from Follow the Money

Are imbalances correcting?

January 22, 2008

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European policy makers think so particularly those imbalances that in their view originate on this side of the pond. The current account deficit - setting aside the bulge from $90 rather than $60 oil -- is heading down. Households seem to be cutting back on other purchases rather than borrowing more as their petrol bill goes up, so perhaps the household savings rate isn’t veering into more negative territory. Painful, sure. But ultimately healthy.

I am not 100% convinced, though, that all imbalances are correcting. To me the biggest imbalance in the global economy is the gap between the current account deficit that private investors want to finance and the current account deficit the US now runs. That imbalance-- at least in my view -- seems to be getting bigger, not smaller. The deficit that private investors want to finance seems to be falling even faster far faster than the actual deficit.

Of course, when US investors take risk off the table and bring funds home, the dollar can rally. But the trend over the past two years has been pretty clear: as interest rate differentials move against the US, private willingness to finance the US deficit falls. And even back in 2005 private investors weren’t willing to cover the entire deficit.

George Soros says this cannot go on. At some point, Fed cuts in short-term rates won’t bring long-term rates down - as foreign investors will no longer be willing to hold dollars. The US will have to limp through a slowdown without any (additional) boost from monetary policy.

"If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an end."

So far, though, there are no signs of trouble. Ten year rates are now around 3.5%. With oil around $90. Two-year rates are even lower: John Jansen of Across the Curve reports they dropped under 2% today.

The Fed seems to think the US is already in a recession (Dr. Hamilton: "I believe the FOMC cast its vote today with those who declare that a recession has already begun" ) And one of the questions that I have long pondered is who would finance the US during a slump, even one that helped to bring the US external deficit down gradually. The only real answer I could come up with was the same folks who financed the expansion of the US deficit at time when private demand for US assets remained subdued.

I spend a lot of time tracking central bank reserves. Even so, I cannot prove the following point. It is something I believe to be true, but cannot back with hard data - though the buildup of UK treasury holdings is perhaps indirect evidence.

I suspect that some central banks have gotten a little bit more conservative with their funds over the past three months even as some sovereign wealth funds have gotten more aggressive. And remember, the flow through central banks is a lot bigger - somewhere between 6 and 10 times bigger - than the flow through wealth funds.

Put it this way: Would any central bank reserve manager want to be the one who recommended dabbling in the US asset-backed securities market last spring? The one who recommended a 10% allocation for global equities in December? Central banks don’t like losing money, at least not in dollar terms. If they lend a dollar out, they want a dollar and (a very small amount of) change back.

Or consider another case - a rather important one. China’s State Administration of Foreign Exchange doesn’t seem to have much credit market exposure. Prepayment risk on Agency MBS - absolutely. But not outright credit risk. However, China does seem to have allowed the Bank of China and to a lesser degree the other large state commercial banks the freedom to experiment with higher-yielding dollar debt after they were recapitalized with fx reserves.

Does anyone think China’s bank regulators are currently telling the Bank of China that the meltdown in the subprime market represents an opportunity to double-down?

If central banks are less willing to take on risk at a time when their reserves are still growing, that would, in turn, help to finance a counter-cyclical US macroeconomic policy during a recession.

That at least is my current very tentative thinking.

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