Barbarians at the Fed

By: John Mauldin | Sat, Feb 21, 2004
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This week we are going to visit my Worry Closet, where things goes bump in the night. There are many writers who assure us that those sounds are imaginary and I should go back to sleep. But others suggest the sounds may emanate from some real substance, and that their corpus is growing in the dark. We will review the arguments while we take a quick peep into the closet.

But first, a few comments about last week's letter. I was writing about bond ladders and fixed income investments. Many of you rightly noted that I did not mention foreign currencies or other alternatives to government bonds.

First, I was trying to talk about building structured bond portfolios and not about what should actually go in them. The letter was getting long as it was. But I should have noted that I think foreign bonds and non-US currency Certificates of Deposits are appropriate for fixed income investors. I have been suggesting them for almost two years. Investors who took the advice are happy. Your broker or investment advisor should be able to get you foreign denominated bonds, and you can get CDs in a wide variety of foreign currencies by calling Chuck Butler at Everbank at 800-926-4922. He can help suggest which currencies are appropriate in today's market, as this changes constantly. (I should note that Everbank is a sponsor of my publisher's website.) Also, there are any numbers of good fixed income opportunities besides government bonds, which are toward the bottom of my list. Just keep your US maturities short.

Finally, this thought from my friends at Bridport Investor Services, a Geneva based firm which sells some $40 billion in bonds per year to the largest of institutions in Europe. They are some of the more sophisticated observers of the bond market. They suggest to clients that the average maturity for US dollar bonds be about 3 years, while they would average between 5-10 years for euros, depending upon circumstances, and last week they suggested moving further out for euros as a trading opportunity. And now, let's go peek in my worry closet.

The Stubborn Trade Deficit

One of the good things about finishing my book is that I have more time to read. Normally, I read 150-200 articles, letters, publications and books a week and then sit down on Friday to write about what I felt was the most interesting or important things I learned that week, trying to draw my thoughts from a variety of authors. This week, I was struck by the number of articles and commentary on the trade deficit and the decline of the dollar, as well as some disturbing statistics.

We are going to look at a number of them, and then see if we can see a pattern emerging. [As it turns out, this letter ended up being longer than usual, but it does have some very good source material, which should prove of interest.]

First, one of the things a falling dollar is supposed to do is to drive up the price of imports, thus presumably slowing down their purchase. Further it should make our exports cheaper for the world to buy, which should increase demand for those exports. The combination thus is supposed to help solve the massive balance of trade deficit we currently have.

There is, of course, a lag time between the currency dropping and the balance of trade being affected. I seem to remember reading a few years ago that it would be about two years.

Well, it has been almost two years since the dollar began its slide. And what has been the result? Numerous commentators wrote about the most recent trade data, but none more compellingly than one of my long time fave analysts, Greg Weldon:

"The US Trade Balance (an oxymoron for sure) has tilted into RECORD deficit 'territory', with Imports hitting new RECORD highs, DESPITE the depreciation of the US dollar, a depreciation that was SUPPOSED to elicit a 're-balancing.'

"So what gives ???

"Simply, deflationary forces are at work here, as US Imports of Capital Goods expanded by $1.23 billion during the month of December, to their highest single-month total since 2001 ... amid, a DEFLATION in Import Prices of ... Capital Goods, pegged at minus (-) 0.9% yr-yr as of January's data.

"On the flip-side, Export Sales of US Capital Goods fell by an eerily similar amount, posting a $1.22 billion December contraction, due to a steep decline in aircraft exports. Oh, and Export Prices of Capital Goods are also into 'deflation', posting a year-year decline of (-) 1.1% in January.

"Still searching for the 'Engine-of-Global-Growth' ... OUTSIDE of the US ??? Still ... waiting for Godot too ??? Problem IS that the US engine continues to sound more like Junior's driveway go-cart, rather than Dale Junior's Daytona winning speed-machine."

(Greg's daily letter runs about $400 a month or so, and he does a special daily metals only letter which is less, but for my larger trader and hedge fund readers, I would suggest giving Bill O'Herron a call at 203-858-1459 and trying him out. FYI, I get nothing for this free promo, but simply really like Greg's work. And now back to our regular feature.)

Think about the above for a moment. We are importing more "stuff," but we are paying less for it. This is not how currency devaluation is supposed to work.

But aren't we seeing inflation in commodity prices? The answer is of course yes. But it is evidently not translating itself into higher product prices, at least not yet.

Yet it is hurting producers outside of the US, who are finding they cannot pass along higher prices. Witness Korea, who this week announced they are shifting part of their foreign reserves to buy commodities, and are clearly intent on helping their manufacturing sector by taking up the shock of higher metal prices. China, as well, is beginning to invest part of their reserves in commodities.

As I have been writing for years, there are serious deflationary forces at work in the world at large. There is an imbalance in world trade, as the US has accounted for 96% of the growth in world trade for the last few years. (Morgan Stanley) Thus, foreign nations have to be willing to either not take depreciating US dollars and suffer the inevitable slowdown in their economies, or take less for their products in order to be able to keep their work forces producing and economies bumping along.

Now, let's move on to the article that prompted the direction of this week's letter. Peter Bernstein has been writing Economics and Portfolio Strategy for 30 years. He is the author of the best-selling book, Against the Gods - The Story of Risk and one of the most celebrated (and revered) investment analysts in the world. (FYI, the book is one of my most highly recommended reads.) His voice is one of calm and reason. Thus, when I read this month's letter entitled The Dollar Problem Revisited, I raised my eyebrow more than a little.

He starts out with the following premise:

"In case you had not noticed, the U.S. international financial position has not deteriorated. Americans can readily adjust to whatever problems do exist and should focus their attention elsewhere. Recent advocates of this hopeful view are not minor-league players. They include such serious authorities as Dr. William Poole, President of the St. Louis Fed, Professor Jeremy Siegel of Wharton, Dr. Catherine Mann of the Institute of International Economics, and Professor Douglas Irwin of Dartmouth.

"We fail to find reassurance in the views expressed by this eminent group of experts. Neither the past experience they cite nor the teachings of theory on which they rely appear to us to be relevant to the current situation, which is unique on all scores.

"The odds on a dollar crisis are high enough to warrant setting aside some portion of portfolio assets as a hedge to protect the positive bets that most portfolios contain. We emphasize that our concerns about a potential dollar crisis are not immediate. Nor are we predicting that this dreaded outcome is inevitable; a prediction that bold would be out of character for us. But as we review the facts and the lessons of theory, a dollar crisis appears to be a real possibility. As all the necessary conditions for this catastrophe are in place, no investor can afford to ignore risks of this magnitude.

"The decision-making approach of Pascal's Wager is relevant: when the consequences of a particular outcome would be extremely destructive, one has to hedge, regardless of one's estimate of the probabilities. And no one can know the probabilities with certainty."

I, too, have read the above writers in the Journal and elsewhere, along with many of their breed, tell us why "this time it is different" and that a correction in the dollar will not be a problem, nor should we be worried about huge trade deficits. Some improbably argue that the trade deficit is good, because it means the world desires our dollars and investments, and will continue to do so.

But this is clearly an unsustainable trend. That does not mean it ends tomorrow, but it will not last for long. Depending upon where you get the statistic, foreign central banks own between 39-45% of our government debt. Throw in private investors and it is even larger. At current trade deficit levels, this would grow to 65% within five years.

In an article entitled Living Beyond Our Means, Rebecca McCaughrin of Morgan Stanley writes:

"No matter how you slice the data, foreigners and Asian central banks in particular have become important lenders of last resort to the US. Yet US authorities continue to downplay the risks of growing dependence. Greenspan's claim during his semi-annual testimony to Congress that outright selling of US securities by Asian central banks would not have a material impact on interest rates is the latest case in point.

"In our view, it's hard to buy the argument that a retrenchment by foreign central banks would not have an impact on Treasury yields. Overseas investors and central banks hold $1.4 trillion, or 36%, of the $3.9 trillion outstanding stock of US Treasuries. Japan and China are two of the largest foreign sources, collectively holding $669 billion. That's not small change. And the pace of accumulation has shown no signs of abating. Demand in the latest US Treasury auctions has been very strong, with foreigners snapping up nearly half of the $56 billion in auctioned securities. In January, Japanese authorities spent a record $67 billion intervening in FX markets (presumably targeting US government assets), and the new fiscal year draft budget proposes an additional Y43 trillion (raising the total to Y140 trillion) for intervention."

While McCaughrin goes on to suggest that there is no reason to believe that central banks will stop their accumulation of dollar assets. Her worry is "... private investors - who tend to be less steady and more profit-driven - have also ramped up their exposure to US Treasuries in the last several years and now hold nearly as much as central banks. In fact, US exposure to central banks should be applauded, we believe, as they provide a buffer to the vagaries of private investors. A sell-off by central banks is not the straw that will break the camel's back, in our view, especially as long as currency competitiveness remains a key priority."

Now, let's return to Bernstein's letter: I jump to the end and his conclusion:

"In conclusion, we offer one final quotation on this matter. The source, from a presentation at Federal Reserve Bank of Atlanta on January 7, 2004, is every bit as impeccable as those we have cited above.

Here is the quotation:

'Those whose jobs are restructured face a difficult environment....The key to easing adjustment for the individuals affected is training and education....But although the U.S. economy continues to be far more vigorous than most others, foreign investors may be becoming less willing to finance the gap between what we spend and what we produce. With the current account deficit climbing, that gap is growing fast - evidently faster than the appetite for U.S. assets....The global economy does face a potential long-term structural issue. If investors are reaching a point at which assets denominated in U.S. dollars are becoming as large a share of their portfolios as they see appropriate, our trade deficit will need to shrink. We will not be able to call so much on an increasing share of world saving to finance our spending....[D]emand or spending in the United States will need to be considerably more restrained on both domestic and foreign goods, and more U.S. production will need to be exported abroad....If the fiscal path does not change, unless private savings rise considerably to compensate, interest rates will be higher than they otherwise would be to ration the scarcer savings, and we will have slower growth in the capital stock and in the number of houses and autos....The U.S. current account will not correct in isolation.'

"This man views the dollar problem in the same framework that we consider it. His name is Donald Kohn, long-time senior staffer at the Federal Reserve Board in Washington and the most recent appointee as a Member of the Board.

"We stated at the outset that a dollar crisis is not baked in the cake. But all the necessary ingredients for the baking are present. We suggest that facing reality is preferable to being taken by surprise and unprepared.


"Others write at length about this. We can put it in a few words.

"Many people focus on the yawning spread in savings rates as the key to these problems. To us, that is a cop-out and a short-cut to what we perceive as the heart of the matter.

"As Mr. Kohn concludes, 'The U.S. current account will not correct in isolation.' One or both of two steps are essential. Other countries must buy more goods and services from us over time - which means taking the many unpalatable steps to accelerate economic growth - or be willing to increase without limit their outflow of capital to our shores. Such decisions among our trading partners abroad will in turn reflect what is happening here in terms of competitive costs of goods and services and competitive returns to capital.

"The risk is that the opposite occurs, as we suggested above ... The current excess of imports and the trend toward job losses in services can stifle the animal spirits Americans need to turn the situation around and to continue attracting foreign risk capital. Central banks will not eat our Treasury bonds indefinitely.

"That is clearly not the only possible outcome. But that is why we worry and keep reminding our readers of the serious nature of these dilemmas."

(You can learn more about Peter at His letter is $1,750 per year for 20 issues.)

The Barbarians at the Fed Door

And that brings us to the growing criticism of Fed policy. There are increasing suggestions from near and far that the Fed is creating another bubble economy.

I have used this quote before, but it is always instrsuctive as we begin a discussion on Fed policy: "According to economic theorist Joseph Schumpeter, economic recoveries that are purely a consequence of fiscal and monetary stimulus must ultimately fail. Schumpeter writes: "Our analysis leads us to believe that recovery is sound only if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own.'" (The Daily Reckoning)

Should the Fed stop its easy money policy? Is it creating another bubble? Let's look at just two of the critics of current Fed policy. Typical of many, Andy Xie writes from Hong Kong, suggesting that Fed policy should change from targeting inflation and employment to:

"Macroeconomic policies should aim for stable growth rather than full employment, in my view. The integration of global labor forces through outsourcing makes the former difficult to attain. Too much stimulus only inflames asset markets, shortening and amplifying economic cycles. Thus, macro policy should aim at capping credit growth and fiscal deficits.

"Improving structural flexibility should become the primary tool to increase labor demand. With the rigidities that have developed in mature economies, growth simply cannot increase demand sufficiently to achieve full employment and offer labor economic security in exchange for a slower growth rate. This puts the burden of economic adjustment disproportionately on macroeconomic stimulus.

"The sustainability of globalization depends critically on whether the West is willing to embrace structural flexibility as the main tool for absorbing adjustment, rather than relying solely on stimulus. If the West continues to look to macro stimulus to solve economic problems, I believe it will lead to more bubbles that could eventually end with a major crash, a prolonged recession, and possibly trade protectionism that would derail globalization."

What Xie seems to be suggesting is that we allow the unemployment rate to rise because the global labor arbitrage makes full employment difficult if not impossible, and that by using massive amounts of stimulus, we create another bubble. Thus, the US should tolerate jobs leaving our shores and adjust slowly over time. Eat your spinach. He clearly did not take US Politics 101.

Further, by West, he means the US and Europe. But Europe sees the problem in different terms. Otmar Issing, the chief economist at the European Central Bank, writing in the Wall street Journal "We have repeatedly experienced situations," writes Issing, "in which market participants found it more rewarding to follow a trend than to bet against it despite their own view that the development was not sustainable. It is worth noting that with hindsight, i.e. after the collapse, almost everybody seems to agree that a 'bubble' has burst. Is it not difficult, then, to accept the argument that it should be totally impossible to make any judgment ex ante? Should it not be the role of central banks to communicate concerns in an appropriate form and thereby to try to contribute to a more sober assessment of asset price developments?"

Bill Bonner writes about this op-ed piece, noting: "Translation: 'Hey Mr. Greenspan, sober up, you've got an asset bubble on your hands, you big lush.' It appears a strong currency makes central bankers [Issing's euro] rhetorically cocky. But Issing is right. He has essentially rebuked his colleagues in the U.S. with this sentence - '... It should not be overlooked that most exceptional increases in prices for stocks and real estate in history were accompanied by strong expansions of money and/or credit. Just as consumer-price inflation is often described as a situation of 'too much money chasing too few goods,' asset-price inflation could similarly be characterized as 'too much money chasing too few assets.'"

So, let me get this straight. The Fed should raise rates to prick an asset bubble (housing and the stock market) so as to prevent a subsequent and even greater bubble collapse? Greenspan should proactively work to create a recession - one which would be deflationary - so as to reduce the value of American housing?

Because that is what would happen. If, and when the Fed starts to raise rates, the markets will react rather swiftly and violently. There is one thing, Dennis Gartman suggests, that the markets have learned from watching the Fed for 90 years: when the Fed reverses policy, the new trend tends to last longer and go further than anyone expected.

Whenever the rate increases begin, the markets will immediately move rates up by 2-3% on the shorter maturities, and longer maturities will rise significantly as well. Mortgages will rise by at least 1.5% and maybe more within a very short time. Re-financing will drop from its already lower levels, and new housing and existing home sales, not to mention home values, will come under pressure.

How does this work, you ask? A 2% rise in mortgage rates means an extra $3,400 per year on the average home payment. That means fewer people qualify for the average home. That means demand slows, which suggests supply increases. When demand slows and supply increases it is usually accompanied by lower prices.

If the US economy was robustly producing new jobs AND if we were seeing rise in real incomes, both of which are not in evidence, a rise in rates would not stifle housing demand or housing values. But in the current Steroid Economy, which is driven by stimulus, it would be an economy killer. Thus, Schumpeter's contention that a stimulus led recovery is not sustainable.

We have Met the Enemy, and He is Us

The Fed was all over the place last year, assuring us that they do not even want to flirt with deflation. We have the tools, they assured us, to contain any "unwelcome" arrival of deflation. Yet today, the year over year CPI deflator is at 0.7%, about half of what it was a year ago. That, gentle reader, is flirting with deflation in a world where the money supply is not growing.

For a quick and solid analysis of the money supply growth problem, we turn to Lacy Hunt, of Hoisington Asset Management in Austin, Texas who is quoted in thoughtful welling@weeden. (

"Dr. Hunt, points out that M2 and M3 contracted in the fourth quarter at the fastest rates since the end of World War II (6.8% for M3), and that it's even more alarming that the six-month change in M3 hovers close to zero, since sustained stagnation in the aggregates 'foreshadows slower economic growth.' The last time, he added, that both money supply measures had negative growth rates was in 1992-1993--not exactly a time of great economic performance, as reflected in then - Candidate Clinton's slogan, 'It's the economy, stupid.'

"Dr. Hunt warns, too, that 'sharp contractions in the money supply in a low inflationary environment can be hazardous to economic health. After all, disinflation is too little money chasing too many goods. And the last time money growth contracted, inflation rates slowed markedly.' With the core PCE deflator showing a yearly gain of just 0.8%, he warns, inflation doesn't have far to fall before turning into deflation. In fact, Dr. Hunt adds, 'while the drop in the Ms may be a reaction to the rise in real interest rates in the second half of '03, it may also be an early sign that the Fed is now 'pushing on a string' in the words of Keynes. Which would mean that demand for credit is falling because there is already too much debt and borrowers are uncomfortable with this much leverage--thereby raising the specter of debt deflation.

"What's more, advised Dr. Hunt, don't breathe easy because M3 rebounded in January, apparently growing at close to an 11% annual rate-because an accounting change (FASB's FIN 46, which basically makes banks consolidate the assets and liabilities of special purpose entities) is messing up the comparability of the money supply stats. It's not something the Fed has been advertising, Dr. Hunt says. He had to notice a footnote in the stats, and Ried Thunberg's Bill Jordan had to chase down Fed officials for a clarification of some muddy reporting, but when all is said and done, this pair of gimlet-eyed Fed watchers reports that rather than rebounding sharply in January, M3 was essentially flat, or maybe up 1%. Not a bullish portent."

Repeat: The Fed is Not Going to Raise Rates

And now I come back to one of my constant themes: The Fed is not going to raise rates for far longer than the mainstream thinks. Certainly not this summer or before the fall elections. Until employment numbers begin to rise and new jobs are being created at a clip of 200,000 per month for several months, it is just not in the cards. Plus, inflation must be somewhere north of 2%.

Going back to Greenspan's speech of last August where he said we must pursue policies which avoid the worst possibilities, even if we allow for some problems, the die was cast. The worst possibility for a central banker is an "unwelcome" deflation. Raising rates in the current environment, where consumer sentiment is slipping, is far too risky, in the current Fed view.

As an aside, I find it somewhat odd that consumer sentiment is falling as housing prices and the stock market rise. I am not certain what that means. Perhaps it is merely a reflection of all the negative speeches by Democratic candidates, blaming everything but tooth decay on President Bush, screaming (literally) about lost jobs, the worst economy since Hoover, etc. I know I get depressed when I listen to them. But this is something that bears watching.

Now that we've peeked into my worry closet, where is that sound coming from? It is the stubborn refusal of the trade deficit to show even the slightest hint of declining in the face of a declining dollar. If we are to come to a peaceful conclusion to our imbalances, that must happen and happen soon.

But with all of Asia seemingly bent upon keeping their currencies competitive and selling their products for whatever dollars they can get and for now willing to take the hit on dollar devaluation in order to keep their factories humming and employment growing, we plod along.

China is the linchpin. When they allow their currency to rise, assuming it does, the rest of Asia goes along with them. There should be no illusion about this fact: we are no longer in control of our currency. We are subject to the tender self-interested mercies of the world, and especially china and Japan.

Of course, this fits in with my overall theme that we are in a Muddle Through Economy for the remainder of the decade. The forces mentioned above, plus the global labor arbitrage, will serve to keep us below an average of 3% growth, plus produce a probable two more recessions this decade. Peter is right. "The current excess of imports and the trend toward job losses in services can stifle the animal spirits Americans need to turn the situation around and to continue attracting foreign risk capital. Central banks [and private foreign investor -JM] will not eat our Treasury bonds indefinitely."

Unless job growth and income picks up significantly, we will slowly see the current spurt of growth, spurred by stimulus, begin to fade. The next recession will eventually emerge, as there is always a next recession. Will it be one in which we start from 1% rates with little room for Fed maneuvering? Anything the Fed does at that point to provide the necessary stimulus to keep us from deflation will take us into unknown policy territory.

History Suggests a Bump in the Road

I have done a lot of thinking and studying about trade deficits. I can find no instance where a country saw its trade deficit rise to 5% and had a smooth landing. There was always a rough patch which followed. I invite readers to show me one case where that observation is wrong. I really would like to know.

We are in a situation without precedent. I continue to believe that we are ok for most of this year, as more stimulus from tax rebates is now ready to flood the economy. But there is an end to that road. Retail sales are slowing.

We have just come through the biggest and most massive stimulus for any economy in world history, and we have not been able to create enough jobs or increase business investment much beyond replacement. (As noted in previous letters, much of the improvement in the unemployment rate is from the removal of millions of people from the unemployed side of the ledger, as they have stopped looking for jobs, and thus, by government reckoning, are not unemployed.)

It seems to me to be setting us up for a recession beginning sometime next year or 2006 at the latest. It is hard to tell, because with the Fed artificially holding short term rates down, the most reliable predictor of recessions, an inverted yield curve, cannot be definition happen. (An inverted yield curve is when short terms rates rise above long term rates, and since WW2, has always been followed within four quarters by a recession.)

But that is enough for today.

My bride is on her way to Puerto Vallarta, Mexico. I am writing the letter one day early this week. I was looking forward to being home with the boys for the weekend, but sadly must fly to San Diego tomorrow for a memorial service for the father of one of my good friends.

I will be hosting my own private first annual Accredited Investor Strategic Investment Conference April 22-24in La Jolla, California. Richard Russell will be speaking live and in person, as well as George Gilder, Rob Arnott, Martin Barnes and yours truly, plus a host of others. Details will soon follow.

I will be in Las Vegas speaking at The Money Show from May 11-13. This is a massive event. They expect over 10,000 attendees, and you can register for free at

Your off to catch a plane analyst,


John Mauldin

Author: John Mauldin

John Mauldin

John Mauldin

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