Treasury Yields and Currency

At the moment there is a great deal of talk about the falling prices of treasuries. The explanation for this appears to fall into two camps; one explanation is that there is perception that the worst of the crisis is over (meaning that investors are willing to abandon the 'safe haven' of treasuries), and the other is that markets are being spooked by government deficits and quantitative easing (QE - money printing) of the Federal Reserve. Without being a market insider, it is difficult to judge the relative importance of either factor.

One of the errors on this blog has been to overestimate the collective intelligence of the markets, which means that the former explanation is quite plausible. However, the critical factor in the US treasuries market are the rate of QE and the continued confidence of overseas buyers (in particular China). I will return to this, which is a well worn theme of the blog.

The really curious part in this is that any 'recovery' that might involve a move out of treasuries is quite simply impossible. The US is on course for a deficit of $1.84 trillion, which represents about 13% of GDP, and the 'recovery' therefore must be financed through treasuries. If there is any concerted move out of treasuries into other assets, what will be funding the deficit? During the early part of the crisis there was a 'flight to safety' into treasuries, which has inevitably held yields down on bonds, and allowed the growing deficits to be financed. If at any point this process sees any significant reversal, then funding the deficit will become increasingly difficult.

Quite simply, aside from the fact that a failure to fund the deficit would be catastrophic, what kind of 'recovery' is it, if it is being financed by borrowing 13% of GDP?

A long time ago, I made an analogy with a household to explain the absurdity of this notion. A household has been racking up huge debts due to too much expenditure on the 'good things in life', but continues spending. All the time the family's debt is increasing, and then the bad news comes. The wife's job is under threat, and the husband's working hours are being reduced. Their income is declining, but the cost and size of the debt is increasing. They are in deep financial trouble, and are borrowing more and more money in order to keep their lifestyle and also to make payments on previous debt.

It looks like the household is in crisis, and they will soon go bankrupt if they continue their profligate spending. Fortunately, so it seems to our irresponsible family, a visitor comes to their house from 'Dodgy Loan Corporation' and offers them a further and much bigger new loan. They look at the figures, and it appears that, if they accept the loan, the family will be able to continue to live the same lifestyle as they had before. A massive weight lifts off their shoulders, and they live happily ever after.....

We can all (I hope) see the problem in the happy ending. I have not mentioned the prospects for the family's income increasing in the future, and without a massive increase in income, bankruptcy will just be delayed. Sadly, for the family, there is no identifiable prospect of such a massive increase in income in the future, and they are just hoping that 'something will turn up'.

As such, when there is talk of recovery, it is necessary to ask how much of the 'recovery' is simply the massive amount of new borrowing appearing in economic activity. Whilst the money may allow, for a short while, a perception that all is OK, spending is simply exceeding income on an ever greater scale. The debts are just getting bigger, and the prospects of ever repaying are diminishing.

The underlying problem that arises is that the equivalent of the 'Dodgy Loan Corporation' is China, and China is less and less willing to lend. The problem for China is that they have already lent huge amounts, and bankruptcy will mean a loss on their previous lending. The next problem that China has is that the 'family' refuses to rein in their spending, and is continuing to spend more than they earn. In the event of bankruptcy, they lose it all, but if they continue there is no prospects of repayment of the new debt. They are faced with the problem of whether they too might believe that 'something will turn up', or whether they cut their losses.

I have, for months now, been highlighting the many articles in which China has been sounding warnings to the US about their profligacy, and will not repeat the same points I have made many times before. The important point is that China is losing patience, and certainly does not believe that the US policy is sustainable. The best expression of the doubts about the prospects for the US in China was not from official channels, but through the laughter from Chinese students in response to a speech by Geithner in China. He had proposed that the Chinese $US assets were 'very safe'.

The problem for the US is that China does represent the 'Dodgy Loan Corporation', and without their ongoing financial support, the US is bankrupt.

This returns to the question of the bond markets, and the impossibility of a 'recovery' in which money moves out of treasuries into other assets. The only way any movement of money out of treasuries into other assets might be sustained is if China steps up to the plate as the Dodgy Loan Corporation, and actually makes up for the shortfall that will arise. In other words, if other creditors are withdrawing support (for whatever reason), somebody has to enter the market in their place.

It looks very unlikely that China is going to play this role.

The question then arises as to how this problem might play out. I would like to give a firm answer, but must speculate. The problem is that it is impossible to forecast how markets might shift in a situation of an impossible dilemma. If the markets move out of treasuries into other assets, then increasing doubts about the viability of the US state will arise. At the same time, many other indices will tick up, apparently suggesting that recovery is around the corner. In other words the signals will contradict one another. If recovery is around the corner, then perhaps the US state is viable after all. If recovery occurs, then the state will be able to repay the borrowing.

The problem is that the recovery is not a 'recovery'. It is an upswing that is resultant in further expansion in borrowing.

I have to assume that the collective intelligence of the market is not very high, as indications over the last year suggest that they have a limited ability to adapt to new circumstances. Whilst they must eventually adapt, they are slow to do so. In the end, markets will shift towards acceptance of reality, but the process is delayed by clinging on to old paradigms.

In the interim, it is very likely that there are going to be wild swings in sentiment, and what appear to be contradictory indicators appearing all over the news.

These problems are not restricted to the US.

As many of the readers will be aware, there are significant problems in many of the traditionally rich countries - in the Euro area, the UK and in Japan. Each of these economies has a range of problems, similar solutions such as government stimuli and QE, and varying degrees of underlying economic problems. The key question that many investors will be asking in this situation is not which is the best bet as an investment, but which is least worst. I have recently written an article for TFR, in which I outline the underlying problems for investors - determining which currency might be 'safe'.

In the article, I ask why Sterling rose despite the negative watch on the currency from S&P. I will not repeat the article (you can read it here), but the underlying point is that all of the traditionally wealthy economies are looking 'ugly'. As a result, as has happened recently with Sterling, currencies will shift on any news - whether good or bad (e.g. the decline in Sterling as a result of the troubles of Gordon Brown).

What I am trying to do here is paint a picture of the potential for extreme volatility in the coming months. In particular, there are many contradictory forces within individual economies, and uncertainties about the relative health of the traditionally wealthy economies, when one is compared to another. There is, therefore, going to a period of considerable uncertainty as the underlying economic changes start to work through markets, and as investors flee from one high risk into another high risk.

The certainties in this scenario is that the economic shape will eventually shift to reflect the underlying shift in wealth, which is the shift from the traditionally wealthy countries to the 'emerging' markets, and that the economies of countries like the UK and US will be left in tatters.

It is also increasingly probable, but still not certain, that China is going to emerge as the dominant economic power.

In other words, what we are seeing is the final process of the shift of the world into the new economic shape. The only questions that remain are how the process will actually play out, over what timescale, and the level of drama with which the change happens.

Note 1: I have long been discussing the prospects of the RMB as the new reserve currency. I pointed out long ago that the Chinese government would never openly declare such an intention, but that they would rather use proxies. A recent article in the Telegraph reports a continuation of this process:

Guo Shuqing, the chairman of state-controlled China Construction Bank (CCB), also said he is exploring the possibility of issuing loans to trading companies in yuan, allowing Chinese and foreign companies to settle their bills in yuan rather than in dollars.

Mr Guo said the issuing of yuan bonds in Hong Kong and Shanghai would help to develop the debt markets in China and promote the yuan as a major international currency.

The reality is that Mr. Guo would never say such a thing without approval of the government. However, the government is still in a position where they can deny any such intentions, and deny any plan to make the RMB the reserve currency. In the interim, the IMF has suggested that their SDR might be the new reserve currency, following the line of the head of the Chinese central bank. Perhaps they do not realise that this proposal from China was simply a method of indirectly attacking the $US, as an early step in manouvering the RMB in to position as the replacement?

Note 2: Some replies to comments on the last article:

Lord Sidcup: I would like to reply to your 'bafflement', and might do so in the future. However, that is a complete post rather than a reply to a comment. I hope to answer your question at some stage.

Luke Skywalker: Some interesting ideas, which again need a long answer. I would hope though that I have answered many of them throughout the blog.

Matt: I have previously discussed the land tax idea I believe (following another commentator pointing it out), so I would guess that you can find my thoughts in the archive. If I remember correctly, my main worry was how the tax might be assessed. However, it is a long while ago. Overall I remained unconvinced, and will therefore apologise for not revisiting the subject.

Tiberius: Your quote seems to sum up the nature of the process of accepting reality and is relevant to this post, so I will requote here:

"All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident."
- Arthur Schopenhauer

Lord Keynes: Thank you for your many links, and well researched comments. I have previously read (and commented on, I believe) 'The Roving Cavaliers of Credit', which was linked to by a previous commentator. Like many such articles, it is very clever, but I believe misses the real basics of economics. If you increase the money supply, eventually it must lead to inflation. However you look at it, if you have 100 units of output, and 100 units of money, if you increase the units of money without increasing output, there is more money per unit of output. That, in the end, must lead to inflation. It is just a question of time....whether output can expand faster than the impact of the increase in supply.

Note 3: I am a bit short of time for replies, so apologies for the brevity and not including replies to all the comments. I wanted to take time to highlight a little discussion I had on the Von Mises Institute (Austrian Economics) comments section. I have argued in this blog for a fixed 'fiat' money supply, and posted a brief suggestion to that effect. I was rather surprised by the response. I am not certain that my idea is sound, and am open to positive or negative comments. However, I was a little surprised at the dogmatism of the responses from (presumably) Austrian economists. I have copied one of the replies below:

• Cynicus Economicus,

  "regarding the origin of money, I do not believe this is an issue."

  You vastly underestimate the importance of this issue. Money can only originate in the processes of the market. In other words, the best money is chosen by the market. Moneys that don't originate on the market are not good moneys. So the system you're advocating would entail bad money because it cannot originate in the processes of the market.

  "Electronic money is the obvious answer, not paper money"

  Electronic money cannot originate in the processes of the market. The money commodity must have prior barter value before it can originate on the market. Electronic money doesn't have prior barter value. Furthermore, electronic money does not possess an important characteristic of good money: scarcity.

  To be blunt, the system you suggest has no promise.

This was a bad example, but I did feel that they did not address the points that I made. I am not sure that I was very eloquent, but even so...I seem to recall MattinShanghai identifying the Austrian school as dogmatic, and feel I have to agree. This is a pity, as I do like their arguments against Keynesianism. Am I being unfair to them - was my argument addressed? Or was it just poorly expressed, or completely unsound. Comments welcomed.....