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     Oct 26, 2005
Greenspan's conundrum
By Axel Merk

US Federal Reserve Bank Chairman Alan Greenspan is confused - why are long-term interest rates so low? Is what he calls "too low" a risk premium courtesy of his successful policies? Inflation runs at an 18-year high. Will gold climb further, and the dollar resume its decline?

Let us start with Greenspan's "conundrum". Many flat out say the market has it all wrong and will come to its senses, suggesting that long-term interest rates will rise dramatically. Maybe. Market prices reflect the average of all participants' expectations. If your opinion diverges from the average, then you may choose to invest accordingly in anticipation that the market will converge on your scenario. Of course, in the future, market prices will not reflect the facts then, but expectations at that point; be aware of the old saying that markets may stay irrational longer than you can stay solvent. While we often disagree with what the average is thinking, it is a good starting point in any analysis. If you know your



opponent's strategy, it is much easier to win than if you are convinced of yourself and blindly execute your own strategy without reference to your environment.

Similarly, if Greenspan tells us he doesn't understand the yield curve (the relationship between longer and shorter dated securities), we should be worried. He might just push the economy in the wrong direction if he doesn't know where it is heading.

Enough modesty - let us attempt to explain what so few have been able to. Some say low long-term rates suggest we have no inflationary pressures. Joe Battipaglia, an eternal bull who tells us to "look at the facts", dismisses arguments that inflation is in the pipeline and that the soaring price of gold is a reflection of jewelry demand picking up in Asia and China. With due respect to Battipaglia, this is nonsense. The gold price, in our view, clearly signals that we have inflationary pressures and a flight to hard money; the expected increase in jewelry demand cannot fully explain its rise.

But why are long-term interest rates so low then? Is it the foreign purchases of US debt? They are a factor in holding long rates down, but let us keep in mind that foreign governments tend to purchase mostly shorter-dated maturities. What about corporate America as a buyer of longer-dated debt securities? While the US consumer is heavily in debt, corporate America has amassed enormous amounts of cash after cleaning up its balance sheets - many US corporations are now adding to the demand rather than supply in the fixed-income markets as they manage their cash.

We believe there is another story behind the low rates of longer securities that is all too obvious: the US economy is slowing down. But there is a difference: after all, we had GDP growing at 3.3% in the 2nd quarter - not exactly a sign of a stalling economy. One can argue that GDP is overstated because of inflation, and that an economy that must offer "employee discounts" to sell cars is in trouble. We would like to take it a step further. We had one airline after another declare bankruptcy; now the world's largest automotive supplier, Delphi, has declared bankruptcy. General Motors and Ford are likely bankruptcy candidates. What is happening is that corporations cannot pass costs on to consumers. Greenspan has been arguing that prices have to rise at some point because of costs being passed on. Stagflation advocates have said that wage pressure will build. What is different from the 1970s is that we now have Asia at our doorstep flooding us with cheap goods. The analysis cannot stop there. We believe that companies that cannot adapt will simply disappear (or be kept alive with subsidies or protectionism). If you are a European exporter and cannot pass on your higher costs and lower margins due to a strong euro, you might just vanish.

The Greenspan conundrum, unplugged, means: Our low long-term interest rates suggest that we are going to lose entire industries in the looming economic downturn. Industries that cannot adapt quickly enough to our global economy will be wiped out; cutting expenses is important for them, but will not be enough, as no developed country can compete with the cost of labor in Asia. Instead these companies must focus on superior value. Some European firms have long embraced a luxury brand model; but that may not be enough if these firms do not control their distribution channels. As an example, Safeway dictates what the cost of a six-pack of beer is. If you can't meet that price, there will be others that will.

There are a number of reasons why it is so much more difficult to pass on higher costs these days. Much of it has to do with Asia over-producing goods as a result of their subsidized exchange rates. Asia believes that it must generate economic growth at all cost to provide jobs and political stability. The result is a surge in world commodity prices (we had high commodity prices before the hurricanes) and low consumer goods prices. In addition, take a US consumer that is heavily in debt, and you end up with very little pricing power. Corporate America is squeezed by both high raw material prices and a lack of pricing power, resulting in accelerated outsourcing. US policy makers have added to this vicious cycle with low taxes and low interest rates. What US policy has done is to accelerate a cycle to the point where the transition is too fast for old economy companies to keep up.

The US economy is a diversified economy with great success stories; one of the more recent ones is the rise of Google. Google is all that "old economy" is not: flexible and capable of thriving in this environment. Highly accommodating monetary and fiscal policies have helped pick up the slack of ailing industries. This is not the place to discuss whether an economy can survive long-term if it entirely dismantles its manufacturing base and exclusively focuses on services. What we do know, though, is that the accommodating policies have created inflationary pressures in just about all sectors of the economy where we cannot import goods from Asia. And while we are at it, we also created a phenomenal housing bubble that has allowed the US consumer to increase spending (by taking out home equity loans and refinancing) while real hourly wages have been on the decline.

We do not see a conflict in low long-term rates and high gold prices - at least not for now (depending on Federal Reserve actions down the road, long-term rates can easily rise substantially). What about inflation and economic growth going forward? The Fed has been steadily raising rates. Bill Seidman, respected for his role in handling the Savings & Loan (S&L) crisis in the 1980s and now chief commentator on CNBC, says Federal Funds rates would need to move to 5.5% just to have a neutral impact on economic growth. We agree: even with the many small increases in rates, we still have an accommodating monetary policy, one that fosters growth and inflation. At the same time, the economy is clearly slowing down. Because consumer debt is at record levels and consumer spending comprises an ever larger share of the US economy, the economy is ever more sensitive to changes in interest rates. The federal government is also more interest-rate sensitive: not only has the absolute debt increased dramatically, but since the former treasury secretary, Robert E Rubin, abolished the 30-year bond, the duration of federal debt has significantly decreased. In plain English: the government has joined the large portion of irresponsible consumers by refinancing its debt with the equivalent of adjustable rate mortgages.

Corporate America has reasonable-looking balance sheets, but we cannot rely on them to bail this economy out. The reason Corporate America has not invested much of its cash is because it sees the shakiness of the American consumer and is reluctant to invest. Policies in the US and Asia have led to such a rapid acceleration in the pace of change that much of the developed world cannot keep up. We hear a lot about the US economy being less energy-dependent than in the 1970s. That's only partially true. We consume a lot more than we did in the 1970s. Nowadays, many of the goods are produced abroad, but it still takes energy to produce them. For now, foreign producers have absorbed the high energy cost through lower margins. We still need to transport these goods within the US, which is causing us plenty of pain with high energy prices. In Asia, companies also get squeezed more and more. While China is a cheap-labor country, it is not a low-cost country.

We believe Asia will continue its path as long as it can afford it. We also believe that we cannot assume Asian countries will react rationally when US consumption slows. It is unclear whether Asian countries will try to devalue their currencies even further in a desperate attempt to continue to sell to the United States, even at a loss. Governments in Asia may be more interested in political stability - presumably achieved through economic stability - rather than internal transformation. Some argue that Asia would be better off if the region deployed its massive labor force to focus on internal growth rather than feeding the US consumer. While that may be the case long-term, political leaders are afraid of the transition: if its largest customer, the US, were to diminish in importance, the void would pop some of the bubbles that years of over-expansion have caused within Asia.

What does this all mean for the dollar? We believe the dollar continues to be at serious risk as the balance of payments between the United States and the rest of the world is unsustainable and further escalating. Currently, foreigners have to purchase more than $2 billion worth of US denominated assets each day just to keep the dollar from falling. Until a year ago, many of these purchases were direct purchases of US government securities. Over the past year, a shift to direct investments has taken place; the highest profile move was China's failed attempt to purchase US oil firm Unocal. As China is rebuffed from securing its future resource needs in the US, it has moved to purchase resources in other regions in the world. Not only is China diversifying away from US dollar assets, more and more governments openly talk about moves to diversify their dollar holdings. As countries look for alternatives to the US dollar as a reserve currency, gold and the euro are gaining a higher profile. We also believe countries will intensify dealing in the local currencies of their trading partners. For example, as China wants to diversify its export market, it may acquire more euros to subsidize its sales to the region; conversely, as China is going to get ever-more resource hungry, it will engage in more trade with resource rich countries, notably Australia and Canada.

If US consumption drops, there might be a drop in the trade deficit. A lower trade deficit will require fewer purchases by foreigners of US dollars. However, a drop in the trade deficit may not be enough to support the dollar. The United States next year will pay more to foreigners in interest charges on its own debt than it receives in interest. With US debt growing rapidly, interest rates rising and much of US debt in short-term securities, this will have a negative impact on the balance of payments. Also, if - as we suspect - US consumption slows just as the housing market enters a more-serious decline, foreigners may be less willing to invest in US assets. We do not believe the fundamental pressure on the dollar will go away unless and until policies are put in place to foster savings and investment rather than consumption. In the short term, an already negative US savings rate may decline further as this winter's higher heating costs will surprise many. This will be offset in the medium term by an inability to extract further equity from refinancing; US credit card companies are also about to double the minimum payment required on outstanding balances, which may provide short-term relief to the reported savings rate. For now, consumers continue to believe that their real earnings will grow and have refused to cope with reality.

In the meantime, expect inflationary pressures to continue to build, just at a time when the US economy is slowing.

Axel Merk is Manager of the Merk Hard Currency Fund

(Copyright 2005, Axel Merk)

 

 
 


 

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