Easy money fuels global equities, for now

by Levi Folk | December 4, 2006

The global economic expansion remains intact and equity markets are finding strength from easy credit conditions in Europe, Japan and the United States. The U.S. economy may be slowing, but the spectre of an economic slowdown rather than a full-blown recession could mean more gains are in store for equity investors.

The U.S. bond market has been signalling a U.S. economic recession since July this year.

Historically, when the interest rate on a three-month treasury bill moved higher than the yield on a 10-year treasury bond (an inverted yield curve), a “credit crunch” would ensue according to Dr. Ed Yardeni, chief investment strategist at Oak Associates in the United States.

The crunch occurred because banks borrow on the short end of the yield curve and lend on the long end. The result was a retrenchment in lending and a subsequent economic downturn.

Falling yields on treasury bonds in the United States do not appear to be reflecting an economic recession as some might presume but more likely a “global glut of savings,” according to Yardeni. This idea was advanced early last year by Ben Bernanke, the governor of the U.S. Federal Reserve Board.

This savings glut is the flipside of the U.S. current account deficit, largely comprised of the trade deficit. China, Japan and the rest of the world are saving what the United States consumes in excess of domestic production. The Peoples Bank of China (PBoC) has purchased more than US$1-trillion in foreign exchange reserves to stop its currency, the yuan, from appreciating.

These reserves represent part of China’s net savings, which are in turn channelled into U.S. treasury securities and bank deposits. Hence the global savings glut is pushing down U.S. bond yields.

Dr. Marc Faber, noted international economist and author of The Gloom, Boom, & Doom Report, has suggested recently that credit conditions in the United States remain quite loose, this despite the 17 consecutive interest rate hikes engineered by the Fed since 2003. Monetary conditions have actually been “tightening” in the United States since early 2004, according to the U.S. Federal Reserve Board, yet credit growth remains robust.

If rates are high, why does credit remain loose? The answer may lie in the foreign official dollar reserves held by foreign central banks in the U.S. banking system, the PBoC’s US$1-trillion for example. Roughly 30% of foreign reserves were invested in bank deposits globally as recently as March, 2006, according to the Bank for International Settlements. So, credit conditions in the United States remain quite loose despite that the Fed has been hiking rates quite aggressively since 2003.

The U.S. economy is slowing but could avert a full-blown recession next year in part because credit remains quite loose. The stock market appears sanguine about prospects for the U.S. economy for the next year judging by the impressive rally staged by the Dow Jones industrial average since August of this year.

Yardeni points out that, yes, the housing and automotive markets are a drag on the U.S. economy, yet the economy remains resilient.

“Taking out housing and autos shows the rest of the economy is in a mid-cycle acceleration with ‘core’ real GDP up 3.7% year-over-year during the third quarter versus 2.6% in mid-2005,” said Yardeni, the perma-bull who expects profits to remain strong into 2007.

The real deal on borrowing is in Japan, however, where a zero interest rate policy engineered by the Bank of Japan (BoJ) to fight endemic deflation has allowed hedge fund managers to borrow cheaply in yen and invest that money in euros, U.S. dollars, you name it, whatever markets looked best.

This yen carry trade, as it is called, came briefly undone in June of this year when it was suggested the BoJ could begin normalizing interest rates (the bank ended its policy of quantitative monetary easing) as Japan’s economy strengthened. You may recall the swoon in global security prices around that time.

The yen carry trade appears intact today and remains an important source of liquidity that is supporting global asset prices. Rates in Japan are unlikely to rise until the Japanese economy is at greater risk of overheating, and that does not appear imminent. So, global financial markets could continue to melt up, as it were, over the near term as credit conditions remain favourable.

The day of reckoning will surely come, and when the easy credit conditions unwind, expect a global market correction with the riskiest assets getting hit hardest.

Given that the economic expansion appears long in the tooth by historical standards, investors would be wise not to overindulge in risky assets. The rally may not end soon, but it will end badly.