Who's in charge of US interest rates?
Has the United States Federal Reserve lost control over interest rates? It seems unthinkable, but that is what may be happening in the US bond market, where the unusual behaviour of interest rates continues to stump the experts, according to Richard Duncan in the revised edition of The Dollar Crisis: Causes, Consequences and Cures.
Since the rate-rising cycle began in June last year, the Fed has increased rates by 25 basis points on eight occasions, bringing the target rate to 3 per cent. Despite these efforts, the 10-year bond rate - which is determined by the market - has fallen by 43 basis points to just 4.07 per cent.
'We have this very unusual situation at the moment where the [US] economy is growing quite strongly, almost 4 per cent [GDP growth], but still the 10-year bond yields are dropping despite the fact the Fed is increasing quite steadily now,' Mr Duncan says.
Bond yields normally shadow the direction set by the Fed, especially during periods of strong economic growth. There are a few cases where bond yields could fall despite the Fed's actions; for example, when investors anticipate recession and move out of stocks and into fixed income. But most analysts admit to being confused by recent developments.
Fed chairman Alan Greenspan has been at a loss to explain falling bond yields, initially labelling the situation a 'mathematic aberration'. When the puzzle persisted, he said it could be due to a variety of factors including hedge funds and accumulation by Asian central banks, but conceded it was a mystery or 'conundrum'.
'It is very embarrassing for him to admit that he cannot explain this,' says Mr Duncan.
'To lose control over interest rates is to lose control over the economy.'
So what is going on? Mr Duncan argues US Treasuries are no longer following the Fed's lead, and are instead taking their cues from abroad. More specifically, what's driving down yields is an imbalance in the amount of dollars being accumulated by the Asian central banks and the issuance of new US government debt.
The recycling of trade surpluses back into the US bond market worked well in 2003 when the US current-account deficit was roughly equal to the fiscal budget deficit. However, cracks began to appear last year, when the fiscal deficit shrank, due in part to stronger tax receipts, while the current account deficit exploded to US$666 billion.
As foreign central banks scrambled to recycle their ballooning dollar balances they faced a shortage of new treasury and agency debt.
'If they cannot buy newly issued bonds, they have to buy existing bonds, and by buying existing bonds they push up the price of those bonds and they push down the yields,' Mr Duncan says.
Mr Duncan set out the basic theory in his 2003 book in which he argued that countries that enjoy a trade surplus with the US would seek to 'sterilise' the excess accumulation of dollars in a process that amounts to a continual extension of easy credit. Central banks in countries like China print their own currency, using those funds to purchase trade-surplus dollars, and in turn channel those into US bonds.
Low bond yields in turn stimulate the US economy, which sucks in more imports from Asia. The virtuous circle enables Asian countries to prevent their currencies from rising, and keeps their export-led economies ticking. The consequences, however, are excess liquidity creation, globally low interest rates and unlimited fuel for asset-price bubbles.
The new edition of the Dollar Crisis, released in paper back, contains five new chapters that focus on the changes in the global economy during the last two years.
Based in Hong Kong as a banking and insurance analyst for a European institution, Mr Duncan was with the IMF in Bangkok during the Asian financial meltdown. In June last year he forecast bond yields would decline by year's end, a highly unorthodox view at the time.
What's worrying this year, says Mr Duncan, is that the glue holding together a global economy dependent upon US consumption is set to come further unstuck.
With the US current-account deficit on track to exceed US$800 billion, and a fiscal deficit estimated at just US$300 billion, that leaves near half a trillion surplus dollars looking for a home in the US bond market. 'This is a huge problem because Greenspan and the Fed are trying to push up interest rates to try to cool the property bubble,' Mr Duncan says.
If the yield curve continues to flatten, the Fed may be forced to cut interest rates. At the current pace of 25-basis-point increases every six weeks, there may be hard decisions to be faced by late summer.
'This is posing a real challenge for the Fed,' Mr Duncan says. 'Should they continue increasing the Federal funds rate and invert the yield curve?
'Or should they just stop increasing the Federal funds rate, at which point there will be market euphoria and stocks would go up and property prices would go up and the whole property bubble would get bigger and bigger?'
Compounding the problem, agencies such as Fannie Mae and Freddie Mac, facing scrutiny over accounting, are likely to slow down the pace of new debt issuance. Faced with shrinking options, Asian central banks may look beyond the bond market to dollar-denominated assets such as office buildings and other real estate.
Low mortgage rates would also continue to add fuel to the US housing market at a time when the Fed has already warned of 'froth'.
Another concern is the solvency of insurance companies and corporate pension schemes. The dilemma faced by General Motors in recent months could be a sign of things to come.
'If interest rates go lower and lower, it becomes increasingly difficult for those corporations to earn enough money on their bond portfolios to pay those pensions,' Mr Duncan says.
'When that happens, pensions become under-funded and companies have to take from their profit-and-loss accounts to top up their pension accounts.'
He believes the Fed first became aware of the dimension of the problem last year, and signalled its concern in a policy speech in November. Mr Greenspan's speech was designed, says Mr Duncan, to talk the dollar lower as a means of reining in the excesses and shrinking the current-account deficit.
Washington has also adopted a sense of urgency in its hard line with China in recent weeks, signalling perhaps concern about looming financial instability.
'The real scary thing is that a 10 per cent revaluation will take China's wage rate from US$5 to US$5.50, so their trade surplus with the US would just keep growing,' he says. 'What the US has in mind, I suspect, is they are not talking 10 per cent revaluation, they are talking 10 per cent a year. It is not just China specific, it is all of Asia.'