The Real Interest Rate Conundrum



By
Henry C.K. Liu

Part I: The Real Interest Rate Conundrum

Part II: Currency Devaluation Depresses Wages Globally


This article appeared in AToL on June 13, 2007 as How currency devaluation destroys wealth




In today’s financial world, a liquidity boom produces rising nominal or face value in return on investment (ROI) with an increasingly hollow economy in two ways: 1) by devaluing all currencies against real assets and 2) by keeping down wages and worker benefits around the globe.

Thus while all currencies devalue steadily but not at the same pace, all of them devalue faster against real assets and slower against labor cost because wage adjustments tend to lag behind both real and nominal inflation rates. This translates directly into low real valuation for labor, structurally constraining growth of demand to fall behind growth of supply. This in turn leads to an overcapacity economy of declining consumer purchasing power. Neo-classical economists call this the business cycle which Keynesians assert that it must be countered with demand management through full employment with rising wages supported by deficit financing in down cycles.

The Laws of Overcapacity

The first law of overcapacity is that it is deflationary (falling market prices of assets) which in turn requires falling wages to maintain corporate earnings.  The second law of overcapacity is that it discourages new plant expansion so that existing capital assets appreciate in market value in nominal terms as liquidity increases, causing the stock markets to rise even though their economic value remains stagnant.

But the laws of overcapacity naturally lead to a downward economic spiral that ends in depression. Moreover, socio-political stability requires nominal wages to continue to rise above inflation. Thus the convenient monetarist solution is to allow stealth but real devaluation of currencies against real assets, but with a slower devaluation rate against the value of labor, giving wage earners the false feeling of gaining while actually losing. The global regime of declining currency value is one that will lead to a new form of slavery, despite a rise in living standards from higher labor productivity and resource utilization as a result of technological progress.

Universal Currency Devaluation Masked by Exchange Rate Regime

Universal currency devaluation is masked by an exchange rate regime in which currencies rise and fall unevenly against each other around the benchmark US dollar as the prime reserve currency while all currencies fall against hard assets in unison but at different rates due to varying local conditions. The uneven rates of currency devaluation present windows of profit opportunity for arbitrageurs in the global foreign exchange and financial markets. A network of interlocking asset bubbles then grows around the world as a result of dollar hegemony and the emergence of deregulated global currency and financial markets, jumping over national borders, fuelled by a general devaluation of all currencies while the trading public is distracted to focus on the relative exchange value of one currency against another.

Thus while both the dollar and the euro steadily fall, Europeans are comforted by seeing their currency rise against the dollar in recent years when in fact the euro has merely been temporarily falling at a slower rate than the dollar. As the dollar, the prime benchmark reserve currency for trade and finance, devalues against assets, the exchange rate regime in the current international finance architecture will eventually drag all currencies down with the dollar, lest the trading partners of the US should find themselves saddled with trade penalties associated with inoperative exchange rates.

A Confused Public

The general public is further confused by uncertainty about whether a rising currency is good or bad for them. They are told to rejoice when their currency falls as the goods they produce will sell in larger quantity because they can be bought with less money by foreigners, even their own income per unit of production will fall and they themselves will be crowded out of restaurants and shops in their own hometowns by suddenly richer foreign tourists. Ironically, while any normal citizen should find the prospect of receiving less money for the same amount of product he/she produces unappetizing, policymakers insist that there is no alternative systemically. In the mean time, the rich in the world get richer from declining wages worldwide.

All the economies of the world are competing in global markets by pushing their domestic wages and worker benefits down in search of globalized “growth”. The global market has turned into an arena for universal voluntary slavery to serve global capital.

Wicksell’s Ideas Obsolete

Wicksell’s idea of fighting inflation by pegging interest rate to ROI, operative under industrial capitalism, is problematic in finance capitalism because of the emergence of structured finance in which the traditional discounted rate of return for industrial investment tend to be overwhelmed by astronomical returns from financial manipulation routinely expected of hedge funds and private equity firms. To fight stealth inflation from currency devaluation, Wicksell’s notion of pegging interest rate to ROI in structured finance would set interest rate so high as to make the sky-high Volcker rate of 19.93% pegged to money supply look tame.

Further, in Wicksell’s time, there were no exchange rate issues as there was no foreign exchange market since the reserve currency was based on the gold standard with other currencies adopting fixed exchange rates against it and cross border movement of funds was strictly regulated and current accounts between trading nations were settled in gold regularly through adjustment of national accounts in the Bank of International Settlement. Domestic interest rates had no direct immediate effect on the exchange value of a country’s currency. Today, domestic interest rates have a bearing on currency exchange rates, albeit increasingly less directly. High domestic interest rates will push a currency’s exchange rate upward, hurting a country’s current account balance, worsening domestic inflation, even though this relationship is increasingly obscured by the decoupling of nominal interest rate from the real interest rate and the decoupling of exchange rate between currencies from the real value of all currencies as derivative of a fiat dollar as the main reserve currency.

The Lessons of 1987

The 1987 crash was unleashed by the sudden collapse of the safety dam of portfolio insurance, a hedging strategy made possible by the new option pricing theory advanced by Noble Laureates Merton/Scholes. Institutional investors found it possible to better managing risk by protecting their portfolios from unexpected losses with positions in stock index futures. Any fall in stock prices can be compensated by selling futures bought when stock prices were higher.

This strategy, while operative for each individual portfolio, actually caused the entire market to collapse from the dynamics of automatic herd-selling of futures. Investors could afford to take greater risks in rising markets because portfolio insurance offered a disciplined way of avoiding risk in declines, albeit only individually. As some portfolio insurers sold and market prices fell precipitously, the computer programs of other insurers then triggered further sales causing further declines which in turn caused the first group of insurers to sell even more stock and so on, in a high speed downward spiral.  This in turn generated other sell orders from the same sources and the market experienced a computer-generated meltdown.

The 1987 crash provided clear empirical evidence of the structural flaw in market fundamentalism which is the belief that the optimum common welfare is only achievable through a market equilibrium created by the effect of countless individual decisions of all market participants each seeking to maximize his own private gain, and that such market equilibrium should not be distorted by any collective measures in the name of the common good. Aggregate individual decisions and actions in unorganized unison can and often do turn into systemic crises that are detrimental to the common good.  Unregulated free markets can quickly become failed markets. Markets do not simply grow naturally after a spring rain. Markets are artificial constructs designed collectively by key participants who agree to play by certain rules. All markets are planned with the aim of eliminating any characteristic of being free for all operations. Free market is as much a fantasy as free love.

In response to the 1987 crash, the US Federal Reserve under its newly installed chairman, Alan Greenspan, with merely nine weeks in the powerful office, immediately flooded the banking system with new reserves, by having the Fed Open Market Committee (FOMC) buy massive quantities of government securities from the market.  He announced the day following the crash that the Fed would “serve as a source of liquidity to support the economic and financial system.”  Greenspan created US$12 billion of new bank reserves by buying up government securities from the market, the proceeds from which would enter the banking system.

The $12 billion injection of “high-power money” in one day caused the FFR to fall by 75 basis points and halted the financial panic, though it did not cure the financial problem, which caused the economy to plunge into a recession that persisted for five subsequent years.

High-power money injected into the banking system enables banks to create more bank money through multiple credit-recycling, lending repeatedly the same funds minus the amount of required bank reserves at each turn.  At 10% reserve requirement, $12 billion of new high power money could generate in theory up to $120 billions of new bank money in the form of recycled bank loans from new deposits from borrowers.

The Brady Commission investigation of the 1987 crash shows that on October 19, 1987, portfolio insurance trades in S&P 500 index futures and NYSE stocks that crashed the market amounted to only $6 billion by a few large traders, out of a market trading total of $42 billion. The Fed’s liquidity injection of $120 billion was three times the market trading total and 20 times the trades executed by portfolio insurance.

Yet post-mortem analyses of the 1987 crash suggest that though portfolio insurance strategies were designed to be interest rate neutral, declining FFR was actually causing financial firms that used these strategies to lose money from exchange rate effects. The belated awareness of this effect caused many institutions that had not understood the full dynamics of the strategies to shut down their previously highly profitable bond arbitrage units. This move later led to the migratory birth of new, stand-alone hedge funds such as Long Term Capital Management (LTCM) which continued to apply similar gighly leverage strategies for spectacular trading profit of over 70% return on equity that eventual led it to the edge of bankruptcy when Russia unexpectedly defaulted of its dollar bonds in the summer of 1998. The Fed had to orchestrate a private-sector creditor bailout of LTCM to limit systemic damage to the financial markets. The net effect was to extend the liquidity bubble further that migrated from distressed sector to healthy sector.

The 1987 crash reflected a stock market bubble burst the liquidity cure for which led to a property bubble that when burst in turn caused the Savings and Loan crisis. The Financial Institutions Reform Recovery and Enforcement Act (FIRREA) was enacted by the US Congress in August, 1989, to bail out the wayward thrift industry in the S&L crisis by creating the Resolution Trust Corporation (RTC) to take over failed savings banks and disposed of their distressed assets at fire sale prices.  The Federal Reserve reacted to the S&L crisis with further massive injection of liquidity into the commercial banking system, lowering the FFR from its high of 9.86% reached on May 10, 1989 to 3% on September 4, 1992, making the real rate near zero until February 4, 1994.  It was too late to help George Bush, Sr. in his second term election in November, 1992, but it gave the Clinton era a liquidity boom. Since there were few assets worth investing in a down market plagued by overcapacity, most of the new money went into relatively low-yield bonds.  This resulted in a bond bubble by 1993, which then burst in 1994 when the Fed finally started to raise the short-term rate, reaching 6% on February 1, 1995.

By 1994, Greenspan was already riding on the back of the debt tiger from which he could not dismount without being devoured by it. The DJIA was below 4,000 in 1994 and rose steadily to a bubble of near 12,000 by 2000, a 300% rise, while Greenspan raised the FFR seven times from 3% to 6% between February 4, 1994, and February 1, 1995, a 100% rise, to try to curb "irrational exuberance" in the stock market, and kept it above 5% until October 15, 1998, after contagion from the 1997 Asian Financial Crisis hit Wall Street, when the Fed reversed course on interest rates.

By the mid-1990s, excess liquidity had fueled a worldwide equity rally that found its way into the Asian emerging markets, where it fed an unprecedented bubble of easy money in the form of undervalued currencies pegged to a falling US dollar.  When the Asian emerging market bubble crashed abruptly on July 2, 1997 as the Thai central bank suddenly ran out of foreign exchange reserves in a matter of days trying to maintain its unsustainable currency peg, followed by the Russian debt crisis in 1998, all the major central banks of the world reacted yet again by pumping even more liquidity into the global banking system, exacerbating a new wave of global decline in currency value. During this period, the dollar never rose in real value although its exchange rate with Asia currencies rose because the Asian currencies were falling in value faster than the dollar.

Confusing Money with Wealth

Money itself is not wealth, only a generally accepted measuring unit of wealth. Liquidity, the flooding of the financial system with money, does not necessarily add wealth.  Liquidity accelerates financial transactions that can create or destroy wealth depending on the terms of exchange. In the days of industrial capitalism, wealth was created by the creation of productive hard assets, while in finance capitalism wealth is created only by earnings. Where as wealth is increased by more production in industrial capitalism, earnings in finance capitalism increase only money income which only adds wealth if the purchasing power of money does not decline. When asset prices rise without real expansion of the purchasing power of earnings, money is simply devalued while the nominal value of assets increases as real wealth remains stagnant or even declines.

Initially, this flood of money that began in 1994 inflated another bond bubble, which popped viciously in 1999.  Then, more liquidity released by the Fed boosted equity prices further and provided the fuel for the enormous tech stock bubble of 1999 and early 2000.

The Fed’s Money Creation Addiction

The first three years of the 21st century saw a world-wide equity market crash followed by a recession plagued by global overcapacity, over-indebtedness, and over-leveraging.  And the response of central banks was always more liquidity through low interest rates in relation to return on capital, which helped pump up the bond bubble in 2003 and supported artificial rallies in housing prices, equities, commodity prices, higher corporate debt without changing debt/equity ratios and mushrooming emerging markets, particularly China.  Fools were calling it a US-led recovery.

A Bubble within a Bubble

Once the genie of excess liquidity is out of the bottle, it is almost inevitable that a bigger genie will have to be let out of a bigger bottle to keep the ongoing bubble from bursting, to avoid the nasty consequences of a burst bubble for the financial system and the real economy.  Central banks round the world, led by the US Federal Reserve, despite their pivotal role in helping to create financial bubbles, nevertheless declare that bubbles cannot be anticipated and nothing can be done to prevent them, but central bankers comfort markets by claiming magical power to handle the destructive consequences of bubbles, through a one-note monetary policy of short-term rate cuts to inject fresh liquidity, to save a bursting bubble by creating a bigger bubble. With structured finance, bubbles can be created by endogenous liquidity and bubbles about to burst are expected by be rescued by central bank intervention.

And even if central banks reacted to asset bubbles by raising short-term interest rates, the extent of the rate hikes needed to reverse asset prices in times of exuberance might be so large that it would destabilize the real economy worse than a bubble burst would.  This view is supported by the experience Greenspan had in his battle against “irrational exuberance.”  While declaring that central banks cannot prevent bubbles, the Fed has admitted more than once that it sees as one of the roles of a central bank the support of the market value of financial assets, however inflated. Instead of being the guardian against moral hazard, the Fed has become the promoter of moral hazard.

Good Economic News Bad for Dysfunctional Markets

A market anomaly is thus created in which equity prices rise in response to what normally would be considered bad news for the real economy, such as falling home sales, because the market then would expect the Fed will lower short-term rates, causing equity prices to rise, even though home mortgage rates are tied to 10-year Treasuries rates. Conversely, equity prices would fall in response to what normally would be considered good economic news such as rising home sales because that would cause the Fed to raise short-term rates which really do not have any direct connection to home finance.  This is because the market knows that in a bubble about to burst, good news of further expansion is bad news.

US Debt Structured as Russian Matryoshka Nesting Dolls

US financial assets have been built not only on debt, but on debt recycled at high velocity. It is a form of turbo debt in which one dollar of debt can act as equity to finance over $100 of credit through sequential leveraged financing and leveraged securitization. Borrowers in turn become lenders who themselves lend borrowed money. Massive financial energy is released through chain reaction of a tiny amount of equity.

Debt is not intrinsically objectionable if it is adequately collateralized by real assets, and the proceeds are invested to increase real national income above what is needed to service the debt.  But turbo debt by definition is generated by practically no equity. And if debt is serviced mostly by the wealth effect of debt-propelled asset appreciation, a bubble is in the making.  The so-called air-ball financing enabled the telecom bubble of the 1990s, when it was widely used in financing telecom expansion in the 1990s. Air-ball financing involves the use of unrealistically anticipated future earnings as collateral for financing over-investments in hope of generating those earnings.  A housing bubble exists because houses are being financed and refinanced by full-value mortgages collateralized only by the anticipated continuing rise in home prices. A liquidity boom generates asset bubbles because liquidity is not wealth, only an illusion of wealth. And the rise in asset prices beyond the growth of GDP is really a decline in currency value. A market rise of 40% against a GDP growth of 3% translates into a currency depreciation of 37% in a year.

Debt Securitization Blurs the distinction between Debt and Equity

The pervasive securitization of debt accompanied by a complex network of hedging blurs the all important dividing line between debtor and creditor, and allows an economy to borrow from itself, not just against its future, but against its current and less sophisticated debt, not for productive investment to generate real wealth, but for financial manipulation to achieve virtual profit. The use of debt as collateral for more sophisticated debt has characteristics of a bubble.  The broad unbundling of risk to maximize transactional surplus (profit) ultimately leads to the socialization of risk (transferring unit risk into systemic risk) while the privatization of the resultant profit remains a sacred prerequisite. This mal-distribution of virtual wealth exacerbates both the risk and the effect of a bubble by make a bubble inside a bubble.

The Bank of International Settlement “Lamfalussy Report" defines systemic risk as “the risk that the illiquidity or failure of one institution, and its resulting inability to meet its obligations when due, will lead to the illiquidity or failure of other institutions.” The prospect of systemic risk becomes commonplace when lenders are also borrowers who depend on the return of the funds they lent to pay for the sums they borrowed. Risk of illiquidity, not any drop in demand for goods or loans, is the improvised explosive device (IED) of financial terrorism that puts in harm’s way unsuspecting investors running a relay race in the debt securitization thread mill.

<>Whether or when a bubble will burst depends on the central bank’s ability to extend the bubble’s elasticity, which is not unlimited, albeit flexible through inventive redefinitions of theoretical relationships and the cause-effect paradigm. To support the market, a central bank needs increasingly to intervene, which in turn destroys the market.  As is already apparent, the Federal Reserve is increasingly reduced to an irrelevant role of rationalizing the virtual finance economy rather than directing it.  It has adopted the role of a cleanup crew rather than the guardian of public financial health. Ironically, a cure for a debt bubble can come from a blood-letting asset hyper inflation, euphemistically called “unlocking value”. In that scenario, the traditional strategy of holding cash gives no protection because real currency value can fall faster than nominal asset price depreciation. The name for such a scenario is hyper inflation which has brought down many governments a socio-economic systems in history.

In a financial bubble, the real economy may not be growing, but the monetary value of financial assets rises, and is defined as growth, not inflation.  Thus we have robust “recoveries” that continue to lose jobs with the value of money protected by high unemployment and stagnant income from wages.  Or we can have a recovery with low unemployment with rising nominal income that is accompanied by a decline in real aggregate income with wages falling behind inflation. In the finance sector, wealth is created by escalating systemic risk-taking, known as the “Greenspan put.”  Inflation and deflation have become two sides of the same coin that alternate as monetary concerns in a matter of months, through a highly-manipulated global foreign exchange market that tends to destabilize real economies via a multitude of conduits such as wealth effects, balance sheet effects, recurring alternates of credit excesses and crunches and liquidity booms and busts.

Central Banks Never Allow Deflation to Correct Past Inflation

Central banks seldom adjust their monetary policies to arrest asset bubbles and related imbalances and instabilities. The days of the central banker being the spoiler who takes away the punch bowl when the party gets going are long gone.  Central bankers now bring stronger drinks when the party slows.  While central banks still clings to the mandatory task of fighting inflation, they never try to reverse inflation by allowing deflation. Thus any battle lost against insipid inflation is a battle lost forever, with no prospect of ever regaining lost ground. Thus among market participants, bulls enjoy the advantage of having the wind of inflation behind them even in a continuous bear market.

Inflation Targeting Becomes Labor Targeting

In the US, the Fed has served notice that it is prepared to move toward inflation targeting to prevent deflation, as suggested by then board member Ben Bernanke, now Fed Chairman. Prices of asset can only go up but never allowed to fall, even to adjust previous irrational exuberance. Trapped by their own doctrinaire fixation, central banks will continue to provide excess liquidity to support asset price bubbles, and to mask the destructiveness of burst bubbles by unleashing new bubbles with more liquidity, euphemistically known as recoveries. At the same time, central banks will vehemently fight inflation as measured by rising wages. Thus central banking operates with a severe institutional bias against labor.

Market Volatility a Necessary Windows for Financial Profit

In fact, market volatility, another term for shot-term instability, in the financial sector of the economy has become a major source of profit for financial institutions.  Long-term investors are endangered species in the financial world; most market participants have become leveraged traders for short-term profit, even pension funds and university endowment funds. The only factor of production that maintains any semblance of stability is wages.

The recurring financial crises around the world shared similar characteristics. Each crisis was largely unanticipated by market analysts and central bank economists, with the forward markets providing no indication of the impending upheaval. Going into each crisis, complacent traders took on highly leveraged long positions in currencies, bonds, or spread products that soon came under heavy speculative counterattack.  In each case, traders adopted trading models constructed from historical paradigms to guide their trading strategies. When a decisive majority of traders followed similar trading strategies, the market would overshoot from technical pressure and conventional wisdom became disconnected with reality. But once a crisis hit and conventional wisdom was discredited by facts, traders rushed to liquidate their highly leveraged positions en mass, hoping for timely exit before the crowd. In each instance, the rush to unwind highly-leveraged positions accentuated the magnitude of the currency or fixed-income crises.

Exchange Rates and Purchasing Power Parity

Theoretically, exchange rates adjust to achieve purchasing power parity (PPP) between two currencies. PPP is achieved when a unit of domestic currency can purchase the same quantity of goods in another economy when converted to foreign currency at the prevailing exchange rate, to conform to the law of one price. If PPP holds, then identical baskets of goods should sell for the same price in each economy after exchange rate conversion. If they do not, then opportunities for “risk-free profits” will exist through arbitrage in foreign exchange markets that translates into massive flows of funds across national borders. Eventually, price arbitrage will set a market exchange rate or the prices of goods in the two economies will change so that PPP between the two currencies is reestablished. With deregulated global capital markets, prices of assets also adjust towards convergence of PPP between two currencies to cause market crashes.

Profiting from Market Overshoots

In adjusting, the market tends to overshoot up or down like the swing of a pendulum until equilibrium sets in.  But if the overshoot is boosted each time by speculative forces, then the swings of the pendulum will never reach equilibrium. The dollar exchange rate overshoots of 1985 and 1995, similar to the 1994 global bear market in bonds, proved to be transitory events.  But while the dollar crisis episodes represented dramatic overshoots at major turning points in the dollar’s long-term trend of decline, the 1994 global bond market sell-off in hind sight seemed to be simply an interruption of a long-term rally in global bonds, although substantial losses were incurred during the sell-off.  This was because the Fed used a bigger bubble to cushion the collapsing bond bubble, keeping interest rates low, causing nominal bond prices to rise, while in fact real value of bond might have declined.

The Lessons of 1994

It is instructive to analyze the situation in 1994 because the data and dynamics are by now indisputable. Going into 1994, many highly-leveraged fund managers had taken on huge long-duration positions in several key markets after riding the 1993 global bull market in bonds created by historically low interest rates, and thought that additional hefty returns could be achieved in 1994 by maintaining those highly-leveraged long positions. But they evidently ignored the fact that leading indicators of global economic activity were already turning up strongly from the long period of monetary ease accompanied by currency devaluation, making those long positions extremely vulnerable if there should be a shift in monetary policy towards tightness, meaning rising interest rates.

The Federal Reserve’s rate hike from its low of 1% that began on June 30 1994 that eventually reached the current 5.25% on June 29, 2006 was the catalyst for traders to unwind their highly-leveraged long positions, triggering a major sell-off in bond markets around the globe. Global bond yields rose by 200-300 basis points, or 2-3 percentage points, on average over the first three quarters of 1994, causing a collapse in bond prices. By the fourth quarter of 1994, bond yields managed to stabilize and then begin to fall steadily in 1995, causing a bond price rebound. By late 1995, bond yields had returned to their pre-crisis levels.

This pattern of collapse followed by stabilization and then recovery through stealth inflation was not too dissimilar from the pattern of the dollar’s collapse in early 1995. In both crises, the collapse stage took place over a 3-6-month period, followed by a period of stabilization that lasted about three months and a recovery period that took place over a 3-12-month period.

But were these real recoveries, or were they merely the stabilization of uneven currency devaluation?  Could it be that the dollar never did recover, but other currencies finally caught up with the dollar’s collapse? Dollars interest rates were not rising at a pace demanded by its fall in real purchasing power.

More Lessons in 1998

The 1998 credit spread crisis shares a number of similar features with the 1994 bond market crisis. As in the 1994 crisis, fund managers in 1998 once again took on aggressive highly-leveraged long positions, this time in spread products, evidently believing that credit spreads would continue to narrow. Unfortunately, Russia’s decision on August 26 1998 to engineer a controlled default on its debt obligations led to a complete re-assessment of credit risk by global investors. The herd-like rush to exit caused the collapse of the hedge fund LTCM.

Fear that default risk might increase and spread worldwide led to a mad scramble for liquidity. Quality spreads in the US corporate bond market widened dramatically and stood at recession levels. Indeed, the yield spread between Baa corporate bonds and US Treasuries widened to levels not seen since the 1990-91 recession. US corporations became less willing to borrow and therefore curtailed investment-spending, which clearly dampened US growth in subsequent years. High-yield spreads are tied to fundamentals such as expected future default rates. But spreads are also related to market liquidity in ways that are not yet well understood even by the most seasoned professionals.

Liquidity Can Disappear Quickly

Liquidity, a fundamental concept relating to the quantity of money in monetary policy, can also be defined in the market as the ability to buy or sell large quantities of assets quickly and at low discount and cost. Normally liquid assets can become illiquid in a market meltdown. The vast majority of equilibrium asset pricing models do not consider the effect of trading and thus ignore the time and cost of transforming financial assets into cash or vice versa, particularly in times of distress or exuberance, rational or irrational. Recent financial crises, however, suggest that, at times, market conditions can become suddenly severe and liquidity can decline or even disappear extremely quickly, even overnight or even in the middle of a trading day.  Such liquidity shocks are a potential channel through which asset prices are influenced, or distorted by liquidity.

The Decoupling of Bonds from Stocks

In 1994, the bond market was caught on the wrong side of economic fundamentals and yanked down with the shifting tide of higher rates at the Fed. But stocks skated through relatively unscathed, because credit was still available and investors recognized the bond market needed an adjustment that more accurately reflected the central bank’s new thinking.

A bond fund’s “duration” measures the theoretical impact that one percentage point rise in interest rates would have on the net asset value of a fund. A bond fund with five-year “duration” could be expected to drop by 5% in value if interest rates rose by one percentage point. Conversely, a one percentage point drop in rates would cause a fund with five-year duration to increase by 5% in value.

To figure total return, changes to net asset value (NAV) should be added or subtracted from the income generated by the fund. So a bond portfolio with a 3% yield whose NAV drops 5% would suffer a loss of 2% on a total return basis over a 12-month period.

Long-term bond funds often have effective durations of at least seven years. In that case, a rise in long-term interest rates of 2 percentage points over the next 12 months would cause at least a 14% drop in value. With yields on long-term Treasury bonds at 5%, such an increase would translate into a loss of 9% or more for fund shareholders - similar to when the Fed tightened monetary policy in 1994.

To protect against that possibility, investors keep fixed-income money in short-term corporate bonds, typically with durations of six months or less. With yields of long bonds below 5%, it would take a 9 percentage point boost in short-term interest rates just to push the total return on such funds into the red over a one-year period. In the current environment of massive over-capacity and debt, the chances of that happening are about zero. That is why long bonds will rise as surely as tomorrow’s sun.

The Lessons of 2003

In July 2003, Federal Reserve officials engaged in damage control after Greenspan spooked the bond market in congressional testimony by suggesting that FFR at 1%  might have fallen as low as they will go. Greenspan further disappointed investors by noting that the Fed was unlikely to engage in “unconventional” market activities, such as buying long-term government bonds to drive down long-term rates which had stayed inverted for extended periods.

The policy of using interest rate cuts to pump up demand has been tested to destruction since 1994. But all policies carry costs. The costs in this case included most obviously the dangers both of pushing down long-term interest rates as well as short-term to a level that may be unsustainable, and subsequently re-igniting inflationary pressures. In other words, the Federal Reserve was creating a bond bubble similar to the equity bubble, and then protecting the equity bubble by creating conditions where that bond bubble would be popped. But investors that anticipated this scenario were fooled. Long-term rates stayed low because massive capital in-flow came from foreign central banks operating under dollar hegemony. Bonds rose in 1994 further and faster than at any stage in the previous 4 decades and collapsed in 1996 and again in 2003.

Once market participants think the market is turning against bonds through a rise in interest rates, they are likely to stampede out of bonds, creating a bond crash similar to the equity crash. Traders hedge their risk exposure in bonds with compensating position in interest rate futures by adopting immunization strategies by constant rebalancing price risk with coupon reinvestment risk which changes in opposite directions. In the 1950s the bond market was considered a safe, conservative investment. At that time a buy-and-hold strategy was sufficient. However, since the 1960s, inflation has increased, and interest rates have become more volatile. Thus, with more volatile interest rates, there exists a greater profit potential with bonds. Also, the Macaulay duration, named after introducer of the concept, being the weighted average maturity of a bond where the weights are the relative discounted cash flows in each period, came into use in the 1970s.

Under conditions of a liquidity boom, rising rates lowers bond prices as well as equity prices. That combination is explosive enough, but adding to it the impotence of rising interest rates to halt the declining value of the dollar, we have a mixture of deadly financial dynamite that can be detonated by seemingly unrelated minor developments at unexpected times.

Psychological Effect of a Bond Crash

The psychosocial effect of a bond crash on market sentiment is highly damaging. Market participants and investors have been conditioned to think that lower return on bonds are justified by their being less risky than equities. On a 30-year or longer basis, this is a correct view, but not on a three or five-year term. Under current market conditions, there exists at least as large a possibility of 10-year bonds falling by 25% over the any 18 months as there is of shares falling by the same amount. Yet investors in bonds do not have that same awareness of risk as equity investors, so the consequences could be serious.  A typical portfolio with one-third in bonds will not escape losses in a bear market.

Total Return Swaps

Total return swaps (TRS) can make short-term dollar loans (liabilities) appear as portfolio investments. Also, the requirement to meet margin or collateral calls on derivatives may generate sudden, large foreign exchange flows that would not be indicated by the amount of foreign debt and securities in a nation's balance of payments accounts. As a result, the balance of payments accounts no longer serve as well to assess country risk. Even for the dollar, which is protected by dollar hegemony in which the US can print more dollars at will, the long-term consequences of currency devaluation will cause structural damage to both the economy and investors. In the event of currency devaluation or a sharp downturn in securities prices, derivatives such as foreign exchange forwards and swaps and TRS functioned to quicken the pace and deepen the impact of the crisis.

Derivatives transactions with emerging market financial institutions generally involve strict collateral or margin requirements. Asian firms swapping the TRS on a local security against LIBOR (London Inter-bank Offer Rate) post US dollars or Treasury securities as collateral; the rate of collateralization is estimated at around 20 percent of the national principal of the swap. If the market value of the swap position were to decline, then East Asian firms would have to add to their collateral in order to bring it up required maintenance level. Thus a sharp fall in the price of the underlying security, such as would occur at the beginning of a currency devaluation or broader financial crisis, would require Asian firms to immediately add dollar assets to their collateral in proportion to the loss in the present value of their swap position. This would trigger an immediate outflow of foreign currency reserves as local currency and other assets were exchanged into dollars in order to meet their collateral requirements. This would not only quicken the pace of the crisis, it would also deepen the impact of the crisis by putting further downward pressure on the exchange rate and asset prices thus increasing the losses to the financial sector.

The Mergers and Acquisition Time Bomb

In 2006, the dollar volume for merger and acquisitions deals was $4 trillion, which was one third of US GDP.

What are mergers? Mergers between corporations in theory create value by improving efficiency and synergy in an overcapacity economy.  This is generally achieved by laying off redundant workers and executives to create a leaner merged company and by selling off non-core subsidiaries that could be run more profitably by others.  Generally, mergers shrink production and business activities to improve profit margin and reduce competition. In other words, mergers squeeze financial value from downsizing the economy.

What are acquisitions? Acquisitions of Public companies by private equity firms are attempts to create value by taking public companies private on the theory that public companies are inherently inefficient because of regulations on corporate governance, such as the Sarbine-Oxley Act. By taking public companies private, the new private owner can restructure the company with greater flexibility out of the public eye with less disclosure and to resell the restructured company for high profit within a relatively short time, usually to a public corporate buyer or through an IPO. The irony is that private equity firms are now lining up to sell equity to the public, which is the equivalence of the anti-prostitution Church running a Cat House.

These trends are by definition cyclical, depending of a fragile combination of abundant cheap money and low price of the target companies and an enabling tax structure. For example, one of causes of the 1987 crash, aside from the exchange rate effects of the Plaza and Louvre Accords, was a threat by the US House of Representatives Ways and Means Committee to eliminate the tax deduction for interest expenses incurred in leveraged buyouts. Still another cause was the 1986 US Tax Act, which while sharply lowering marginal tax rates, nevertheless raised the capital gains tax to 28% from 20% and left capital gains without the protection against inflated gains that indexing would have provided. This caused investors to sell equities to avoid negative net after-tax returns and contributed significantly to the 1987 crash. There were other factors, such as the effect of portfolio insurance on the futures market, etc. At present, the IRS allows carry fees earned by private equity firms to be taxed at 15% capital gain rate rather than the 35% orfdinary income tax rate. A change in that ruling can do havoc to the private equity sector,

The Wall Street Journal ran a report by William M. Bulkeley on June 7, 2007 that the IRS shut a corporate-tax loophole two days after IBM used it on March 29 to avoid $1.6 billion in US taxes by structuring a $12.5 billion share buyback through a new subsidiary in the Netherlands.   The IRS calls the IBM maneuver a "Triangular Reorganization" in which the foreign unit spent $1 billion in cash and $11.5 billion in borrowed funds to buy 188.8 million shares, or 8% of outstanding, from a group of investment banks what had borrowed the shares from institutional investors. The investment banks will buy share in the open market for returning the borrowed shared over the next nine months and IBM will make whole any losses to the investment banks if IBM share prices should rise.  IBM intends to repay the loans with earnings from its foreign subsidiaries with tax rates averaging 22%, substantially below the average US rate of 40%, saving $1.6 billion.  The contradiction, aside from tax avoidance with no business purpose, is that the transaction gave IBM a reduced incentive to see its share rise in the open market until the $11.5 billion loans are repaid.

The PPI/CPI Spread

Since 2003, the producer price index (PPI) has risen by 16.4%, while the consumer price index (CPI) is only up 12.5%. This is caused by globalized trade through cross-border wage arbitrage keeping consumer prices down. CPI is heavily weighted toward import prices while PPI is weighted toward export prices. Import prices fall while export prices rise when the dollar rises against foreign currencies.

Even though exchange rate is only a part of the reasons for the US trade deficit, Congress has fixated on the idea of forcing China to revalue its currency upward against the dollar. But a falling dollar causes China's central bank to demand compensatory higher dollar interest rates for the US sovereign debt it buys, which in turn slows the US economy.

A higher short-term rate is important in its inflationary effect on CPI because it drives the rates for much of consumer credit, such as credit-card loans and auto loans, as well as adjustable home mortgages. The long 10-year bond rate drives fixed mortgage rates only at the time the mortgage is taken, but rising long-term rates will depress the price of outstanding long bonds to compensate for the gap in yields.

A falling dollar will artificially lift overseas profits of US transnational corporations and in turn lift equity prices while the US domestic economy stagnates or declines.

Opening Foreign Financial Markets to Rescue the US Trade Deficit

Among the objections against globalization: including income inequality, workers’ rights abuse and the environment abuse, the most serious has been the devastating recurring destruction brought on by currency-induced financial crises in developing countries. In the past decade, globalization has also depressed wages in the advanced economies. 

But now the destructiveness of financial globalization is beginning to be undeniable. Even pro-globalized trade economists now are forced to acknowledge cross border capital flows as the Fifth Horseman of Apocalypse of financial globalization through no-holds-barred deregulation and liberalization in structured finance that leaves large segment of the world’s population in all countries in financial ruins.

The comparative advantage of “free trade” has long been neutralized by a dysfunctional international finance architecture that devastates the poor and weak in all economies, rich or poor. Amid this growing resistance, the US is trying to ply open financial markets faster everywhere, particularly China.

Central Banks Distort Domestic Prices

In today’s globalized financial markets, the central bank in every nation distorts all prices in the local economy to prevent economic adaptation to changing world prices in key commodities, such as oil. Domestic interest rates are forced to rise during a recession to prevent capital flight. This is true regardless if the currency is free-floating or pegged to the dollar. The only difference is that the penalties manifest themselves in different forms, via asset depreciation for floating currencies and via a drain in foreign reserves in pegged currencies. As noted earlier, dollar hegemony uses currency crisis as the widely-deployed improvised explosive devise (IED) in finance terrorism against domestic development in all countries rich and poor.

Ironically, while the advance economies are plague with overcapacity from stagnation and disparity of income, there is rising evidence that low-wage production in East and South Asia, which in the past decade has been the main factor in containing global inflation, is going through a sea change to build pressure for global inflation.  While unemployment is still serious all over Asia, including booming economies such as China and India, existing plants in the export sectors of these countries are running near full capacity. This is because foreign investment goes only into projects that yield extraordinary return on foreign investment from low wages in the export sector while unemployment continues to rise in the domestic sectors.

Social and political pressures in reaction to income disparity are giving labor everywhere a stronger voice in demanding more equal distribution of the benefits of globalized trade, in the form of living wages and more liberal benefits and protection of worker rights. Thus while both China and India are still burdened with oversupply of human resources with a glut of underemployment or high unemployment, plant capacity in their export sectors can grow only at higher costs to meet consumer demand in their export markets for low-cost goods. This is because the excess labor is located in the rural interior where there are no plants and where the cost of building new plants and the transportation network to serve the export sector are economically not viable. And the plants located along the coastal regions are experiencing a labor shortage because more migrant workers cannot be accommodated for lack of low-cost housing.

But higher costs in China will result in higher prices for Chinese exports and reduced US demand for goods until US wages rise, which is registered as inflation. As a result, central banks of the world are increasingly anxious about structural inflation, forcing them to tighten monetary policy by raising interest rates. The Goldilock era of a happy combination of high growth, low inflation and low interest rates may be coming to an end. Fed Chairman Ben Bernanke told a bankers conference in South Africa on June 5 that rising wages and environmental costs in China would have an upward effect on US inflation. The IMF has calculated that low-wage imports from China had reduced US inflation by one percentage point. Many economic projections expect global growth will no longer contain inflation. Rather, going forward, further global growth will translate into inflationary pressures.

With cost-pushed inflation bringing higher interest rates in a cycle of slowing economy and weaker earnings caused by a housing bust, rising wages that still fail to keep up with real inflation from currency devaluation, dwindling consumer demand from income disparity, with trade friction threatening to turn into protectionist measures, cheap money can evaporate quickly to put a sudden stop to the recent merger and acquisition frenzy by private equity firms, and turn completed deals into bankruptcy candidates. While each of these developments may not by itself be serious enough to bring the economy to a halt, a confluence of all such interrelation developments can produce a whirlpool effect that sucks everything down a black hole of vanishing virtual money.

Income is All

The fountainhead of this financial whirlpool is located in the conundrum that rising interest rates are impotent in reversing the decline of the purchasing power of the dollar. What is needed is a redefinition of economic growth to be measured by rising purchasing power of wages rather than by nominal GDP increases. And that path is through closing the disparity of income and wealth in every economy, rich and poor, among people and between economies.

The timeless adage in economics that income is all holds even more true today.