Category — Emerging Markets

Martin Feldstein’s column, (June 29, 2009) on inflation opines that while federal stimulus is still necessary, a combination of looming deficits, federal reserve bond purchases, and skittishness of foreign investors are pushing yields on the 10 Year Treasury up to alarming levels.

Feldstein’s major premise is detailed in the second paragraph of his column: Higher Yields have led to higher mortgage rates, reducing home buying, depressing net worth tremendously in the last six months. Further, lower home prices have caused more defaults and “weakened bank balance sheets”.

Lets correct some facts: Between 2006 and Six Months ago (December 2008), house prices dropped 27 percent. From December 2008 to March 2009 - the latest month of data,  housing prices fell comparatively 7%. Further, August 2009 Futures for Case-Shiller Composite index is currently trading at 152.0 slightly above where the index level stood in December of 2008, bookmarking the recent rise in treasury yields.

Feldstein, in his column, notes that the current spread between 10-year TIPS and 10 year Treasuries shows an inflation expectation of 2% annually. That inflation predictions have “jumped” to slightly over 2% per year is hardly alarming. 2% is often seen as an inflation target. That the jump in rates is perpetrated by fears foreign investors may no longer continue to buy US debt is simply not true.

China, most notably, while making loud noises is in a “dollar trap”, argued most notably by Paul Krugman. Fail to purchase US Treasuries, and decline the dollar’s value, making our goods cheaper and China’s goods more expensive, ending China’s competitive advantage in manufacturing.

At a high-level, if manufacturing in China continues to keep durable good costs down, and the Federal Stimulus package will improve roads and cargo lines, reducing transportation costs, price increases outside of energy spikes are hard to imagine for durable goods measured in CPI.

Perhaps Feldstein’s view of investor skittishness and his call for the Fed to assure the markets it will curb future “inflationary lending” are really directed at asset inflation: Perhaps investors believe that while policy makers are acting vigorously, nothing structurally has or is going to change to prevent another asset bubble similar to house price inflation witnessed over this past decade.

Asset inflation, be it houses or equities, is much harder to prevent than inflation in durable goods. Let us hope our fiscal stimulus and monetary policy are giving the economy surer footing to produce more, sharing those productivity gains across a wider spectrum, ensuring a diverse economy in the odds of preventing future asset bubbles.

The Federal Reserve released its combined 2008 Financial Statements on April 20, 2009. 2008 was stunning, with the balance sheet growing from $915 billion to $2.245 trillion. The major increases were in the commercial paper facility, foreign currency swaps, and term asset backed facility. Essentially - stabilizing mechanisms for short term market operations (both foreign and domestic) to continue.

The increase of $1.33 trillion is slightly larger than the gain in US GDP from $13.178 trillion to $14.264 trillion from 2006 to 2008. Essentially, the gains in US GDP from 2006 - when the Case-Shiller Composite Housing Index reached its peak - to 2008 are now sitting on the Fed’s books when they should be out in the private economy, on the balance sheets of companies, creating the next wave of products and services.

There are those who have argued the Fed’s actions will cause tremendous inflation. It is important to remember the major actions of the Fed are all preventing short term credit disruptions, which if not collectively implemented,  would have all lead to price declines, deflation.

Currency Swaps, worth roughly $553 billion or 1% of world GDP, are held against a basket of G-20 currencies, have most likely prevented an increasing demand for dollar. In the fall of 2008, the demand for the dollar reached a recent record high. Further appreciation would have further pressured US producers, unable to compete on price for various goods/services. The only solution would have been to cut costs to reduce prices.

Commercial Paper, worth $333 billion, is necessary to keep working capital afloat. Without it, the only solution to meet existing funding needs or return previously funded commercial paper would have been to liquidate existing inventory at reduced prices.

Term Asset-Backed Facility (TAF), worth roughly $450 billion, is further short term financing to allow banks to continue liquidity while suffering losses on their longest duration assets - CMOs. Without access to short term financing, again the only choice would be asset liquidation, further forcing price declines.

True, CPI did not increase in 2008. But added together, the Commercial Paper and TAF are roughly 5% of US GDP. As most companies were levered to the tilt, if the Federal Reserve funding was not there, the US price and consequentially unemployment situation would have been far worse.

As to worries of runaway inflation, the jury is still out. My belief is that the capital these facilities are replacing - in a sense - is now shoring up the balance sheets of various banks and companies. By increasing  equity ratios at companies and banks, future invested dollars from these newly shored up institutions will need higher returns on capital (all else equal), which is equivalent to the Fed raising fed funds rates to control inflation.

Until a recovery though, it is a good thing our economy has not faced deflation, certainly a real possibility in the fall of 2008.

Iceland’s current saga is not a pleasant one. Currently, all banks are nationalized and the government is receiving aid from the IMF. Further, the Bank of Iceland has been forced to raise key interest rates, forcing a recession.

Let’s go back to 2006. According to the IMF, Iceland’s current account deficit grew from 2.6% in 2005 to 4.23% of GDP. The inflation rate was 7% in 2006.

To be sure, credit was certainly cheap in 2006. So cheap that in late November, 2006 the Republic of Iceland issued a five year Euro denominated bond for one billion euros, with a coupon of 3.75% annualy. The yield when it was sold was 3.86% (3.86%!). In context, the bailout of Iceland from the IMF is worth 1.65 billion euros. For a country that two years later would be in default conditions, 2006 certainly was a cheap year.

Remember the good old days of 2006-07?

On a random January 17th, 2007 3-Month LIBOR was 5.36%. Yet two treasuries were bidding 4.91%. The Fed Funds target rate was 5.25%. In short, spreads were short.

More amazing were Emerging Market Bonds and the market’s confidence in sovereign performance.

• On that same January 17th, 2007, the Ukraine’s debt expiring in June, 2013 was priced only 1.35% higher than US government bonds of the same duration.
• South Africa was only 0.97 basis points more and
• Russia, the country that would 18 months later invade Georgia, had debt set to expire in March, 2030 only 100 basis points more than the US treasuries.

(sigh)

The picture is significantly different today.

• At market close on November 12th, Ukraine’s debt noted above is now 18.13% more than US treasuries.
• South Africa’s is 6.61% greater .
• And Russia’s debt is 5.45% higher.

Why?

Current Account Deficits are the place to look.

• Ukraine: At the end of 2006, 3.71% of GDP. Today,  the IMF estimates it is 7.2% of GDP
• South Africa: At the end of 2006, 7.26% of GDP. Today,  the IMF estimates it is 8.0% of GDP
• Russia: At the end of 2006, it had a surplus of 9.50% of GDP. Today,  the IMF estimates it had dropped to 6.4% of GDP.

In general, owing more to debtors outside your own walls creates one of two possibilities:

1. Default (as in the case of Argentina)
2. Currency devaluation, which when importing basic staples or other durables, causes inflation, making the bond payments less valuable

But further, this massive spread increase could also be caused by a flight to “quality” of US Treasuries. Capital is simply skittish of anything but the US Taxpayer. Which, at this point, should give us all pause.

Regardless, the bailout the G1, G3, G7 are trying is crimping the ability for emerging markets to raise capital, increasing strain on IMF funding and solvency.  Crowding out 101 is in effect.

In yesterday’s Financial Times, an article appeared on Ireland’s increasing yield to would be investors of its sovereign debt. While France and Germany’s two year bonds trade at 2.83% and 2.52% respectively, Spain and Italy’s two year bonds trade 3.13% and 3.38% respectively, Ireland had to offer 25 basis points more than average European Yields.

In today’s Financial Times, further evidence of sovereign debt problems as emerging markets are having a harder time raising funds. Most countries signaled out are running high current account deficits. Translation, the sovereign currencies are poised for a revaluation, aka decline.

With current account deficits, there are no foreign reserves (dollars or Euros) to give investors comfort the debt is guaranteed. Many remember the Asian Financial Crisis, where countries debt was loaned in dollars, ran current account deficits, and were forced into dramatic currency revaluations.

Let’s hope the Federal Reserve’s Swaps work.

But the real question is: Given even Euro denominated Ireland’s problems, what would Dani Rodrik do?