The new US Federal Reserve chairman, Ben
Bernanke, believes that the current yield-curve
inversion does not signal an economic slowdown.
Yield-curve inversions occur when
short-term interest rates exceed long-term rates.
Bernanke has argued that when this occurred in the
past, short-term real interest rates were high. To
put
it another way, he says the Fed is merely in
neutral territory and has not yet applied the
brakes to the economy. Long-term interest rates
are low because of a global "savings glut",
because much of the rest of the world would rather
put their money into liquid US assets than invest
it in other economies with underdeveloped
financial markets.
We agree with Bernanke
that real interest rates continue to be low;
indeed, one of the reasons gold has performed so
well is that the Fed has allowed inflation to
creep through the production pipeline, even if
"core inflation" has not yet reached the
consumer.
Bernanke also has a point that
there is simply a lot of cash out in the markets
that has not been invested. Partially this is
because of the Fed's own policies, which have
created a sea of liquidity. Another contributing
factor has been many Asian economies creating
their own bubbles by subsidizing growth with fixed
exchange rates. The very high savings rate of
China, often reported to be 30-40% of disposable
income, is partially due to a lack of attractive
investment alternatives. The Chinese stock market,
for example, has not been able to attract Chinese
retail investors in recent years.
But in
our assessment, Bernanke is wrong. An inverted
yield curve likely signals an economic slowdown,
just as it has many times before. The US consumer
is far more interest-rate sensitive than in the
past, and consumer spending plays an ever greater
role in economic growth; it is now about 70% of
gross domestic product (GDP). Although Americans
have been known as the world's greatest consumers
for some time, never before have consumers bought
so many goods on credit. The Federal Reserve had
to redefine how it measures household-debt-service
payments in 2003 because consumers have come up
with ever more creative ways to buy not only homes
and cars, but just about everything on credit. If
you have watched US television advertisements
recently, you may have noticed that we have
entered yet another phase as automotive (and many
other) ads only state the monthly installment;
with most ads, one can no longer even infer the
full cost of the car, nor the terms of the lease.
Over the past couple of years, consumers
have financed their spending by extracting equity
out of their homes and by adding to their credit
card debt. Real wage growth has been stagnant.
High energy prices have thrown the US savings rate
into negative territory. Globalization has kept a
lid on wage growth as US companies have been
forced to accelerate their outsourcing to compete
in an environment with high raw-material prices
and little pricing power.
Adding these
factors together, we have a highly
interest-rate-sensitive consumer. As interest
rates creep up, spending must slow down sooner
rather than later, unless real wages or asset
prices rise. Bernanke acknowledges that the
housing market will slow; extracting equity from
homes through ever higher mortgages is coming to
an end. Bernanke may hope that corporate America
will put its massive cash buildup to use, but we
believe this US "savings glut" is due to the fact
that US corporations see a fragile US consumer and
better investment opportunities overseas. In our
assessment, the US economy is too dependent on the
consumer these days; other sectors of the economy
will not make up for a slowdown.
US
consumer spending has not declined in more than a
decade. The consumer was enticed to continue
spending as the tech bubble burst - and after
September 11, 2001 - through low interest rates,
low taxes and cheap imports. We are now faced with
an exhausted consumer who required "employee
discounts" last summer to buy cars; who was lured
to the stores the day after the Thanksgiving
holiday in late November with unprecedented
discount offers; and who is being offered a
"US$100,000 discount" when buying a new home
(Centex, one of the United States' largest home
builders, recently had a nationwide "special
offer" on what we interpreted to be the bursting
of the real-estate bubble in real time).
It is our view that an inverted yield
curve does indeed signal a slowing economy. We are
afraid, however, that even as the Fed is likely to
raise rates further, it will not forestall
inflationary pressures. We are rather concerned
that foreigners may be less inclined to finance
the massive US current-account deficit as the
economy slows. In this environment, gold may
continue to do well, and the dollar may continue
to be under pressure.
Axel Merk
is the portfolio manager of the Merk Hard Currency
Fund, a no-load mutual fund that
invests in a basket of hard currencies from
countries with strong monetary policies assembled
to protect against the depreciation of the US
dollar relative to other currencies.
(Copyright 2006 Merk Hard Currency Fund.
Used
by permission.)
