Monday, September 27, 2004

Here's a little mystery to ponder.

Everyone is puzzling over the strange conjunction in the US of rising Fed rates and falling long-term rates. As the Fed raised the federal funds rate from 1.00% to 1.75%, the interest rate on 30-year fixed rate conventional mortgages fell from 6.32% to 5.70% today. Rather than see this strange set of events as a big sign of "no confidence" from the bond market, the rah-rah crowd thinks sees assurance of low interest rates into the infinite future and with them robust economic growth over the rainbow. Economists are even predicting yet another round of home refinancing if the 10-year goes below 3.75% (it's hovering around 4.00% now), yet more fuel for an already out-of-control housing bubble in places like California.

Things look pretty different in the UK. There, rising Bank of England short-term rates have had all the expected knock-on effects for long-term rates. The BoE's repo rate stands at 4.75%, up from 3.50% late last year. Variable rate mortgages are up as well in Britain, from 5.00% last summer to 5.75% today. The quick demise of the UK housing bubble has followed predictably in tow.

So why the "normal" relationship between short-term and long-term rates in the UK but an "abnormal" relationship in the US? That's the $64,000 question.

Here's a guess: massive Asian capital flows to the US are flooding the domestic US market with cheap credit, driving down interest rates and completely negating the effects of Fed tightening.

Let's compare the US and the UK. In 2004:I the US current account deficit was 5.1% of GDP (and growing rapidly as we all know). For the same quarter, the UK current account deficit was just 1.9% of GDP. In addition, we know that the US financial market is not simply a national one but a transnational one thanks to what many call the "dollar bloc" linking the US to East Asia. The effect is that a growing US money supply leaks into Asia, keeping inflation down. In reverse, a shrinking US money supply can import from Asia and thus keep interest rates down. The British pound has no such release valve. Being an overwhelmingly national currency (only about 5% of international reserves are held in sterling), nobody is gobbling up pounds or UK government bonds like discounted Halloween candy. Tie this onto a flagging US economy and a cash-flush US corporate sector and you get credit supply far exceeding credit demand, a wonderful recipe for falling long-term interest rates in the US.

Is this a cause for celebration? Hardly. It simply exacerbates current unsustainable trends such as the US federal budget deficit and our current account deficit as well as spraying toxic "refi" fumes into the American home-owner's paper bag for yet one more huffing binge of equity-withdrawal consumption.

This is simply speculation so far, but there is a logic here worth pursuing.

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