King Canute ordered the tide to stop. Admittedly there is still a healthy demand for short-term government debt, but investors are leery of locking themselves into the seemingly attractive yields of the 30-year bond. There no fears of wage-push inflation because of unemployment and industry running at ¾ capacity. But borrowing costs are sharply increasing and no one knows how government debt can be eliminated. In the short-term the rising yield of bonds stimulates investors to sell to the Fed, the Fed prints more money to pay, the result is more money and downward pressure on the dollar. The Outlook The outlook for the world economy is grim according to a recent paper by Carmel Reinhart and Kenneth Rogoff, The Aftermath of Financial Crises. Crises share 3 characteristics. First, asset market collapses are deep and prolonged. Second, the aftermath of banking crises is associated with profound declines in output and employment. Third, the real government debt explodes. This crisis conforms. But how can recovery occur. The authors make the interesting analysis that the key is revival of credit growth. They look at the time it takes for credit to revive, the time it takes before nominal credit exceeded the level attained before the crisis ( in local currency) and the time it took the ratio of credit to GDP to recover to pre-crisis level. Michael Pomerleano in the Financial Times studied private sector credit in 15 countries, and concludes that on average it took 14.5 quarters for credit to recover to pre-crisis, and the ratio of credit to GDP almost never recovered to the pre-crisis level. This is startling: the US took 15 years to recover from a shock in 1990. What is happening now? Traditionally the banks were the dominant suppliers of credit, but a wider net has to be cast now because the bank's role was supplanted by market-based institutions, especially those involved in securitization. Before mid-2007, non-bank institutions had created a "shadow" system composed of large investment banks, structured investment vehicles and hedge funds larger assets than the banks. This "shadow banking" system is almost defunct and dysfunctional. Stimulus has created money, much of which floods into equities; credit creation has fallen upon banks which are desperately short of capital. There is little credit growth in the world economy, so a sustained recovery is remote. "”"”"”"”"” * Neville Bennett was a long-time Senior Lecturer in History at the University of Canterbury, where he taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared.