In
our assessment, the US Federal Reserve's interest
rate cut was wrong. Forget about the "moral
hazard" of whether the cut would plant the seeds
for further bubbles. Lowering interest rates is
wrong because it will do few any good, but cause
harm to many.
As the most imminent result,
the US dollar has accelerated its decline. When a
country's central bank cuts interest rates, it is
rare that the currency reacts in textbook fashion
and declines
more
than a token amount versus other currencies.
That's because, among other reasons, lower
interest rates may boost growth and make the
currency more attractive for investments. Not so
this time with the Fed's cut: lower interest rates
are unlikely to boost economic growth. The reason?
The markets are facing a valuation problem, not a
liquidity problem.
Will a subprime
borrower be helped by the cut in interest rates?
Will his or her adjustable-rate mortgage that is
about to reset to a much higher rate suddenly
become affordable? Will mortgage derivatives
suddenly become tradable? Or will these illiquid
derivatives be accepted as collateral once again
for speculators to borrow money? We believe the
answer is a clear no because the problems
are prices, not access to money.
To heal
the excesses of the housing bubble, we need lower
home prices; subprime borrowers are best helped by
downsizing, not by receiving subsidies. There is
no shortage of consumers to borrow; there is a
shortage of lenders to lend. Conversely, there is
plenty of cash around; it's just that those who
have cash are not willing to pay the prices
demanded.
The Fed's grave mistake was to
lose control of money supply during the
credit-driven expansion. As volatility, risk and
fear are returning to and are priced back into
markets, we are facing a market-induced credit
contraction. As investors pare down their leverage
and demand higher yields to be compensated for
risk, the Fed is nothing but a small, and in this
case almost irrelevant, participant in the
markets. It's in this context that former Federal
Reserve chairman Alan Greenspan is correct when he
laments in his memoirs that central banking is
becoming less important.
The markets are
facing a major challenge, though, if central
bankers, including Fed chairman Ben Bernanke,
believe they are stronger than the markets.
Pushing liquidity at any cost when the markets
demand a contraction is what gold bugs have been
waiting for; that's a positive way of saying
Bernanke may live up to his "Helicopter Ben"
reputation, flood the market with fiat money and
risk further decreasing the purchasing power of
the US dollar. The problem gets more severe as
many US policymakers believe a weak dollar may
actually be good for Americans.
Bernanke,
in his academic work before becoming Fed chairman,
has expressed that had the US veered away from the
gold standard during the Great Depression, it
would have alleviated the hardship on the people.
In his book Essays on The Great Depression,
Bernanke values this reprieve higher than
preserving the purchasing power of the dollar. In
the past, only the treasury secretary talked in
public about the dollar. Bernanke, however, has
made it a focus of his decision-making process. By
concentrating on the dollar to alleviate hardship,
he throws the baby out with the bathwater.
We are not in the Great Depression.
Importantly, because of significant
current-account and budget deficits, the US
position versus its trading partners is far weaker
than during the 1930s. If the US makes the dollar
less attractive, foreigners may demand to be
compensated through higher interest rates.
Incidentally, in a recent speech in
Germany, Bernanke pointed out that longer-term
interest rates are likely to move higher. He
thinks that we may see higher long-term interest
rates within the next decade. In our opinion, we
might be faced with higher long-term borrowing
costs much sooner.
Bernanke seems to
subscribe to the view that borrowing costs will be
contained because it is in no one's interest for
the dollar to plunge and for foreigners to refrain
from purchasing US debt. He is right that Asian
economies are uniquely dependent on selling to
American consumers; in our assessment, much of
Asia would rather destroy their own currencies
than allow the dollar to fall too much, as it
would throw their domestic economies into turmoil.
But that does not mean one can turn good
policy upside down and force foreigners to invest
in the US. This is where academically trained
central bankers looking at econometric models of
past behavior are playing with fire. At the end of
the day, market forces are stronger than central
bankers, and bad policy will cost dearly.
The major downside risk of a weaker US
dollar is inflation. Consumers see it best at the
price at the gasoline pump. But as foreigners may
reduce their appetite for US debt, and as risk
continues to be priced back into markets, credit
will continue to be tight. Tight credit means less
economic activity, a recession. Central bankers
ought to take away the punch bowl when the economy
gets too hot; instead, the current breed at the
Fed seems to believe "recession" is a four-letter
word.
Does anyone benefit from the
lowering of interest rates in this environment? In
conjunction with higher long-term rates, it
steepens the yield curve. Banks tend to have
short-term deposits (the short end of the yield
curve) and lend money for longer-term projects
(the long end of the yield curve).
The
Fed's policies are thus aimed at restoring
profitability at US banks. The challenge for the
Fed is, of course, that it is difficult to help
both mortgage holders (along with consumer
spending) and banks at the same time, as the
policies required to assist each group are
diametrically opposed. The Fed may be better off
getting out of subsidizing pockets of the economy
and instead focus on what ought to be its mandate,
to preserve price stability.
The Fed's
efforts to boost liquidity in an environment where
market forces call for a recession will cause
commodity prices to continue to be at elevated
levels. It is not surprising that the Canadian
dollar has reached parity versus the greenback:
Canada is a resource-dependent economy that has
its fiscal house in order. The major downside risk
for Canada, its dependence on the US economy, is
mitigated by the Fed's determination to keep at
least resource utilization at high levels.
The European Central Bank has so far
recognized the distinction between the varying
challenges the markets face. By keeping interest
rates high, it acknowledges that inflationary
risks are real. Switzerland just raised rates,
also acting prudently. There has been a lot of
criticism of the Bank of England's (BoE's)
flip-flopping.
While we share much of the
criticism, we have called the BoE a yo-yo central
bank for some time and are not surprised by its
actions: of the Western central banks, the BoE has
the most volatile policy, reversing course on
policy decisions rather frequently; the Brits
wouldn't want to live without this "flexibility".
On a more serious note, this behavior is well
priced into the British pound.
A weak US
dollar may boost the earnings of a couple of
multinationals based in the United States, but it
will weaken the competitive position of the US,
planting seeds for more protectionist policies in
the future. And a country dependent on the mercy
of foreign creditors can ill-afford protectionism.
Rather than protectionism, the solution is to cut
spending, for the government to live within its
means.
In the more likely event that the
government will not drastically reduce its
spending in the wake of a slowing economy,
investors may want to consider how to navigate
through what the future bears. We believe that
risk continues to be underpriced, and that the
credit contraction will not only continue for much
longer, but it will spread to overall corporate
and consumer activity.
Budgets for 2008
are decided on now; many companies prefer to err
on the side of caution in the wake of the recent
turmoil. For growth in US gross domestic product
to turn negative, we only need to have much of
corporate America institute marginal cutbacks.
Axel Merk is the portfolio
manager of the Merk Hard Currency
Fund. (Copyright 2007 Axel Merk.)
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