Competitive Tightening - Part III
In the aforementioned research paper prepared for the Federal Reserve Board, Francis & Veronica Warnock concluded that foreign capital flows have an economically large and statistically significant impact on long-term U.S. interest rates. But, more intriguingly, they questioned whether this impact represents a portfolio shift from foreign to U.S. and vice versa or a global savings glut in which bonds of all countries are being purchased at elevated amounts.
Warnock's paper points out that if the decline in U.S. interest rates is being driven by global trend, then there should be evidence that U.S. rates are being dragged down by foreign rates. That is, in Warnock's framework, a foreign spread variable (foreign rates less U.S. rates) should be positively related to U.S. long rates if a global savings glut is driving foreign and U.S. rates. However, if capital flows into and out of U.S. bonds represent the shifting of global portfolios, then the foreign spread variable should be negatively related to U.S. rates - when foreign rates rise relative to U.S. rates, U.S. rates fall.
Warnock's OLS (Ordinary Least Squares) regression model provides evidence showing that the foreign spread variable is not positive, but rather is negative and significant. When foreign rates rise and fall relative to U.S. rates, the inflows and outflows of foreign capitals are the result of "portfolio-switching" by global bond investors. Over time, it's likely that both effects are at work with varying intensity and relative importance. Nonetheless, the long-term evidence is more supportive of a portfolio-switching effect.
Essentially, the inflows and outflows of foreign capitals that impacted U.S. long-term interest rates were caused by global investors' portfolio shift rather than oversupply of global savings.
With globalization and widespread removal of barriers to foreign investment, the nature of private capital flows has changed since the 1990s. Foreign direct investment and foreign private investment are now playing a more important role. Foreign private investment, in particular, is increasingly channeled to emerging markets by institutional investors and trans-national corporations. Together, they control increasingly large amounts of assets that they can move around globally in search of high profits. The predominant role of the private investors in the allocation of financial and productive assets is now a permanent feature of the world economy. The result of this development has made global financial market more competitive on both the lending and the borrowing side.
Why is this important?
We may be looking at all the wrong places for reasons behind the Fed's recent relentless rate hike. Inflation data, for example, appear to be the wrong places and the wrong reasons because the Fed is NOT an inflation fighter. The Fed is the cause for inflation. If the Fed were sincere about fighting inflation, it shouldn't and wouldn't have promoted insatiable expansion of M3.
Chart 1 is the 52-week (1 year) M3 money supply rate of change. For the week ended March 6, 2006, M3 was increasing at 8.24%, relative to the level of M3 from about a year (52 weeks) ago. The change of the 2005 4th quarter U.S. real GDP from the same quarter a year ago in 2004 was 3.2%. Comparing apple to apple, during the final week of 2005, the 1-year M3 rate of change was 7.50%. The M3 rate of change is thus moving at 2.34 times the speed of the real GDP growth. That's inflation, and the Fed has been aiding it rather than fighting it. It's self-evident that the Fed has no intention of fighting inflation via raising interest rates or otherwise.
The starting data point on Chart 1 derived from comparing current level of M3 money supply reported for the week ended April 18, 2005 to the level of M3 reported 52 weeks ago, on May 3, 2004, when the Total Net Foreign Purchase of U.S. Treasury bonds and notes also began to decline in earnest (see Chart 2). Prior to May 2004, the year-over-year change of total net foreign purchase of U.S. Treasuries had seldom fallen below zero (blue rectangular box). After that, it has been staying mostly in the negative territory (red rectangular box).
If this trend continues and the downward spiral accelerates, the dire consequence of decreasing foreign financing for America's increasing deficits would be a catastrophe for the U.S. economy. In June 2004, at the conclusion of a two-day meeting, the Federal Reserve hence began the first of a series of consecutive rate increases. Unfortunately, the Fed's attempt to entice global investors to switch their portfolios from foreign holdings back to the U.S. Treasury bonds and notes appears to be an exercise in futility. As I've referenced in Part II of Competitive Tightening, U.S. central bank is not the only player competing for capital flows around the globe.
According to the Washington Times March 6, 2006 Editorial/Op-Ed, foreign investors financed 98 percent of the 2004 budget deficit and 95 percent of the 2005 deficit. In 2004, foreign private investors purchased 43 percent and foreign governments bought 57 percent of Treasury notes. However, in 2005, purchases by foreign private investors increased to 83% of Treasury notes financed abroad while foreign government purchases declined to merely 17%. With the dollar appreciating during 2005 by 13% against the euro, 15% against the yen and 10% against the British pound, the purchase of Treasury bonds and notes by private investors generated solid returns for them.
That then leads the Washington Times editorial to more critical questions:
"If the dollar, which depreciated during the 2002-04 period, resumes its decline and if foreign governments maintain the lukewarm demand for Treasury bonds and notes they displayed last year, then who will be available to finance America's rising budget deficit? How high would U.S. interest rates have to rise in an environment of a falling dollar to entice foreign investors to continue financing America's profligacy? Did the decline of net long-term financial flows into the United States from a monthly average of $99 billion (September-November 2005) to $57 billion in December signal a falling foreign demand for U.S. long-term securities at the very moment of rising American dependence upon these flows?"
Unfortunately, the resumption of the dollar's depreciation may be a likely statistical event as the Dollar Index (USD) once again backed down after it reached the critical multi-year support/resistance at approx. 92 in November 2005(Chart 3). The 50-day Slope has also been forming lower highs while headed for the negative territory.
The Dollar Index's inability to advance beyond the critical 92 level since 2004 has been heeded by global investors and central banks alike. What may make it worse this time is the side-effect of the Fed's rate hike, which may eventually erode American consumer's demand for imports, has made exporting countries currency valuation a lesser issue than it used to be. But American consumer's demand may be just one of the problems down the road. Asian economies' need for currency devaluation in order to compete with China for exports to the U.S. had all but changed in July 2005.
On July 22, 2005, China took a small step to allow its yuan to strengthen against the U.S. dollar by 2.1%, from the decade-old peg of $8.28 to $8.11. Chinese yuan has since appreciated 3.03% against U.S. dollar (Chart 3). While it's a small initial step, it was a significant move in the Chinese currency regime. It has thus far led to even more speculative capital inflows into China from global investors betting on further appreciation of Chinese currency. And, it has allowed other Asian authorities to let their currencies appreciate without losing their competitiveness with China. The more China lets its currency move over time, the larger will be the appreciation of other Asian currencies.
"More importantly, It may be the beginning of the unraveling of the so-called Bretton Woods 2 regime, a regime that has allowed until now the cheap financing of the U.S. "twin" deficits (budget and trade)." said Nouriel Roubini, Professor of Economics and International Business Stern School of Business, New York University.
We may be at the end of a competitive devaluing cycle and the beginning of a global Competitive Tightening cycle, and few have recognized the transition yet.
It's not an easy task trying to cover a topic as comprehensive as this in a concise three-part article while under extreme time constraint. Whether or not one agrees with my assertion, I believe a compelling and well-rounded case has been presented over the past few weeks to provoke thoughts and further discussion on this topic. I'd like to end with a quote from "Getting Serious About the Twin Deficits", authored by Menzie D. Chinn, a professor of public affairs and economics at the University of Wisconsin at Madison, who also served as a senior economist for international financial issues on the president's Council of Economic Advisers during the Clinton and George W. Bush administrations.
"A cautionary note regarding America's current path is provided by Britain's loss of military and political primacy in the twentieth century; that development followed a shift from creditor to debtor status. Similarly, a prolonged decline in the dollar's value and increasing indebtedness will erode America's dominance in political and security spheres."