Ask Your Financial Advisor to Explain This:

Ask Your Financial Advisor to Explain This:

As always, there are some things that you can control and some things that you cannot control - things like the economy, demographics, and supply and demand. Today, I will be writing about the economy because we live in “interesting times” and because things are different now than they have been in the past 50 years.

First, there are high short-term interest rates in Europe and the United States. Why mention Europe? Because the point of this article is to make the point that the US is not in control of its money and to ask the question, “Is that your money too?” This discussion is being put forth to start some dialogue and to get you to think about some of things that are out of your control, like the economy, and to prompt you to ask your financial advisor for their take on this change.

Case in point, right now there is a fully inverted yield curve on U.S. Treasuries and the global economy is thriving, new records of economic activity are being measured, stock markets are up, and debt creation is soaring. Traditionally, this situation is the opposite of what one would expect. Why?

Let me explain… an inverted yield curve, defined as three-month Treasuries yielding more that 10-year Treasuries, always means recession, not boom. “The yield curve has predicted every U.S. recession since the 1950’s…”, so what is going on?

To understand this logic, you have to understand that the banks, (the source of all money), make their money by borrowing short and lending long for cars, mortgages, boats, etc., so the greater the spread between the short and long rates, the more profitable the banking business. But, invert this yield curve and the banks find themselves paying more for deposits on savings accounts than they earn by lending. For the global economy, traditionally, this used to mean bad news because the U.S. spending fuels export driven economies of Asia, Latin America, and the Middle East. A credit crunch, (increased short-term lending rates), used to mean world pain. Not so today, what’s changed?

Consider a new paradigm, that the structure of the world’s economy has changed. Author, John Rubino, says consider these things:

1) Today, we have the free flow of capital around the world. This means that cash moves in and out of any one market without any restrictions. This also means that the inverted U.S. yield curve is only inverted from a U.S. investor’s perspective. For example, over in Japan, where they have artificially low over night bank interest rates, (something like 0.5% on what in the U.S. would pay 3%), there is an interest in investing their Yen into our U.S. over night notes because for them, a U.S. inverted yield curve is a steep yield curve! This concept of investing in one bank from another is called the carry trade, the over night carry trade. What has changed is that now Japanese banks and other capital from around the world are participating in the carry trade.

2) There is, at least, one more reason that is even bigger than the amount of money the Japanese are pouring into the U.S. over night market carry trade. I’m talking about the central banks, the mother ship of all banks of any given country, that are buying U.S. dollar debt. The central banks of Japan and China have something like 3 Trillion dollars of U.S. bonds. These government banks have chosen to recycle their trade surpluses back into U.S. Bonds. The reason they do this is because if they did not do this, their own currency, the yen and renminbi, would become less valuable at international exchange rates making the cost of their exported goods more expensive to the U.S. market that they serve.

3) The reason why this is working is because of the new paradigm in the economy, namely that 90% of all foreign money that is buying U.S. securities, is no longer private investors, but foreign governments. They are buying Treasuries, Corporate bonds, mortgages, and stocks because by doing so they keep their own currencies “fairly” valued so the status quo continues, namely the Japanese and Chinese keep selling competitively priced goods to the U.S. consumers, and at the same time, by actively exchanging the trade surplus created into the purchase of U.S. debt, they effectively are giving the U.S. the equivalent of unlimited credit with which to buy more goods at an ever increasing trade surplus that keeps getting “sanitized” by the re-investment of the trade surplus back into U.S. Securities. Got it?

OK, good, because there is just a little bit more to all of this. What has happened with this recycling of debt to a seemingly unlimited potential, is a massive demand for high-grade debt notes, more in fact than the entire U.S. Treasury has. In fact, that’s the reason for something called, “Securitization”, or the building of lesser-grade debt into higher-grade bonds, like gathering up a bunch of home mortgages or credit card imbalances and creating a SPV, “special purpose vehicle.”

Now, here is the reality check… Securitization’s impact on business practices in the financial sector has been seismic. U.S. banks no longer have to hold debt for long periods of time. They can sell it to foreign central banks and use the proceeds to make more debt available and hence, banks have been transformed into the suppliers of raw material for the global economy. This also explains the U.S. banks willingness to lend money in spite of the inverted yield curve. Knowing that they don’t have to hold this debt, they repackage it into an SPV and sell it to central banks with a trade surplus.

The final piece of this transformation is the credit insurance that has recently come on side, meaning they have created new ways to insure against losses involved in borrowing, enter the CDS, “credit default swap” that insure against any losses involved in defaults by a given borrower. Enter hedge funds that have discovered that writing CDS is like writing flood insurance in a drought period. The challenge in finding flood insurance is in finding people who want it, but who doesn’t want cheap money. So, what has changed is that now the banks provide the credit as they always have, but this time the hedge funds are providing credit insurance so the resulting re-packaged “high-grade” debt is being snapped up by central banks that have a trade surplus with the U.S.

I’m not finished yet… armed with cheap credit, a growing number of companies are buying back their stock. For large companies, a strategy of stock buybacks is used to support share prices in the absence of any internal growth opportunities. For the smaller companies, this could make them a target for a leveraged buy out from private equity firms armed with cheap money. Global M & A rose 38% in 2006. And default rates are falling because even the most troubled company can get credit these days.

The result is that the U.S. government is not totally in control any more; securitization has made bank reserve requirements irrelevant. Meanwhile, most financial transactions that are electronic are perceived to be safe and liquid and so can perform some of the functions of money. Combine this new-age credit creation with huge trade imbalances and the result is a unique set of challenges for today’s central banks. Imagine that you are running the U.S. Federal Reserve Board, your economy is running an alarming trade deficit, U.S. dollar backed bonds are ending up in the accounts of your biggest trading partners’ central banks and in response you have engineered an inverted yield curve, which always worked in the good old days, but you know what, it isn’t working now, is it?

This time is different, the banks are still lending like crazy and credit is still cheap. Why? Perhaps the global financial system has shifted away from gradual interest rate changes that were connected simply to shifting mortgage rates. This time, there is a new player on the field that is driving demand for the supply of money and that is the M & A lending activity that is trumping the mortgage backed securities of yesteryear.

Now for the trillion dollar question - is money this cheap sustainable or are we headed off the cliff inevitably, with everybody’s debt mounting and mounting for a great fall? Eighteen months ago, our overseas debt became greater than our overseas assets, a situation, that in the past, would have caused a decline in the value of the U.S. dollar. The U.S. is now the world’s greatest debtor. Those countries holding this debt, largely Japan and China, are dependant on U.S. consumer spending. A rapid falling dollar would be more of a problem for Japan and China than for the U.S. Meanwhile, U.S. banks are continuing to make money on the inverted yield curve by taking more and more risks on credit. For example, 71% of all companies with Standard and Poor’s credit rating had the lowest quality rating in 2006; in 1980, by comparison, only 32% had this poor rating.

How big is this new economy? The value of global credit insurance alone is half the size of the global GDP and it is growing exponentially. Much of it is held by hedge funds that don’t publish audited balance sheets. So, it is clear we are in uncharted waters, and we already know that the social security is not properly funded so we cannot count on that design for our futures either.

Thinking like a CEO means taking into consideration all the situations that are in your control and all the situations that are out of your control, like the economy. I hope this little piece has given you a heads up and reasons to discuss this overview with your financial advisor(s).