Monday, November 26, 2007

The Great Risk Aversion and The Global Economy

The Great Risk Aversion is unfolding and nowhere is this more obvious than in interest rates and credit spreads.

The 3-month US T-bill is at 3.22%, much lower than the Fed Funds target rate of 4.50%. This is not only a signal that the market expects further Fed rate cuts, but it also shows that participants are getting so risk averse they are willing to accept significantly lower returns from an instrument deemed 100% safe (the government can always print more money), instead of lending to the interbank market. The spread between Fed Funds and 3m T-bills is at a 17-year high (see chart below).

Data: FRB

Longer-term Treasury rates are also moving lower: the 2-year note is at 3.07%, the 5-year at 3.41% and the 10-year at 4.00% - all much below the Fed Funds rate and going down fast (click chart to enlarge).

Chart: FRB St. Louis

There is flight to "certainty" taking place right now, even as commodity prices are soaring. Bond investors are clearly dismissing all current inflation worries: the 20-year inflation indexed Treasurys are now yielding 1.98%.

Chart: FRB St. Louis

Credit spreads
are rising, signifying increased unwillingness to provide credit to those borrowers deemed riskier. Commercial paper spreads are on the rise again (chart below).

Chart: FRB

There are many more indicators of credit spreads widening, in the asset-backed and straight corporate bond and loan sectors. The various CDS indices (ABX, CMBX, CDX, LCDX) are all making new lows in most tranches, pointing to increased worries about upcoming defaults and credit events. The result is that as interest rates drop precipitously for government bonds, other borrowers are not benefiting. Lenders are becoming increasingly worried that they are not going to get their principal back, never mind interest payments. Treasury bond rates are no longer indicative of the general level of borrowing costs in the wider economy.

If this was all that was happening, we would unequivocally expect credit destruction to lead to deflation, or at least disinflation. But the ongoing Chinese boom is lifting the economies of the commodity economies (oil block, Brazil, Canada, Russia, Australia), providing a cushion to the global economy.

The question is this: can China replace the US as the global economic locomotive and prevent a worldwide slowdown? In my estimation, no. Despite its soaring growth rates, China remains a poor country and cannot create nearly as much final demand for goods and services as the US. Replacing export business with domestic consumption may be sustained for a while by the expenditure of accumulated reserves, but after they are gone the pantry will not be restocked with export earnings.

Data show that US imports from China are already slowing down; in September they grew by only 9.5% from a year ago, the slowest in at least five years (see chart below).

US Imports from China, percent change from year-ago level (3m moving avg.) Chart: FRB

Bottom line? The evidence suggests that we are heading for a global economic slowdown, despite the surge in commodity prices. Such price action may be better explained by three factors unrelated to marginal physical demand:

a) The weakness in the dollar as global reserve currency.
b) Late-stage market events (i.e. final speculative blow-off) .
c) Resource extraction maximization (e.g. Peak Oil).

17 comments:

  1. The interesting thing to me is that imports from China are still rising. When will we start seeing a year over year decline?

    ReplyDelete
  2. a few possibilities to answer anon's question:

    1) when wal-mart has yoy sales declines (they alone are one of China's biggest trading partners, much larger than most nations).

    2) when stuff is manufactured somewhere besides China.

    3) when there is not enough credit/debt/money (all the same thing) left to buy more cheap plastic crap from China.

    4) soon, very soon.

    ReplyDelete
  3. Don't forget political and market-based reasons for trade with China from the U.S. (and I suspect other countries) to decline: unsafe products leading to crackdowns by regulators and consumers worried about their children's health and safety.

    For instance: contaminated toothpaste and toys containing lead and "date rape" drugs horrify the buying public and government regulators alike. Expect much less demand from China as consumers flee to more expensive domestic toys and products.

    ReplyDelete
  4. Given the "lunatic shopping" on the Black Friday, I do doubt that the customers would start avoiding Chinese products. As long as the products are cheap, and sold on discount, the lunatic will buy them in bulk and on credit.

    ReplyDelete
  5. Hi hell,
    I can only agree and repeat : chinese consumption spending is about 2.5 % of world gdp. but US consumption spending is about 20 % of world gdp. people make the mistake to say that China is contibuting strongly to world gdp growth; they forget to say that chinese growth is based on exports (to the USA and EU) and not on domestic consumption...
    Miju

    ReplyDelete
  6. The China chart says it all. We will lead the rest of the world down. Nice commentary!

    ReplyDelete
  7. Junk bond yield spreads have twice reached or exceeded 10% in the last 15 years (1991 and 2001). See http://www.frbsf.org/publications/economics/letter/2001/el2001-33.html#subhead1

    Each dollar of total credit market debt expansion is now accompanied by only 16 cents of income growth for the entire U.S. (using the table on TCMD and income growth from the Z.1 Flow of Funds report). A 16% interest rate would mean all income goes towards interest payments. With a 4% 90-day T-bill rate and a 10% spread, companies that have to pay 14% on interest would face very bleak times.

    Or is it unlkely that previous 10% spreads will be seen again on junk?

    ReplyDelete
  8. re: junk

    What is even more worrisome is that so many of the bonds issued in the past 5-6 years were junk (or very near it) at the point of issuance.

    Even investment grade bonds in the total corporate bond universe are now mostly BBB, i.e. one step above junk. The CDX Investment Grade index is made up of 125 bonds with an average rating of BBB+.

    regards

    ReplyDelete
  9. Enjoyed your web site even though I spent (invested) a day and a night reading it all.

    Here are a few questions:

    What do you think of using tariffs to restore US manufacturing?

    How do you know that consumers have so much debt? Do you have info about the debt or are you assuming that since spending is more than income that the difference is debt. If the latter, how much of spending can be accounted for by the liquidation of savings?

    ReplyDelete
  10. Dear mike:

    Thank you for considering reading this blog an investment.

    Consumer (household) debt and related statistics are released by the Federal Reserve on a regular basis.

    See:

    http://www.federalreserve.gov/Releases/

    Regards

    ReplyDelete
  11. On the subject of tariffs...

    When I am mad I say, yes, absolutely. When I calm down I say, no, it's a lose-lose bargain.

    I much prefer that the US would embark on a crash course of investing in alternative energy, energy efficiency and environmental remediation technologies and projects, as a way to restore manufacturing and technological prowess. Energy is the biggest business of them all and could provide millions of good jobs and export products to the US.

    ReplyDelete
  12. Excellent post. The game is so over, isn't it Hellasious? Whatever happened on Black Friday (we may be about to have another different sort of Black -Friday soon) that may, may mind you, have been constructive, it will not stem the tsunami of insolvency that is about to break with full force on the shores of the U.S. economy.

    Brace yourselves!

    ReplyDelete
  13. Hellasious:

    I completely agree with you on investing in alternative, renewable energy sources. We have done this in the past with other economic engines of progress (railroads, highways and the internet to name just three). The real problem with alternative energy sources are two-fold:

    1) There is an enormous start-up costs associated with the technologies; and

    2) How to work toward an efficient use of the income that would be generated from its creation. (Mainly what I am trying to get at is avoiding private profits derived from public expenditures. Unlike the previous three I mentioned, any benefit derived would be direct for whatever entity received the income derived from its use; and Americans have a strong aversion to government-owned enterprises, i.e. socialism.)

    And Mike:

    The issue of debt has been a big issue of mine at my blog, too. Of course, my background is a bankruptcy attorney; so I might be a little biased in this area.

    ReplyDelete
  14. Hellasious,

    Excellent post which I agreed with 100% until reaching the words 'peak oil', not because I am an oil fanatic but the theory is neo-malthusian while the methodology and forecasts assume too much (complete knowledge of what can't be known in advance, global geologic constraints, foreknowledge of socio-economic and technological changes to the extent these last are - within 'peak oil' - even considered). The methodology is such that every wrong prediction, which would be nearly all, can be covered by merely pushing the date ahead while all the while maintaining that no matter how often and spectacularly wrong it is right. Somewhat religious.

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