Sunday, July 12, 2009

Central Banks v. Markets - Who Will Win?


One of our favorite topics here at So? is the relationship between global trade, treasury bonds and the dollar. The geopolitical policies that drive these three concerns are one in the same. There were imbalances building in these relationships for many years but while the world economy was humming along nicely, everyone was content with the status quo. With the continuing economic collapse, however, market forces are ravaging economies and the wisdom of the prior policies is being questioned. Allow me to spend today's article summarizing the situation. It really is quite simple once you take the time to break it all down.

Here is the basic relationship: there is a trade imbalance between the United States and the rest of the world. The US simply imports more than it exports. This leaves the US with an abundance of foreign goods and foreign producers with an abundance of dollars. Foreign nations plow these excess dollars into US treasury bonds. They do this for two reasons. One is to artificially prop up the dollar's value and thus keep down their own currency. This is important for their exporters to remain competitive in the game of selling goods to US consumers. The second reason is because they simply have nothing better to do with these dollars. Some nations try to use their dollars to buy US companies, but these efforts are often rebuffed by the US government - see Chinese Drop Bid to Buy US Oil Company and The Dubai Ports World Controversy.

The relationship described above is now threatening to break apart. The catalyst is the US consumer's new frugality. See the personal savings rate as a percentage of disposable personal income courtesy of Calculated Risk:


The long decline from 12% to below zero for the savings rate has ended. Since the recession began the rate has now increased to 6.9%. I expect this rate to reach at least 8% by next year, which is the long term average savings rate. Since incomes are stagnant and savings are rising, this means that consumption must decline. Note that this is good news for the long term, despite what some political hacks and crooked economists might tell you.

Why have consumers stopped spending? There are many reasons. First, because of the economy, many people have lost or are afraid of losing their jobs. No jobs means less spending. Second, demographics. Older people tend to spend less money than middle aged people. As the US population ages, it will spend less in aggregate. Third, the level of credit available to US consumers is in decline. Home equity withdrawals, a key source of credit from 2002-2007, has declined precipitously. Credit card companies are tightening lending standards, lowering limits, increasing minimum payments and raising interest rates.

The US consumer is tapped out. This means that the US trade deficit is declining. See that the trade deficit declined in May courtesy of Calculated Risk:


The trade deficit has decreased. This means that foreign exporters are selling less goods to Americans and their manufacturing has collapsed. See global manufacturing has collapsed courtesy of the Federal Reserve of Dallas:


This means that foreign countries now have less excess dollars now than they had previously. This of course means that there are less dollars to buy US Treasury bonds. This means that Treasury bonds and the dollar must have collapsed, right? Well, not yet at least. Here is a one year dollar chart:


And here is a one year chart of the ten year treasury note:


The longer term charts are not as pretty but clearly there is no collapse yet. Why? One reason is that the dollar and treasury bonds are still seen as safe havens and because of the global recession, there has been increased demand for safe assets and thus dollars and treasury bonds. This is a tenuous psychological response that could give way at any time if market participants reassess their prior biases. Second, central banks have been intervening in the currency and bond markets. See the Swiss franc has depreciated because of the intervention of the Swiss central bank. Next see "Rambo" Fed buys treasuries.

What is going on here? Global trade has been imbalanced for a very long time. This was unsustainable and finally came apart in the past year. The markets want to weaken the dollar and weaken US Treasury bonds until the US trade deficit becomes balanced. This also entails a large decline in global manufacturing, which is too painful for policymakers to accept. The world's central banks are trying to prevent market forces from correcting these imbalances. For now, it is working in two respects: the dollar and treasury bonds have held their value. The intervention is failing in two respects: global trade and US consumer spending are not returning to their prior levels.

So who will win in the end - the central banks or the market forces? In the short run, we cannot know for sure. Global trade and US consumer spending could rebound in the short term. In the long run, however, the market always wins. Until next time...
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