Rate hikes may create 'perfect storm' Commentary: How oil, housing, and China could all crash By Joe Duarte, Market Watch | April 4, 2005 http://cbs.marketwatch.com/news/print_story.asp?print=1&guid= {24EED6D8-E169-476D-90BC-36A4F4F75513}&siteid=google DALLAS (MarketWatch) -- Uneven growth rates in the United, Europe, and Japan especially compared to China are setting up a dangerous situation in a competitive world dependent on oil. Bond and currency markets have recently sounded the alarm, with dramatic climbs in bond yields hitting Germany and the U.S., while the U.S. dollar has begun to fall. On the one hand, the United States is "exporting democracy" to the world. In the view of conservatives, the export of ideology is boosting capitalist practices around the world, and in turn continuing the seemingly never-ending thirst for raw materials, especially in the emerging markets. Yet, in Europe, France and Germany are trying to rig the European Union's financial rules in order to allow the expansion of their budget deficits. U.S. debt rating agencies have, unusually early, sounded the alarm against any tinkering in the E.U.'s budgetary constraints, setting the situation up for potential downgrades, and possibly creating more turbulence in the bond and currency markets. China's Key Role As Europe flounders in its self-inflicted bowl of economic soup, and Japan muddles along, China continues to outpace them all, fed by still relatively low interest rates, and international capital searching for growth. But, even that, will come to an end, at some point, especially if the Federal Reserve raises interest rates further. It's difficult to predict when that magic rate will be hit. But, for those who believe that China's economy addicted to cheap money, the withdrawal syndrome will be painful when it happens. According to Intelligence service Stratfor.com: Chinese "debt is extremely vulnerable to interest rate hikes. As rates rise, that debt will become impossible to maintain, and China will face the beginnings of a financial crisis. Given the makeup of the Chinese financial system, such a development is unavoidable. The only questions regarding the crisis to come are time frame and severity." The coming credit crunch After 9/11 the Fed flooded the world with dollars. Much of that money went to China, driven by the growth rates of the Chinese economy, and escaping what some thought would be a major Depression scenario in the United States. That dramatic change in the flow of capital is responsible for China's seemingly endless expansion. The net effect is that the world economy is now used to cheap credit, and is booming, especially in emerging markets like India, and China. In the United States, million dollar homes are being financed with adjustable rates and low interest only mortgage payments. But the Federal Reserve, and more recently, the European Central Bank are concerned about possible inflation. Furthermore, with global levels of debt at dangerous levels, maintained only by liquidity, the market is likely to be more sensitive to smaller rate hikes, and that the whole system could come apart faster, if the Fed reaches a critical point in its interest rate hikes. According to BankRate.com, 5-year adjustable rate mortgages in the U.S. have risen from 4.2 to 4.8%, over the last six months, while the Fed Funds (www.federalreserve.gov) rate climbed from 1.6% to 2.5%. If, the Fed raises the fed funds rate at one-quarter point from now until September, at each of its upcoming four meetings, rates would be at 3.5%. If there is one surprise half-point rate hike, the Fed Funds could be at 4%. Five-year adjustable rates could theoretically rise to 6% or above, creating a significant increase in the monthly payments for those who can't or won't lock in lower rates. The oil connection With the IEA projecting a 25% increase in Chinese oil consumption for 2005, OPEC is continuing to pump at full tilt. Yet, this is a dangerous game, since any kind of significant slowing in the Chinese economy could lead to a major decrease in oil consumption. The bottom line is that a sudden drop in demand would lead to an oil glut. Conclusion Assuming that the Chinese economy hits what is an inevitable bump in the road, that would mean that somewhere later this year, perhaps in July or August, the traditional time for financial markets to start stumbling and churning, we could be in for another Asian meltdown, as in 1997's Thai Bhat debacle. That could mean that by October, the usual bad month in the markets, things could be fully underway. If U.S. households find themselves in a cash flow crunch, as a result of rising mortgage rates, and the Chinese economy is suddenly drained of foreign cash, being repatriated to the United States due to the lure of rising interest rates, a significant change of scenario in the markets is not just likely, but inevitable. The shift could start suddenly, and progress quickly, fueled by fiberoptic communications and the flow of information at the speed of light. A sudden slowing of the global economy would also nearly guarantee lower oil prices, a situation that in and of itself, given the geography of OPEC and Russia, the world's number 1 and 2 oil producers, could lead to geopolitical instability. That would explain the increased volatility in the bond and currency markets of late. (Editor's note: Dr. Joe Duarte's Daily Market IQ is published daily at www.joe-duarte.com. Duarte offers free news coverage and analysis at www.intelligentforecasts.com.) ------------------------ Yahoo! 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