> By George Friedman > Stratfor, Geopolitical Intelligence Report Gosh, this is nostalgic! I haven't seen Stratfor on pen-l in a long time.
> Nor are the numbers devastating in the bond markets. By definition, a > liquidity crisis occurs when the money supply is too tight and demand is too > great. In other words, a liquidity crisis would be reflected in high > interest rates. Not true. The officially-defined money supply isn't especially relevant to a liquidity crisis, among other things because T-bills (which officially don't count as "money" = currency + bank deposits) are often used in exchanges between financial institutions. A liquidity crisis also isn't always reflected in high interest rates, at least not right away. That's because a liquidity crunch involves not just interest rates but also the increased refusal to lend at the going interest rate (intensified [non-price] credit rationing). Further, a liquidity crunch these days does not cause the hoarding of conventionally-defined money or bank reserves. It means a "flight to quality," i.e., "hoarding" of T-bills, instead of making loans. The increased demand for T-bills drives up their prices and -- by what I think should be called the "absolute general law of bonds" -- decreases the interest rates on them. Since T-bills are short-term paper, this depresses short-term interest rates. > That hasn't happened. In fact, both short-term and, > particularly, long-term interest rates have trended downward over the past > weeks. It might be said that interest rates are low, but that lenders won't > lend. If so, that is sectoral and short-term at most. Low interest rates and > no liquidity is an oxymoron. Above, I suggested that short rates are (temporarily) low _because_ banks are refusing to lend. I'd like to hear from any Wall Street folks (Anyone? Bueller? Doug?) if they think this is a reasonable interpretation of what's happened. Just because something is "sectoral" does not mean that the problem is only short-term. If a sector is crucial to the operations of the economy, problems there can mess up the rest of the economy. Time will tell how important the "sector" is. > This is not the result of actions at the Federal Reserve. The Fed can > influence short-term rates, but the longer the yield curve, the longer the > payoff date on a loan or bond and the less impact the Fed has. right (if "the longer the yield curve" means "the longer the term of the bond"). > Long-term > rates reflect the current availability of money and expectations on interest > rates in the future. To my mind, long-term rates reflect current short-term rates _and_ expectations of future short-term rates _and_ the risk premium attached to holding long-term bonds. The "current availability of money" would be the first part of Friedman's formula. He leaves out the risk premium. > In the U.S. stock market -- and world markets, for that matter -- we have > seen nothing like the devastation prophesied. by whom? > As we have said in the past, > the subprime crisis compared with the savings and loan crisis, for example, > is by itself small potatoes. Sure, those financial houses that stocked up on > the securitized mortgage debt are going to be hurt, but that does not > translate into a geopolitical event, or even into a recession. The fall in house asset prices relative to mortgage debt and the fall toward many homeowners having negative equity in their houses isn't going to restrict consumer spending? Most intelligent observers -- or at least, Dean Baker -- see the subprime mess as being just one part of what's happening these days. It's also the fall in house prices and the ability to sell houses. > Many people > are arguing that we are only seeing the tip of the iceberg, and that > defaults in other categories of the mortgage market coupled with declining > housing markets will set off a devastating chain reaction. right. > That may well be the case, though something weird is going on here. Given > the broad belief that the subprime crisis is only the beginning of a general > financial crisis, and that the economy will go into recession, we would have > expected major market declines by now. Markets discount in anticipation of > events, not after events have happened. If financiers are "hoarding" T-bills, that might lower short-term rates so much that it shifted the yield curve downward a bit, lowering long-term rates. > Historically, [stock? financial?] market declines occur > about six months before recessions begin. So far, however, the perceived > liquidity crisis has not been reflected in higher long-term interest rates, > and the perceived recession has not been reflected in a significant decline > in the global equity markets. (anticipated) recessions don't always hurt stock prices, do they? if financiers are hoping for a big rescue from the Fed, stocks might stay high. > When we add in surging oil and commodity prices, we would have expected all > hell to break loose in these markets.... > So what is going on? > > Part of the answer might well be this: For the past five years or so, China > has been throwing around huge amounts of cash. The Chinese made big, big > money selling overseas -- more than even the growing Chinese economy could > metabolize. That led to massive dollar reserves in China and the need for > the Chinese to invest outside their own financial markets. Given that the > United States is China's primary consumer and the only economy large and > stable enough to absorb its reserves, the Chinese -- state and nonstate > entities alike -- regard the U.S. markets as safe-havens for their > investments. That is one of the things that have kept interest rates > relatively low and the equity markets moving. This process of Asian money > flowing into U.S. markets goes back to the early 1980s. this is right, I believe. China's money goes into long-term assets, not T-bills (since they're not hoarding due to financial problems). With their currency roughly fixed to the dollar, there's no direct currency risk (yet). The inflow of Chinese funds has been propping up US financial markets and keeping US interest rates relatively low. It pushes down the long-term end of the yield curve, not the short-term end. If they expect the dollar to continue to fall (and the Euro to continue to rise), however, they'd shift funds over to Euro-denominated assets -- because they don't want to miss the gains they'd get from Euro appreciation. But if they think that they'd suffer from large losses on their dollar-denominated assets as a result, they might hold off. > Another part of the answer might lie in the self-stabilizing feature of oil > prices, the rise of which should be devastating to U.S. markets at first > glance. The size of the price surge and the stability of demand have created > dollar reserves in oil-exporting countries far in excess of anything that > can be absorbed locally. The United Arab Emirates, for example, has made so > much money, particularly in 2007, that it has to invest in overseas markets. there's some truth to that. gotta go! maybe I'll comment on the rest later. -- Jim Devine / "The conventional view serves to protect us from the painful job of thinking." -- John Kenneth Galbraith
