Cleaning House

by Beth-Ann Bovino

A walk through the lower east side in New York can feel like Spring-cleaning at mom’s house. Back then mom would have a “Tag Sale, and everything, including my favorite childhood dreams, was priced to sell. Each item would have a tag on it. A stuffed animal from my crib priced at 25 cents. Barbie dolls, 50 cents, not to mention all the items I collected over time to make my plans to become a famous (fill in blank) come true. The U.S. is also cleaning house, again with everything priced to sell. .

Before, with the dollar a strong reserve currency and an interest rate differential that supported U.S. assets, the U.S. could easily cover its trade deficit with a capital surplus. The capital account surplus was attracted by the high returns and low risk in the U.S. financial markets. Even signs of the housing weakness in the U.S. didn’t slow inflows until the last few months. The financial tides have shifted. Now with oil prices at record levels, housing weak and home prices continuing down, the U.S. is in a recession.

This recession will likely be shallower but longer than previously anticipated. Like 2001, there might not be the usual two consecutive quarters of negative GDP growth. But it will still be a recession. It probably will be officially pronounced one by the Business Cycle Dating Committee of the National Bureau of Economic Research some time later, and certainly feel like one in the minds of most Americans.

Other things we used to take as given are no longer true. The relative bias in favor of U.S. assets has been reduced sharply, because of shrinking relative returns and increased credit risk. The financial shock that erupted in August 2007, when the U.S. subprime mortgage market was derailed by the reversal of the housing boom, has spread quickly and unpredictably, inflicting damage on world financial markets. Despite Fed action to calm markets, lending dried up. The resulting slowdown in capital inflows has pushed borrowing costs higher for both households and businesses, and brought the dollar down.

The U.S. has the largest and most liquid financial market, with about one-third of the global capitalization, and is not expected to give up this status anytime soon. However, as financial globalization continues to develop, other regions will gain prominence in world markets. Higher European interest bond yields, lower U.S. yields, and the weaker dollar have improved returns for European bonds relative to U.S. bonds, with less money coming in. Inflows into the U.S. over the last few years were dominated by fixed income private bonds. It has slowed. Flows are now shifting towards treasury bonds and equities. Real assets are cheaper because of the weak dollar. Foreign money will continue to buy up U.S. investments once investors believe the decline is nearing an end, but they will be buying more real assets and fewer fixed-income securities.

A Safe Bet?

In 2006, U.S. long-term interest rates were a percentage point above equivalent European bond yields. Money looking for the highest possible return on a safe investment thus flowed into the U.S. The surge was not pushed more by low interest rates abroad than by high U.S. interest rates. The U.S. interest rates were low by historical standards, but still higher than what foreign investors could get at home. In 2006, over 85% of the net inflow into the United States came from private sources, and increasingly went into the buying of private rather than government debt. (Only 13% of the inflow went into equities.)

The inflow of funds to the United States had made markets very complacent about risk. Investors’ struggle for yields meant that yield spreads above treasuries hit record lows. The spread of corporate speculative-grade bond yields over U.S. treasuries hit a record low in May 2007 as investors chased higher returns and ignored risk. Markets now aren’t as complacent about risk; they’ve been reminded by the subprime problems that risk is still a four-letter word. Yield spreads have widened well above normal levels corporate bonds (both investment-grade and speculative-grade), well above the historical average and over twice what we saw just over a year ago. The sharp swing from risk also hit household borrowing costs. They have climbed higher, if households can get a loan at all.

Climbing from 45-year lows, U.S. interest rates has now dropped back as problems increased. After raising rates 17 times, the Federal Reserve’s main concern has now abruptly turned to recession risk and the turmoil in financial markets. The liquidity squeeze that began last August, brought about by the U.S. subprime mortgage problems, forced the Fed and other central banks to change direction quickly. The financial shock spread far beyond the subprime mortgage market to a general crisis of confidence. Since then, the Fed has cut rates by 3.25 percentage points to 2%. The Fed cuts helped some borrowers with adjustable rate loans coming up for a reset on their loan. The Fed has also helped reduce corporate costs, but creating various term lending facilities, coordinated with other major central banks. Corporate yield spreads are, however, still wide by historical standards.

The decline in Fed-controlled short-term interest rates has not, however, been echoed in long-term bond yields. That’s because interest rates are determined by global markets. The globalization of bond markets means that a central bank has less influence on long-term interest rates than in the past. The U.S. financial markets have illustrated that in the last few years, as a Fed tightening by 4.25% was met by indifference in the bond market. The Fed has now cut rate by 3.25%, which was also met with similar indifference. European rates are now above U.S. rates, making U.S. securities less attractive and reducing foreign inflows. This has prevented U.S. bond yields from dropping in line with short-term rates.

Foreign net buying of long-term U.S. assets slipped in 2007, to $1.00 trillion from its $1.14 trillion peak in 2006. While stocks saw a record annual inflow in 2007, inflows into fixed income dropped sharply. Risk aversion was the dominant theme in the first quarter of 2008. The March report continues to show weaker foreign inflows, suggesting the decline in the dollar isn’t over. Long-term inflows that did come in, came from official sources (central banks, trying to stabilize markets) and less from private money—not a healthy sign. Foreign buying was dominated by money going into safe-haven government bonds, while private accounts sold off sharply. Foreign purchases of U.S. financial assets will likely remain weak through yearend. But, if investors outside the U.S. continue to worry about the risk of a dollar decline, the result could be both a sharp drop in the dollar and a sharp rise in U.S. interest rates, extending the recession at home.

At Bargain Prices

Recent financial market stress has had an impact on foreign exchange markets. The real effective exchange rate for the U.S. dollar has declined sharply since mid-2007, with the dollar down 8% over last year. Foreign investment in U.S. bonds and equities has been dampened by reduced confidence in both the liquidity of and the returns on such assets, as well as by the weakening of U.S. growth prospects and the Fed’s interest rate cuts. Weaker foreign inflows pushed the dollar lower. Now foreign investors have lost confidence in U.S. securities and the U.S. dollar, and money is not so easy to come by, and only at higher interest rates.

The silver lining is improving U.S. sales to foreign bargain hunters. The decline in the value of the U.S. dollar has helped boost net exports, bringing the U.S. current account deficit down to 4.9% of GDP by the fourth quarter of 2007. This is well below its 6.6% peak in the third quarter 2006. But, while improving, the current gap is still-high, and financing from abroad will now require higher bond yields.

The weak dollar will continue to attract money into some U.S. assets; at least once investors believe the dollar decline is nearing an end. Although yield spreads make U.S. bonds less attractive, the weak dollar makes real assets cheaper. U.S. firms are becoming targets for foreign buyers, who see current pricing, especially in euros, yen, pounds, or Canadian dollars, as a bargain.

According to the Bureau of Economic Analysis, foreign direct investment into the U.S. was $199.3 billion in 2007, after $175.4 billion in 2006.and $101.0 billion in 2005. Outlays in 2007 were the fourth largest recorded and the highest since 2000. Foreign money bought a substantial amount of our real estate (this was already indicated, anecdotally). Outlays also increased sharply in manufacturing and wholesale trade.

Not Going Out Of Business

The massive inflow of funds to the U.S. once helped the U.S. easily cover its trade deficit. But things have changed. Now the relative bias in favor of U.S. assets has been cut, because of shrinking relative returns and increased credit risk. Fed action has helped reduce interest rate spreads somewhat, though they are still high. The resulting slowdown in capital inflows has brought the dollar down.

Foreign purchases of U.S. assets will likely remain weak through 2008. Higher European interest bond yields, relative to U.S. yields, and the weaker dollar have made investing in European bonds more attractive than investing here. As a result, the inflows into U.S. financial assets, once dominated by fixed income private bonds, are now smaller. What money that comes in has shifted towards safe-haven treasury bonds and real assets. Real assets are cheaper because of the weak dollar. We expect foreign money to continue to buy up U.S. investments once investors believe the decline is nearing an end, but they will be buying more real assets and fewer private fixed-income securities.

While we expect inflows to slow, but not stop, things could go wrong. We’re worried that with the increased credit risk and the falling dollar the U.S. investments will become even less attractive to foreign investors. That could push bond yields up higher and the dollar down even more than we had already anticipated. The ‘Tag Sale’ would feel more like a ‘Going Out Of Business’ Sale. This scenario is not likely, but neither were $130 oil prices a few years ago.

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