TESTING AN INFLATION AND RECESSION INDICATOR

How Reliable Is "Bond Vigilantes"?

by

Chih kwan Chen

forcastglobaleconomy.com

(June 2, 2010)



Abstract

           The spread between the yield of 10 year Treasury Note and the yield of
           3 month Treasury Bill is defined as an inflation and recession indicator,
           nicknamed as "Bond Vigilantes". The reliability of this indicator is tested
           from early 1950s to present with the reasons of success and failure of the
           indicator analyzed in detail. The future course of the economy is discussed
           in the context of the prognosis of the indicator at present.













Introduction

The massive monetary and fiscal stimuli introduced to fight the recession have stirred up the fear of inflation. It is wanting to have some forward looking indicator of inflation so we will have some idea whether or not The Federal Reserve will be able to tighten the monetary policy in time to keep inflation at bay. In this context the phrase, "Bond Vigilantes", comes into our mind. Many bond market participants claim that "Bond Vigilantes" serves as an accurate indicator of future inflation trends. The purpose of this article is to test the reliability of "Bond Vigilantes" as an inflation indicator, and then to see what this indicator is saying now about the future inflation. Before we can proceed, we need to explain first what "Bond Vigilantes" really is.

The long-term interest rates, or equivalently the yields of long-term bonds, are sensitive to inflation. If inflation flares up, interest rates in general will move up whereas current buyers of long-term bonds will be locked into meager yields for many years to come. On the other hand if inflation subsides and interest rates fall, current buyers of long-term bonds will be happy winners by locking in lucrative yields for a long time. Thus long-term bond buyers have every incentive to guess the inflation trend correctly so that their consensus may serve as an inflation indicator. Following this logic, it is tempting to use the peaks and valleys of the yield curve of long-term bonds as the indicator of coming inflation trends. However, many professional bond traders use "leverage", that is to borrow in short-term and use the borrowed money to buy long-term bonds in order to profit from the difference in the long-term and the short-term interest rates. As the result the peaks and valleys of the yield curve of long-term bonds tend to synchronize with the peaks and valleys of the yield curve of short-term debt instruments respectively. Short-term interest rates are tightly controlled by The Federal Reserve. This implies that to use the peaks and valleys of the yield curve of long-term bonds as an inflation indicator is tantamount to test the ability of The Federal Reserve to anticipate inflation trends. Unfortunately The Federal Reserve has a rather poor record on the front of predicting future inflation trends as has been discussed in Comment 31 of this website. To study the real sentiment of the buyers of long-term bonds, we need to look into the difference between the yield of long-term bonds and the yield of short-term instruments. If the buyers of long-term bonds, especially those professional ones, expects an inflation surge ahead due to loose monetary policy, they will be reluctant to buy more long-term bonds so the yield difference between long-term bonds and short-term instruments will widen. In the meanwhile higher long-term interest rates than short-term interest rates tend to brake on the overheated economy. On the other hand if those professional bond buyers feel that the monetary policy is too tight so that a recession and a period of calm inflation is in store, they will buy long-term bonds vigorously to lock in the lucrative yields and thus to cause the yield spread to narrow. Of course, lower long term interest rates relative to the short-term rates will stimulate the economy. In that sense professional long-term bond buyers are serving the role of vigilantes checking against the often erratic monetary policy of The federal reserve. That is how the phrase "Bond Vigilantes" originates.

With the meaning of "Bond Vigilantes" made clear, we are ready to proceed to analyze the reliability of "Bond Vigilantes" as an inflation indicator. The next section is devoted to the discussion of the method used in this analysis. The six sections succeeding Section 2 cover six different time periods in the chronological order. In the last section the probable course of the economy in terms of inflation trends is discussed and compared to the prognosis of "Bond Vigilantes".

2. Methods Used in This Analysis

The yield of 10 year T. Note is used as the representative of long-term interest rates in this analysis, and the yield of 3 month T. Bill is used as the representative of short-term interest rates. The difference between the yield of 10 year T. Note and the yield of 3 month T. Bill is simply called "The Spread" throughout this writing. In the following graph the quarterly averages of the yield of 10 year T. Note and of the yield of 3 month T. Bill are plotted as the blue and the red curves respectively. To measure inflation, quarterly average of CPI is plotted in logarithmic scale as the purple curve in the graph. We should note that in a logarithmic scale data points on a straight line are rising or declining at a constant rate. Thus by looking at the slope of the purple CPI curve, we can tell about the inflation trend, with steeper slope associated with an intensifying inflation and vice versa. The green curve in the graph consists of quarterly averages of the monetary base, also plotted in a logarithmic scale. The monetary base measures directly the amount of money created by The Federal Reserve. With the tools of the analysis identified, we are now ready to move into the analysis itself by studying six distinctive time periods starting from early 1950s.

3. Pre-globalization Period I : The Age of Innocence

The blue yield curve of 10 year T. Note in the graph starts from the second quarter of 1953 when the T. Note was first introduced. The U. S. economy was at the threshold of a recession. Though the inflation surge of 1950 had subsided, "Bond Vigilantes" was still edgy about inflation so "The Spread" was kept substantially wide. As the 1953-1954 recession hit, The Federal Reserve lowered short-term interest rates abruptly, sending the yield of 3 month T. Bill to tumble from 2.1% at the second quarter of 1953 to 0.8% by the second quarter of 1954. That abrupt loosening of the monetary policy made "Bond Vigilantes" more anxious so "The Spread" widened further toward the second quarter of 1954 (marked as Point A in the graph). Once sensing the end of the recession The Federal reserve raised short-term interest rates without waiting for the actual inflation surge, but the previous loosening of monetary policy was too simulative and the timing of the raise of interest rates still too late to prevent another inflation surge. Inflation did surge ahead starting from 1956 as if underscoring the worry of "Bond Vigilantes". With the inflation surge short-term interest rates was pushed up further by the now panicking Federal Reserve. However, "Bond Vigilantes" became increasingly convinced that a recession and a hiatus of inflation were not far behind so "The Spread" dwindled toward Point B in the graph, at the third quarter of 1957. The anticipated recession had actually arrived in the second quarter of 1957 already and lasted until the second quarter of 1958, bringing along a one-year long calmed inflation environment. The Federal reserve lowered short-term interest rates vigorously as the 1957-1958 recession hit, sending the yield of 3 month T. Bill tumbling from 3.4% to 0.8% within two quarters. This wanton loosening of the monetary policy raised inflation fear of "Bond Vigilantes" so "The Spread" widened to 2.2% by the second quarter of 1958 (Point C in the graph). Not waiting the official confirmation of the end of the recession, The Federal Reserve raised short-term interest rates as vigorously as it had lowered the rates so the yield of 3 month T. Bill shot up even at the time when the purple CPI curve became flat. However, the stimulus effect of the previous vigorous lowering of short-term interest rates was too much to overcome even with the vigorous raising of interest rates, so inflation rekindled as projected by "Bond Vigilantes" with wide "Spread" at Point C and beyond. As inflation appeared anew, short-term interest rates shot up further. Finally "Bond Vigilantes" gave its approval by narrowing "The Spread" down to 0.4 % by the end of 1959 (Point D), signaling the anticipation of another recession and a period of clamed inflation. The recession hit in the second quarter of 1960 and a short period of calmed inflation followed as foretold by "Bond Vigilantes".

Throughout the time period covered by the previous paragraph, the predictions of "Bond Vigilantes" about inflation trends and recessions all hit the marks, so we named that period as "The Age of Innocence" of "Bond Vigilantes".

4. Pre-globalization Period II: The Years of Tear

Short-term interest rates were lowered abruptly by The federal Reserve as the 1960 recession set in. "Bond Vigilantes" was concerned that the sharp drop of short-term interest rates would shorten the period of calm inflation usually associated with a recession so "The Spread" was widened substantially. That worry of "Bond Vigilantes" was vindicated as inflation started to heat up from the second half of 1961, pushing short-term interest rates higher with it. "Bond Vigilantes" was heartened by the rise of short-term interest rates to the degree that allowed "The Spread" to narrow from Point E accordingly. Unfortunately the rise of short-term interest rates was too timid to control inflation. At the turn of 1964 to 1965 inflation had shown signs of speeding up further already. Thus The Federal Reserve pushed up short-term interest rate further but at the pace far more timid than the cases before 1960. "Bond Vigilantes" was convinced that the gentle rise of short-term interest rates was enough to bring on a recession and a period of calm inflation so "The Spread" was narrowed further and became negative by the fourth quarter of 1967 (Point F in the graph). However, "Bond Vigilantes" got no recession but more inflation and more sharper rise of short-term interest rates. By the third quarter of 1969 (Point G) "The Spread" became negative again. A recession did come in 1969 and lasted until 1970 but the pace of inflation only slowed down modestly. The Federal Reserve played its old trick of lowering short-term interest rate vigorously to fight the 1969-1970 recession. "Bond Vigilantes" widened "The Spread" sharply in response to the wanton loose money policy of The Federal Reserve, apparently learned the lesson of under estimating inflation from Points E to F to G. Indeed the inflation turned into hyper inflation as early as the second half of 1972 and short-term interest rates was pushed up sharply from the second quarter of 1972 (at Point H in the graph) by The Federal reserve to fight the hyper inflation. The confidence toward The Federal Reserve had returned and "Bond Vigilantes" narrowed "The Spread" steadily until "The Spread" became negative by the third quarter of 1973 (at Point J in the graph). "Bond Vigilantes" did get the recession that tied to the first energy crisis but the rising pace of inflation only moderated slightly. In spite of the danger of hyper inflation The Federal Reserve deliberately lowered short-term interest rates vigorously to fight the 1973-1975 recession. That time "Bond Vigilantes" was not fooled and had kept "The Spread" extremely wide until the first quarter of 1977 (Point K in the graph). Surely enough another bout of hyper inflation hit. With the second bout of hyper inflation, Paul Volcker became the chairman of The Federal Reserve Board and the target of the monetary policy was switched away from short-term interest rates toward the money supplies. That policy change meant that short-term interest rates were allowed to rise to whatever level necessary to control the inflation. Showing confidence with Paul Volcker’s iron fist monetary policy, "Bond Vigilantes" narrowed "The Spread" to negative for a sustained period until early 1980s (Point L in the graph). "Bond Vigilantes" got not only one but two consecutive recessions, and the back of the hyper inflation was finally broken. Beyond Point L a new era called "the era of globalization" has dawned.

Looking back at the 20 year span from early 1960s to early 1980s, the persistent underestimate of inflation by "Bond Vigilantes" is especially noticeable. Why such remarkable failures of "Bond Vigilantes"? The answer is that "Bond Vigilantes" had failed to realize the ground shifting changes of the monetary policy during that 20 year period. Let us see how the monetary policy had changed so much from the time before 1960.

After The World War II western countries established the Brenton Woods Gold Standard. Under this gold standard system U. S. Dollar served a the conduit to the price of gold. Other western countries pegged their currencies to U. S. Dollar, and U. S. Government promised to maintain the price of gold at $34/troy ounce. Private parties were not allowed to redeem gold from U. S. Treasury in exchange for dollars, but other central banks could redeem gold from U. S. Treasury with dollars. Under a gold standard the creation of paper money should be checked. The best way to see how much paper money is created is to look at the monetary base, which consists of currency in circulation, total reserve deposited with The Federal Reserve by commercial banks and other small components. Unfortunately the data of monetary base published by The Federal Reserve Board only goes back to 1959. Most of the time the overwhelming majority of the monetary base is composed of currency in circulation and the majority of currency in circulation is made up of notes issued by The Federal Reserve. Thus we used the data about the outstanding amount of the notes issued by The Federal Reserve from 1950 to 1970 as compiled by Richard G. Anderson as the substitute to the monetary base. From 1950 to 1960 the amount of outstanding notes issued by The federal Reserve increased by about 50%. However, from 1960 to 1970 the amount of outstanding Federal reserve Notes increased more than 100%, indicating the quickened pace of money creation. Why that change of monetary policy? There is a school of economists called "Keynesian School" of economists. They do not like gold and consider gold as a useless metal. They promote the creation of money as the government sees fit without the restrain of the amount of gold in reserve. Since the change of the administration in 1961 economists from Keynesian School dominated the making of monetary and fiscal policies. Thus huge amount of money was created from thin air. Such wanton creation of money naturally drove up the price of gold vs. U. S. Dollar. Under the Brenton Woods Gold Standard system, U. S. Government had the duty to keep the price of gold at $34/troy ounce. U. S. Government sold gold from its reserve to keep the price of gold at $34/troy ounce. According to the compilation by Timothy Green U. S. Government had more than 15,000 metric tons of gold in its reserve in 1960, but by 1970 the reserve gold had dwindled to about 9,000 metric tons. That kind of depletion of gold reserve, of course, could not have been sustained. In 1971 the Brenton Woods Gold Standard was scrapped as U. S. Government stopped to support the price of gold in order to preserve its gold reserve. With the gold standard doing away as Keynesians desired, the flood gate of money creation was open. As the green monetary base curve in the graph shows, the monetary base kept growing with a brisk pace through 1960s and 1970s. Such wanton growth of money naturally ignited the hyper inflation of 1970s. "Bond Vigilantes" had failed to notice the difference with Keynesians in power so suffered humiliating defeat through most of the time during that 20 year period.

It is worth to note that in countering the Keynesian School, there arise a school called The Monetarists. They argue for targeting the money supplies instead of short-term interest rates in the monetary policy to control inflation. Paul Volcker borrowed a chapter from the Monetarists and finally broke the back of the hyper inflation. From the graph we can see that the yield of 10 year T. Note had risen relentlessly through the 20 year period under discussion. Except near the end of that period at Point L, bond buyers should have suffered heavy losses after losses. In that sense we call the 20 year period "The Years of Tear" for "Bond Vigilantes".

5. Globalization and The First Phase of Runaway Trade Deficit: Coming of Age of Japan and the Junk Bond Bubble

The slope of the purple CPI curve has changed drastically from very steep to moderately steep around the end of 1981. The green monetary base curve also had a short period of slower growth in 1981. Short-term interest rates peaked at Point L, that is, in 1981 and then started to tumble. "The Spread" was widened from the fear of "Bond Vigilantes" that the hyper inflation might return. The monetary base curve had started to grow strongly again from 1982. The Federal Reserve nudged up short-term interest rates some what from the fourth quarter of 1982 (Point M) to the third quarter of 1984, and then dropped short-term interest rates more sharply until Point O, the fourth quarter of 1986. What The federal Reserve was doing with those gyrating short-term interest rates was to control the growth rate of the monetary base at a moderate pace. Throughout the period from Point M to Point O, "Bond Vigilantes" was not impressed so "The Spread" was kept wide. The slope of the purple CPI curve steepened from the end of 1986 but the rise of inflation was much tamer compared to the hyper inflation of 1970s. In response to the rise of inflation The Federal Reserve tightened the monetary policy so short-term interest rates rose from the end of 1986 (Point O) until the first quarter of 1989. It was in the fourth quarter of 1989 (Point P) when short-term interest rates had started to drop again, "Bond Vigilantes" was finally convinced that a recession was looming so "The Spread" narrowed substantially to herald the arrival of another recession. The 1990-1991 recession did follow the prognosis of "Bond Vigilantes". How did "Bond Vigilantes" have perceived the arrival of the recession? Let us look into the evolution of economic environments at that time to resolve the mystery.

Throughout the period from early 1980s to early 1990s, the inflation fear of "Bond Vigilantes" was not materialized. What was so different in 1980s compared to 1970s? In one word it was the doing of the "globalization" process. "Globalization" is a process to liberalize the currency market and to lower tariffs so that both capitals and goods can move across national boundaries easily. "Globalization" has been promoted by a group of clever economists, and has been supported strongly by Wall Street, big businesses and politicians alike. To the general public it was sold with sweet talks like, "Let labor intensive and tedious manufacturing activities exported to developing countries. Highly intelligent and sophisticated manufacturing activities will be retained in The United States and will flourish due to American ingenuity. Consumers will have more to consume, will live better life and The United States will dominate the global economy well into the future as far as eyes can see." However, once the "globalization" was enacted in Reagan era, it was not "American ingenuity" but "Japanese "diligence" dominated the market. Japanese yen was fixed at 360 Yen/Dollar after the War, but was allowed to float since 1970s. By the middle of 1980s Dollar had declined to 250 Yen/Dollar level already. With an educated and diligent work force and the mindset to perfect their products in addition to numerous incremental innovations, high quality but moderately priced made in Japan consumer goods flooded U. S. market in spite of vastly devalued Dollar vs. Yen. On the other hand expensive Yen had forced Japanese manufacturers to shift labor intensive lower end productions to developing countries like Taiwan. During 1980s lower end inexpensive made-in-Taiwan consumer goods were in many American stores. It was the flood of made in Japan and Taiwan goods that had kept U. S. inflation at bay, but it was also those torrent of imports that had induced the first phase of runaway U. S. trade deficit. By the second quarter of 1987 U. S. trade deficit had reached 3.14 % of Nominal GDP. "Bond Vigilantes" had failed to comprehend the sea change of economic structure forced upon by "globalization" so it was frightened by the shadow of another round of hyper inflation that had never shown up.

The onslaught of imports caused substantial hardship on American manufacturers. Political pressure rose on Reagan administration. In early 1985 it was agreed that Dollar should devalue against Yen, and Japan promised to stimulate its domestic consumption so that the incentive to export would be reduced. Dollar fell abruptly from 250 Yen/Dollar to the level of 125 Yen/Dollar. With the collapse of Dollar, American manufacturers bounced back and carried the economy forward for a while, whereas U. S. trade deficit waned in 1987. Without the help from the runaway trade deficit, continued economic expansion spelled "inflation" as can be seen from the steepened slope of the CPI curve starting from 1987. With the pick up of inflation short-term interest rates also rose in synchronization. "Bond Vigilantes" welcome the tightening of the monetary policy and narrowed "The Spread’ in accordance. Near the end of 1989 (Point P) "The Spread" became very narrow, indicating that "Bond Vigilantes" was preparing for the sky to fall. What had caused "Bond Vigilantes" to conclude that the sky would really fall? We need to understand the reason before we can proceed farther.

Running trade deficit means that dollars are handed over to foreign exporters. Foreign exporters in turn must sell those dollars for their local currencies so that they can continue to do business. Those dollars from the trade deficit fall eventually into the hands of foreign governments and large foreign financial institutions, and they must bring those dollars back into U. S. financial markets to be lent out as big block loans. Due to the usual multiplication effect from the process of loans generating more loans, amount of loans that is many times the size of the original seed money will be generated eventually. During the first phase of runaway trade deficit, Wall Street directed a large part of those loans induce by the runaway trade deficit into the financing of junk bonds that were used to facilitate corporate raiding and leveraged buy-outs. The wane of trade deficit in 1987 meant the reduced seed money for junk bond financing, and thus the burst of the junk bond bubble. With the burst of the junk bond bubble, stocks lost a powerful support and crashed in the fall of 1987. Since the existing junk bonds had a maturity like 3 to 5 years, businesses that issued junk bonds and reduced their own financial status to junk could still operate until the maturity of their junk bonds. When those junk bonds matured and not able to refinance, those junk bond laden companies fell, bringing down many "savings and loans" that had bought those defaulting junk bonds. The flare up of the "savings and loans crisis" thus pushed the economy into the recession of 1990-1991. "Bond Vigilantes" was able to comprehend the pessimistic environment and projected the arrival of the recession. During the recession U. S. trade deficit nearly balanced and inflation also slowed down markedly. After the recession the era of the second phase of runaway U. S. trade deficit had arrived.

6. The second Phase of Runaway U. S. trade deficit: Japan’s Near-zero Interest rates and the U. S. Stock Market Bubble

Short-term interest rates was lowered by The Federal Reserve in 1989 under the pressure of teetering junk bond market and the spreading "savings and loans" crisis. In response to the monetary easing, the monetary base rose briskly again. "Bond Vigilantes" feared the resurgence of inflation and widened "The Spread" to an unprecedented level. However, not only the feared inflation never came, but the inflation rate never returned to the level before the 1990-1991 recession as the slope of the purple CPI curve attests. It was the runaway trade deficit that had spooked the inflation expectation again. Let us see what were the same and what were different in the second phase of runaway trade deficit from the first phase of runaway trade deficit in Reagan era.

Japan’s land price based bubble was punctured by the government in 1991. With the reduced domestic consumption in the aftermath of the burst of the bubble, Japanese industrial powerhouses refocused their energy on the U. S. market. With improved productivity gains and relentless innovations, the level of 125 Yen/Dollar had ceased to be a barrier for determined Japanese exporters. As U. S. economy emerged from the 1990-1991 recession, Japan made products returned to the U. S. market with vengeance and suppressed the inflation. Seeing the return of U. S. trade deficit with Japan, the currency market had started to push down U. S. Dollar against Japanese Yen, trying to stop the reemergence of the runaway trade imbalance. We should note that the currency market has a built-in mechanism to counter the expanding trade imbalance. It was not easy to stop the galloping trade deficit with Japan. By 1995 Dollar had collapsed down to 80 Yen/Dollar level. In order to save the collapsing Dollar, short-term interest rates were raised in 1994 though there was no signs of accelerating inflation at that time. The monetary base flattened out in 1995 and the economy slowed down. The collapsing Dollar and slowed-down economy finally reined in the trade deficit that had started to fall sharply in the first half of 1995. Japanese Government was concerned about the sharp fall of U. S. trade deficit since it would nullify its plan to use massive exports to boost Japanese economy out of the stagnation in the aftermath of the burst of the bubble. Japanese Government made an unprecedented gamble by lowering interest rates to near zero in the middle of 1995. The effects of this near-zero interest rates on Japanese economy is discussed in detail in article 1 so will not be repeated here. Near-zero interest rates in Japan induced massive waves of "yen carry trades" that is to borrow yen at near-zero interest rate, sell those borrowed yens for dollars and then use those dollars to buy high yielding instruments. Thus Dollar rose sharply against Japanese yen and the U. S. trade deficit exploded in 1997 with the usual two year delay for trade balance to be influenced by drastic moves in currency exchange rates. That explosion of U. S. trade deficit formed the core of the second phase of runaway trade deficit. It was this second phase of runaway trade deficit that suppressed the inflation further as the further reduction of the slope of the CPI curve from 1997 attests. The calmer inflation finally heartened "Bond Vigilantes" and "The Spread" was narrowed substantially as the result. Then inflation flared up in 1999 due to the overzealous demand induced by the stock market bubble, short-term interest rates shot up, and by the third quarter of 2000 "The Spread" became negative. That was the prediction of "Bond Vigilantes" about the coming of a recession. The recession did arrive in the fourth quarter of 2000, according to our classification of recessions contained in Comment 71. Let us see what had prompted "Bond Vigilantes" to make such a superb call.

During the second phase of runaway trade deficit, flow-back dollars from the trade deficit went into the stock market, riding on the coming of age of the internet. As inflation calmed down due to the runaway trade deficit, The Federal Reserve lowered short-term interest rates and further inflamed the stock market bubble. Then came the adverse effect of Japan’s near-zero interest rate policy. At that time some American economists were promoting the idea of pegging currencies of developing countries to U. S. Dollar to prevent inflation, and many developing countries listened to the advice. As yen carry trades induced by Japan’s near-zero interest rates pushed up U. S. Dollar vs. Japanese Yen, so were the currencies of small Asian countries that pegged their currencies to U. S. Dollar. Quickly the products of those Asian countries lost competitive power. Those Asian countries started to run trade deficits just like The United States, issued sovereign debts to cover their trade deficits, and enjoyed good life for a while. Also many hedge funds listened to the advice of those American economists and thought the peg to Dollar was gold, so they scooped up the high yielding sovereign debts from those Asian countries. When the hedge funds recognized that emperors had no cloths, they ran to the exit at once and touched off the Asian financial crises. In the aftermath of the crises, IMF stepped in and forced those affected Asian countries to decouple from and devalue their currencies vs. U. S. Dollar. By 1998 the shock wave of Asian currency devaluation reached Russia, forcing its currency to decouple and devalue against Dollar, too. At that point a large hedge fund was caught holding a lot of Russian sovereign debts bought with borrowed money. From the fear that the demise of the large hedge fund will endanger the whole financial system, The Federal Reserve under Alan Greenspan forced Wall Street firms to bail out the hedge fund cooperatively. Thus Dollar tumbled from the peak of above 170 Yen/Dollar down to 125 Yen/Dollar. By 1999 the shock wave reached Latin America and forced Dollar down further to 110 Yen/Dollar level. With the usual 2 years of time delay U. S. trade deficit started to wane in 2000, the stock markets lost their source of funding and crashed, as predicted in article 1 of December of 1998. "Bond Vigilantes" apparently got the same wind in 2000 and issued that superb pre-warning of the coming recession. With the 2000-2001 recession the second phase of runaway trade deficit gave way to the third phase of runaway trade deficit as will be discussed in the next section.

7. The Third Phase of Runaway Trade Deficit: The Emergence of China and the Mortgage Bubble

The global trade picture has changed substantially due to the emergence of China when the economy started to recover from the 2000-2001 recession. China had devalued its currency, Yuan, from 1.55 Yuan/Dollar at the beginning of 1981 to 8.72 Yuan/Dollar by the beginning of 1994. The massive devaluation of Yuan has induced mass migration of Taiwan Merchants into China. The capital and the know how of those Taiwan Merchants combined with the numerous low cost labor resources in China has transformed China into the global factory of goods for export. By 2000 U. S. trade deficit with China had matched the U. S. trade deficit with Japan already, and by 2007 U. S. trade deficit with China has ballooned to three times of the trade deficit with Japan. Since Chinese Yuan was pegged to U. S. Dollar at above 8 Yuan/Dollar level until the middle of 2005, trade deficit with China expanded rapidly as the economy recovered from the 2000-2001 recession. The rapidly expanding trade deficit with China had suppressed inflation until 2003 and nullified the inflation worry of "Bond Vigilantes" for a while. However, inflation did come back in 2004. The whole economic environment at that time was rather interesting to the degree to deserve our close examination.

The Federal Reserve lowered short-term interest rates drastically as the 2000-2001 recession hit. "Bond Vigilantes" widened "The Spread" to express its fear of the reemergence of inflation. However, the monetary easing was not very effective as the rounding shape of the green monetary base curve illustrates. Why the monetary stimulus was not effective? Because the economy by that time has become so addicted to trade deficit that it cannot grow at normal pace until the trade deficit expanded way above the peak reached in the second phase of runaway trade deficit. The surge of inflation from 2004 was due to the external force of exploding crude oil price. As U. S. trade deficit exploded upward, Asian countries, especially China, had experienced the matching runaway trade surplus. The runaway trade surplus brought in numerous U. S. dollars into China, all wanting to be exchanged to Yuan. Chinese Government buys up all those dollars in order to keep Yuan pegged to Dollar so that Chinese exporters can continue to export to The United States. When Chinese Government buys dollars, it must release matching amount of Yuan into Chinese market. Those massive amount of Yuan eventually falls into the hands of commercial banks in China. Related parties borrow those Yuan liquidities from banks and starts massive infrastructure constructions. That is the recipe of the so called "economic miracle". Such an economic miracle demands the consumption of large amount of raw material, especially crude oil. Thus crude oil price exploded upward, and eventually brought on the inflation surge starting from 2004. The inflation surge pushed up short-term interest rates, and led "Bond Vigilantes" to narrow "The Spread", eventually to negative territory by the third quarter of 2006. That was another excellent call from "Bond Vigilantes" about the coming recession. Actually there were quite a few forewarnings about this recession, though those signals were missed by most of the economists and Wall Street analysts. The steadily slowing growth rate of the green monetary base is one of such signals. The trend change of the consumer spending and GDP is another sign as has been pointed out in an update of July 28, 2007 and a graph added later in an earlier note. Even earlier in Comment 25 of October 18, 2005 the coming of a recession in 2008 was mentioned due to the gradual upward revaluation of Yuan starting from the middle of 2005 and the usual two year time delay for the change of currency exchange rate to influence the trade deficit. Indeed the runaway trade deficit started to top out from the end of 2006 and ushered in the grand liquidity squeeze that eventually burst the mortgage bubble.

The unique character of the third phase of runaway trade deficit was the mortgage bubble. As mentioned before U. S. economy has become so addicted to trade deficit, it required like 800 billion dollars of trade deficit just to keep U. S. GDP growing like 3% a year. This kind of monstrous trade deficit means that the enormous amount of credits generated by the flow-back dollars need to be pushed on the shoulders of consumers as loans so that consumers have enough money to buy increasing amount of foreign made goods to sustain the monstrous trade deficit. The junk bond market and the flow of money into the pocket of consumers through stock market bubble were too inefficient to accommodate the flow of such a deluge of money. The only debt/credit market capable to achieve this feast was the 30 trillion dollar mortgage market. It turned out even the mortgage market was not big enough to accommodate the disastrous appetite of the third phase of runaway trade deficit. To induce consumers to borrow more and more mortgages, the required amount of down payments and the income requirement to qualify for a mortgage were persistently lowered. Adjustable rate mortgages with teeter rates was introduced in order to induce borrowers with insufficient income to borrow. Such a mortgage bubble naturally pushed the housing prices sky high. The explosion of housing prices fanned the reckless mortgages further from the logic that the skyrocketing housing price will bail out unqualified borrowers anyway. However, as the runaway trade deficit topped out and the seed money to the mortgage bubble stopped to increase, housing price bubble started to burst. Furthermore, the increasing short-term interest rates induced by the inflation surge hit the adjustable rate mortgage borrowers hard, and the foreclosure rate started to increase. With that housing prices turned from stagnation to decline, more borrowers with small amount of down payment saw their homeowner’s equity turned from zero to negative, more foreclosures and finally the whole sky caved in. In any way "Bond Vigilantes" has kept its record of forecasting coming recessions clean during the three phases of runaway trade deficit since the start of the "globalization" in early 1980s, though the realization of its inflation expectations frequently delayed by waves after waves of runaway trade deficits. In the next section we will see how "Bond Vigilantes" has coped with the meltdown of Wall Street and the self-destruction of the "globalization", and what it is saying today.

8. How "Bond Vigilantes" Went Through the Recession and What Is It Saying Today?

The grand liquidity squeeze caused by reduced flow-back dollars as the runaway trade deficit waned had spurned financial firestorms after financial firestorms. The first one at August of 2007 was the purge from the commercial paper market of SIV (Structured Investment Vehicles) that used borrowed money to hold complicated securities and derivatives related to mortgages. Denied the refinancing through the commercial paper market, SIV drew down prearranged credit lines from their sponsoring banks. Thus banks have become de facto owners of those toxic mortgage related assets. In response to the first financial firestorm The Federal Reserve loosened the rules governing the borrowing from its discount window, and encouraged banks to borrow from the discount window with mortgage backed securities as the collateral. The discount window measure turned out not to be effective in relieving liquidity squeeze. As the end of 2007 approached, large banks became nervous about the financial health of their peers so the overnight lending facility among large banks came almost to a standstill. The Federal Reserve started the "term auction facility" to inject liquidity into the banking system instead of discount window, and then lowered short-term interest rates aggressively. All those measures failed to stop the approaching disaster. Next came the failure of Bear Sterns, the fall of Fannie Mae and Freddie Mac, and then the climax in the fall of 2008 that included the failure of Lehman Brothers, the fiasco of AIG, the demise and the sell out of Merrill Lynch, the transformation of Goldman Sachs and Morgan Stanley into bank holding companies so that they can borrow from the discount window, and the unlimited guarantee of commercial papers by FDIC in order to keep the commercial paper market open. At that time The Federal Reserve dropped the short-term interest rate to near zero and started the quantitative easing that is to inject huge amount of liquidity into the banking system. Before the fall of 2008 the total reserve that banks deposited with The Federal Reserve stood at about 45 billion dollars. By the spring of 2010 the total reserve has jumped to over 1.2 trillion dollars. The phenomenal increase of the total reserve is reflected in the near vertical rise of the green monetary base curve in the graph starting from the third quarter of 2008. What has "Bond Vigilantes" done through those tense and dramatic events? It has kept "The Spread" as wide as possible to express its concern that all will not be well at the end. Is this pessimistic prognosis of bond Vigilantes" reliable? In the next and the concluding section we will gaze into the crystal ball and discuss what is in store in the future.

9. Looking Ahead

As has been pointed out in article 13, credits generated by the flow-back dollars from the trade deficit must be lent to needy consumers so that they will have money to buy the next batch of imports. Only by this cycle of more and more debts the runaway trade deficit can sustain itself. However, needy consumers are piling up debts steadily due to year after year of borrowing so that at certain point they will not be able to sustain the debt burden anymore and default. With their default the middlemen (the Wall Street firms) that borrow from the credit pool and lend to consumers will be wiped out and the whole globalization scheme will come to a grinding halt. The financial crises since August of 2007 and the ensuing meltdown of Wall Street and the deep recession were exactly the realization of this process of self-destruction. After the self-destruction the economy and the financial structures still standing are supported by massive governmental stimuli and bailouts. Due to bank’s phobia toward consumer lending, enormous amount of money injected into the financial market are simply re-deposited back to The Federal reserve and is swelling the rank of the total reserve as has been mentioned before. U. S. Government and The Federal Reserve are hoping that as the economy rebounds by a certain degree based on governmental stimuli, banks will regain the appetite of consumer lending. Let us analyze the possible evolution of the current set up to see toward which directions the future course of the economy is heading.

As long as banks refrain from aggressive consumer lending, the only way that consumer spending can increase significantly is through the increase of personal income. For personal income to pick up, business activity must become more robust but that requires more expanded consumer spending. Thus the economy falls into a dead cycle and will not be able to rebound. That is why the government steps in to boost the economy by providing massive fiscal stimuli. At the same time The Federal reserve is injecting huge amount of liquidity into the banking system trying to induce banks to lend to consumers. However, U. S. consumers have been saving little and have been drowning in the sea of debts for many years. Additional aggressive consumer lending should be classified as "reckless lending". Banks have learned the lesson and know very well that if consumers get into debt problem next time, politicians will certainly turn the table and blame the banks again. Thus banks are still refusing to open their wallets toward consumer lending but depositing the majority of the liquidity injected by The federal Reserve back with The Federal reserve. If banks continue to refrain from consumer lending, U. S. Government has no choice but to provide large amount of stimuli and The Federal Reserve is forced to keep the monstrous liquidity injected into the banking system. This process has its own limit. Increased consumer spending means more imports from Asian exporters like China, larger influx of dollars into China, and more dollars Chinese Government must buy from the market to prevent the upward revaluation of its currency Yuan vs. U. S. Dollar. This also means further release of a large amount of Yuan into China’s domestic market in the process of buying those unwanted dollars, and China’s red hot growth rate of 10% a year will be boosted toward 15% a year. Since China’s economy is resource inefficient, such a phenomenal growth will gobble up enormous amount of raw material, especially crude oil. Crude oil price will top the all time high of $150/barrel easily. The skyrocketing crude oil price will boomerang back to cause an inflation surge in the U. S. as in the case of the third phase of runaway trade deficit. At the end the economic growth will slow down, enforcing an wild up and down gyration. "Bond Vigilantes" is fearing such a wild gyration and feels that the rapid growth in recent quarters is pointing exactly toward that direction. That is why "Bond Vigilantes" has kept "The Spread" so wide to express its concern.

The new consumer credit watch dog included in the financial regulation reform bill pending in the U. S. Congress ironically will restrain banks from aggressive consumer lending, and thus necessitate the continuation of massive fiscal stimuli and enormous liquidity injection by The Federal Reserve. If the wild gyration as discussed in the previous paragraph is to be avoided, the growth of the economy needs to be restrained at a very subdued level, like 2% a year. The situation of near-zero interest rate, massive government stimuli, enormous liquidity injection by The federal Reserve, and a very sluggish economic growth is called the "Japan Syndrome". If "Japan Syndrome" becomes the reality, "The Spread" will narrow drastically. At present "Bond Vigilantes" is predicting not "Japan Syndrome" but a wild gyration instead.

What if banks decide to step up consumer lending aggressively? Then the flow-back dollars from the trade deficit will be able to reach U. S. consumers again, and will be able to replace the liquidity injected by The Federal Reserve and carry the economic expansion without governmental stimuli. However, due to the huge size of the injected liquidity, the trade deficit needs to grow far above the peak reached in the third phase of runaway trade deficit. An enormous bubble will result from this fourth phase of runaway trade deficit, and as such a bubble inevitably burst, a global depression far beyond the power of governments to bail out will hit and destroy the economies all around the globe.

In summary if the structure of the globalization remains, there will be no pleasant way out of the economic mess as "Bond Vigilantes" is trying to say. Of course, if the structure of globalization is scrapped, then an equally unpleasant calamity will develop. That is why we always compare the attempt to use the runaway trade deficit to prop up the economy to the taking of illicit drugs to achieve highs. It is very addictive, requires ever increasing dosage to just achieve the same level of highs, very painful if tries to quit the drug, and eventually will destroy the drug taker if nothing is done.