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3 RISKY
BUSINESS Global economy faces a dangerous
year By Jephraim P Gundzik
increasing systemic problems for the US
financial system arising from the collapse of the
US housing market.
Between 2001 and 2005,
very low interest rates in the US, combined with
the proliferation of non-traditional mortgage
products and easy credit access, allowed many
American households to convert substantial home
price gains into income gains through cash-out
mortgage refinancing. Cash-out mortgage
refinancing accounted for
about 50% of all mortgage refinancing between 2001
and 2004. In 2005, cash-out mortgage refinancing
accounted for 73% of all mortgage refinancing. In
the first half of 2006, cash-out refinancing
accounted for a staggering 87% of all refinancing.
Home price appreciation in the US slowed
sharply in the first half of 2006. In the third
quarter of 2006, home prices began to fall
steeply. According to data from the US Census
Bureau, new home prices dropped nearly 10% in
September 2006 from the same period in 2005. This
marks the sharpest fall in US home prices in 35
years. Rising inventories of unsold homes have
been pushing home prices lower.
Recently,
America’s largest home builders and home sellers
have begun trying to convince investors and home
buyers that the housing market has stabilized.
Falling long-term interest rates have reduced
mortgage rates, encouraging a very small number of
buyers to return to the market. However, the
housing sector’s weak pulse is very likely to
vanish again in early 2007 as confusion over
Federal Reserve policy mounts, the pace of
inflation quickens and financial markets in the US
swoon.
America’s economic fairytale has
turned into a nightmare and very few investors
realize it. In addition to producing a sudden and
sharp decline in household income by eliminating
the prospect of new mortgage refinancing for many
Americans, declining prices for new and existing
homes will have a strong negative impact on the US
financial system, severely restraining credit
growth. Falling home prices, especially in what
were once the hottest housing and mortgage markets
in the US, have caused mortgage default rates and
foreclosures to surge higher.
The
combination of rising defaults, foreclosures and
falling collateral values is beginning to weaken
the balance sheets of mortgage lenders, including
several of America’s largest banks. Growing
weakness in the banking sector is very alarming.
Banking sector and economic crises in many
countries over the past 25 years can be traced to
overly enthusiastic credit growth used to finance
either capital investment or real estate
speculation, or both. Japan offers a stunning
example of what can happen after a real estate
bubble bursts.
The Federal Reserve appears
determined to let financial markets “self-correct”
in order to adjust interest rates to changing
expectations for economic growth and inflation.
Self-correction is a defining feature of financial
markets. However, with the Fed rudderless, it is
very unlikely that this self-correction will occur
in an orderly and gradual manner. Rather, such
self-correction will be sudden and sharp.
Dollar devaluation Growing
concern at the Federal Reserve over the impact of
rapidly rising mortgage defaults and foreclosures
on the US banking system will prevent it from
tightening monetary policy in 2007. Inflation in
the US is already substantially higher than
inflation in Europe and Japan. Rising energy
prices joined by rising food prices will have a
greater impact on inflation in the US than in
Europe and Japan because dollar depreciation is
expected to partially offset rising dollar-based
commodity prices in 2007.
In addition,
inflation will rise from a much lower base in
Europe and Japan than in the US. As a result, US
inflation will be much higher than inflation in
most other countries in 2007. More importantly,
real yields on US Treasury securities, which are
only marginally positive now, are expected to
become negative in 2007 as US inflation climbs
higher and the Fed begins to cut interest rates.
At the same time, real yields on European
and Japanese government bonds, which are already
higher than real yields in the US, are expected to
move higher. The growing real yield gap between
the US and other countries will place enormous
downward pressure on the dollar. Waning Fed
credibility and increasing political pressure in
the US for dollar depreciation will speed the
dollar’s decline.
Democrats will take
control of the US Congress in January 2007.
Democrats have a strong history of economic
intervention and are very likely to use trade and
exchange rate policy changes in an attempt to
reinvigorate rapidly slowing US economic growth.
Asia’s economic giants, Japan and China, are
likely to take the brunt of any economic policy
changes engineered in the US Congress.
Legislation in the US aimed at prying open
export markets in Japan and China is likely to
inflame already substantial trade tensions,
especially between Washington and Beijing.
Meanwhile, the implicit change in US exchange rate
policy that will precede
