Comment 49: Tracing the liquidity squeeze: FED's next move? Why the value of Dollar vs. Yen is crucial.
More than a month has passed since we discussed in Comment 48 the financial panic that has engulfed the markets and the monetary authority alike. It is time to review what have happened, map out the future course of the situation, and analyze what is in store for the US economy. The analysis of Comment 48 is based on the observation of Comment 46 that the deflation of the debt bubble is under way due to the stagnated US trade deficit, which in turn is the result of the falling dollar in earlier years. The financial panic is a violent turbulence appeared on the background of the liquidity squeeze that is the natural result of the deflation of the debt bubble. Let us look at the flow of events in detail to gain a clearer grasp about this ongoing liquidity squeeze.
In Comment 48 we have used the interest rate of one month T. Bill as the guide to measure the severity of the financial panic. A better measure is to look at the interest rate spread between one month CD, which is a major tool of banks to borrow from the financial market, and one month T. Bill. In the graph at the right, daily movements of this interest rate spread is plotted from the beginning of June. The worries about subprime mortgages and the difficulty to obtain further financing for merger and acquisition activities have intensified since the middle of July and have caused turmoils in stock markets. However, large players in financial markets, like buyers of commercial papers, seem to live on a different planet and to be aloof about the commotion roiling stock markets. Only on the morning of Aug. 9 they woke up and discovered suddenly that many issuers of commercial papers in their portfolio are deeply involved in the mortgage backed securities and carry substantial risks of default as the mortgage woes deepens. They rushed to the exit at once and sent the commercial paper markets to a grinding halt. As the entities relied heavily upon issuing commercial papers to obtain financing, like mortgage lenders and merger and acquisition activists, are denied access to the commercial paper markets, the burden of financing those entities naturally falls on the shoulder of large banks standing behind those strapped entities. Thus the banks are pulled into the quick sand of the deflation of the debt bubble. This series of events are vividly displayed in the graph of the interest rate spread posted here. During the last half of July until Aug. 9 when stock market players were already very nervous about the implication of the deflation of the debt bubble and the resulting liquidity squeeze, the interest rate spread actually shrank, reflecting the complacency and the misplaced trusts of the players in the financial markets. When they woke up suddenly to the danger on the morning of Aug. 9, the interest rate spread zoomed to above 3.0% from 0.4% in less than 10 days, meaning the crisis has spread to the banking system. It was under such a panicky situation FED has taken the discount window action by lowering the discount window interest rate by 0.5%, extending the length of borrowing period from overnight to one month, and encouraging large banks to bring in mortgage backed securities to the discount window as collateral and borrow from FED. FED's discount window action had temporarily calmed the market and the interest rate spread had dropped below 1% for a short while. However, subsequently the interest rate spread has climbed back above 1.5%. This indicates that the FED's discount window action has failed to put the financial market panic at rest. The failure of the discount window action was not unexpected. FED's intention was to encourage large banks to lend to those entities shunned from commercial paper markets and to take their mortgage backed securities as collateral, and then large banks would bring the mortgage backed securities at hand to the discount window to borrow from FED. The amount of mortgages that are destined to go under during the current ongoing liquidity squeeze has ballooned during the formation of the debt bubble, the result of the third phase of the runaway US trade deficit that had ended about one year ago. The amount of mortgages that will eventually run into trouble is estimated to be anywhere from a few hundred billion dollars to over one trillion dollars. For large banks to comply with FED's discount window design is like to announce in public that they are now the defacto lender of those troubled mortgages, and as the consequence the large banks themselves will be tainted and may be shunned from the financial market. As the interest rate spread persisted above 1.5%, FED has panicked and lowered the target rate of the federal funds by 0.5% on Sept. 18. After the lowering of the target rate, the interest rate spread has moved down slightly for a short period, and then has risen again, implying that the financial markets do not see the woes in the banking system remedied by the cut in the short-term interest rates.
FED's short-term interest rate lowering move has not caused the long-term interest rate to move in either direction in a significant way. Thus FED's move on Sept. 18 has not bailed out adjustable mortgage borrowers nor the holders of mortgage backed securities. A more positive yield curve, that is, lower short-term interest rates and higher long-term interest rates, in general should help banks that have become mortgage lenders, since mortgage lending business is essentially “borrow short and lend long”. However, if banks make new mortgage lendings in a significant amount, they, too, must package those new mortgages into securities and sell them to someone. At the time existing mortgage security holders are suffering from losses it is doubtful there are a large number of eager buyers for such securities. The issuance of new mortgages will be slow, and the recovery of the housing market is still years away. Furthermore, as banks are loading up mortgage backed securities shunned by the commercial paper market, they must find financing for such holdings, too. At the time when the influx of seed money into the financial market, that is, the US trade deficit, is not growing, such funding will be difficult to find. Eventually FED needs to create a substantial amount of liquidity by just printing money to facilitate such funding. Such an action by FED, if taken, is nothing but to monetize the debt bubble, and is always very inflationary (interested readers please see Comment 31 for the discussion).
The most onerous problem of lower interest rates is the value of US Dollar. We will analyze the exchange rates of US Dollar against Chinese Yuan, Euro and Japanese Yen respectively:
Before the consideration of the exchange rate of US Dollar vs. Chinese Yuan, we should keep in mind that the global prosperity under the globalization scheme is due to the runaway trade imbalance, not due to the expanded overall global trade as the promoters of the globalization like to claim. Just think of the case of China. If China has not had the runaway trade surplus, Chinese government would have bought much less US dollars on the market to prevent the rapid appreciation of Chinese Yuan, there would have been much less yuans released into the domestic Chinese markets, Chinese local governments and its related parties would have had trouble in borrowing freely from the local branches of national banks, the investment boom in the fixed assets would not have existed, publicly owned Chinese companies would not have had money to manipulate the Shanghai stock market, and China's economic growth rate would have been sputtering around the lower single digit instead of 10% plus rate of today. On the other side of the ledger, the US prosperity in the globalization era is sustained by the runaway trade deficit since trade deficit supplements personal saving. The runaway US trade deficits have allowed US consumers to spend all their income and some more without any saving to boost the US economic growth. As discussed in articles 1, 2 and 2A, the Reagan era and the Clinton era economic booms were the results of the phase 1 and the phase 2 of runaway trade deficits respectively, and the busts following those booms were due to the decline of traded deficits triggered by the falling dollar vs. Japanese yen in respective earlier years. The recent phase of the runaway trade deficit had started in 2002 and had induced the robust economic expansion along side with the debt bubble that is now deflating thanks to the stagnation of the trade deficit since 2006.
Chinese Yuan is already appreciating slowly vs. US Dollar since the middle of 2005. The effect of this slow appreciation should be felt starting around this time, and the growth rate of US trade deficit with China should start to decline slowly. If US short-term interest rate is lowered by a substantial amount and US Dollar starts to fall precipitously against other major currencies, especially vs. Japanese Yen, the speed of appreciation of Chinese Yuan will accelerate. If that happens, the US trade deficit with China will stagnate around 2010, and the overall US trade deficit will not only stagnate but start to decline, meaning many more years of the accelerated liquidity squeeze. On the other hand if this scenario unfolds, China needs to find new markets, like Europe, to sustain its runaway trade surplus if it wants to continue to develop along the current development model that we call “Taiwan model” (see Comment 39 for the details of the model).
European Union as a whole is increasing its trade deficit rapidly. Since no one is deliberately supporting Euro, the value of Euro should be falling. However, there is a special factor that boosts the value of Euro, and the special factor is the “oil dollars”. As oil price is sustained at a high level, oil producing Russia and middle-east countries earn a large surplus dollars by selling their oil. Many oil producing countries do not want to invest their surplus dollars directly into the US from various political reasons. They rather pour their oil dollars into Europe and exchange them for Euro and British pound. It is European financial institutions that sell Euro to oil producing countries, get their dollars and invest them in the US to gain higher yields, like loading up subprime mortgage backed securities and other risky dollar denominated debt instruments. In other words those European financial institutions are conducting a kind of Euro carry trades just like the infamous yen carry trades. However, as the woes of mortgages deepens, those European institutions are panicking, and are unwinding their Euro carry trades, causing Euro to go up against US Dollar steadily. Since the pouring of oil dollars into Europe is not a one shot event, but is continuing month after month, Euro will continue to rise against US Dollar unless The European Central Bank cuts interest rate drastically to save those European financial institutions caught in the money losing Euro carry trades. If US short-term interest rate is lowered, Euro's appreciation against Dollar will quicken its pace. As Euro strengthens, US trade deficit with EU will shrink further. It will help the US trade deficit but will lengthen the duration of the liquidity squeeze.
The most important currency to watch as FED lowers the short-term interest rate is Japanese Yen since the US Dollar's exchange rate with Japanese Yen has the potential to move suddenly and rapidly, causing Dollar to collapse in a catastrophic way if the situation is not handled right. If that happens, the gigantic house of cards of derivatives will most likely collapse, dragging down the global financial system with it and ushering in a global depression.
Japanese consumers are still suffering from the ill effects of the near zero interest policy installed more than a decade ago. The policy has been initiated by the bureaucrats of The Ministry of Finance of Japan since at that time The Bank of Japan was firmly controlled by The Ministry of Finance. After gaining its autonomy, The Bank of Japan has been trying hard to restore the interest rate to the normal level like 2%. However, once the near-zero interest rates are installed, it is difficult to cut the Japanese economy off of the addiction to such low interest rate, and The Bank of Japan has only managed to jack up the interest rate to 0.5%. This persistent near-zero interest rate environment has induced a large scale speculative financial maneuver called “yen carry trades”; it is to borrow yens at near-zero interest rate, sell the yens for dollars, and invest the dollars in higher yielding debt instruments or buy commodities and global stocks. When the value of dollar slips against yen, those speculative yen carry trades will unwind at once, causing the exchange rate of dollar vs. yen to drop further rapidly, dragging down global stock markets and commodity markets as well. On top of those speculative yen carry trades, there is also a massive amount of more conservative type of yen carry trades conducted by Japanese financial institutions and individual Japanese investors. Those Japanese private parties simply convert yens at hand into dollars to gain higher yields. If dollar drops substantially against yen, this massive conservative type of yen carry trades will also unwind, pushing down dollar further in a lightening speed. Then domestic US capitals and small foreign governments that hold US dollars as reserves will follow to run from the dollar. Finally large foreign governments like China will throw in the towel and dump its massive dollar reserve, and the globalization scheme will come to an abrupt end. The only party that can stop such a disaster is Japanese government since it can print whatever amount of yens necessary, dump those yens on the currency market to buy up all the unwanted dollars. During the reckless adventure of the Greenspan FED in 2003 when it lowered the target rate of the federal funds to 1%, Japanese government bought up nearly 400 billion dollars to reflate the global economy and prevented it from a wholesale collapse. This time if FED acts irresponsibly and lower the interest rate too much, Japanese government probably needs to buy up near 1 trillion dollars to save the situation. Even if Japanese government undertakes such a bold but thankless rescue again this time as mentioned in Comment 47, this pattern will repeat itself with each time requiring a quantum jump in the amount of dollars needed to be bought up by Japanese government. One day when Japanese government can no longer cope with the situation, that will be the day of reckoning of the globalization scheme.
Many readers are probably interested in a more quantitative analysis, like how much FED can lower the short-term interest rate without touching off a catastrophe as discussed in the previous paragraph. Before the onset of this financial panic, the exchange rate of dollar vs. yen was at the level of 121 yen/dollar. When the financial panic set in, the currency market had anticipated the inevitability of FED lowering the target rate of the federal funds, and has taken down the exchange rate to around 115 yen/dollar. After the actual cut of the target rate by 0.5% on Sept. 18, no meaningful reaction has occurred in the currency market with regard to the exchange rate. Using this series of events as a guide, we may expect that the exchange rate between dollar and yen will drop below 110 yen/dollar line if the currency market thinks another cut in the target rate of 0.5% is inevitable. This 110 yen/dollar is the watershed level. Below this level the currency market will quickly drop the dollar-yen exchange rate toward 100 yen/dollar in order to test the resolve of Japanese government to defend the dollar (Note: US government is totally powerless in defending the dollar if FED lowers the interest rate). If Japanese government does not come in for the rescue, the 100 yen/dollar level will be broken like a hot knife going through a butter. The exchange rate then will rapidly test the historical low (means the history after the World War II) of about 80 yen/dollar. If Japanese government still does not act, then the exchange rate may drop to something like 50 yen/dollar, triggering the collapse of the current globalization scheme.