Wednesday, March 17, 2004

The FED's Real Currency Policy Agenda

Here's some of the possible reasons and intracacies for what's happening in Japan's, China's and America's currency markets.

The Fed Loves Power and Creating Profits for Finance Companies

Richard Benson is president of Specialty Finance Group, LLC , offering diversified investment banking services.

In February, when the Federal Reserve’s Monetary Policy Report to the Congress was presented by the Fed Chairman, Alan Greenspan, he made the goals of his legacy crystal clear: For the core business of Wall Street, investment banking and banking (the “carry trade”), he wants to be remembered in the Hall of Fame for having made the finance business the greatest profits in the history of our nation.

The carry trade, for those who are not Wall Street insiders, is the business of borrowing short and lending long. This business is executed by institutions that have access to borrowing directly at the Fed funds rate, or the ability to borrow by using security Repurchase Agreements (“REPO”), most commonly using U.S. Treasury, mortgage-backed, asset-backed, and GSE securities. The carry trade has created the United States finance economy, and about 30% of all profits for S&P companies come from financing activities. The business of borrowing short and lending long has allowed the unprecedented increase in mortgage and consumer borrowing. This has been used by the Fed Chairman to pump up housing prices 45% in the past 4 years so that they can claim household net worth, at $44 Trillion, is the greatest it has ever been.

What has the Chairman actually said and exactly what is it that he wants to accomplish? First, in his speech to the New York Economic Association, he stated that at some point interest rates in the United States will rise. Certainly, Wall Street firms and bank hedge funds engaged in the carry trade care more about a rise in long-term interest rates, than a rise in short-term interest rates. A rise in long-term interest rates can quickly wipe out not only a year’s worth of carry profit, but it can wipe out a financial institution’s capital (the carry trade offers leverage of over 20 to 1). Currently, Fed funds are locked at 1 percent, and the 10-year Treasury note is locked around 3.7 – 4 percent, which offers about a 3 percent carry profit. If short-term rates only went up one-half percent, or 50 basis points, the carry profit would still look okay, unless long-term interest rates rose.

Last year the Fed was talking about fighting deflation by pegging long-term interest rates. Talk was turned into action by cutting deals with the central banks in Japan and China to do just this. Japan and China currently “peg” the 10-year note yield by buying incredible volumes of United States Treasuries. (Japan, China, and other Asian central banks are flooding their markets with new money. This holds the value of their currencies down while these Asian central banks finance the U.S. budget and trade deficits. In return, Asia gets the new factories and new jobs.) This financing of our trade and budget deficits by foreign central banks is the only reason the U.S. carry trade has not collapsed.

The Bush Administration is getting nervous that unless Japan and China revalue their currencies up, we will have virtually no growth before the November Presidential election. For President Bush, this is very bad. However, Greenspan has just said that while Japanese intervention at some point will be problematic, that time is not now. Moreover, Greenspan has also indicated that it would be unwise for China to revalue now because money might flee China. While neither statement on face value is credible, what is obvious is that the only reason the carry trade has not “blown up” is because of Japan and China “pegging the 10-year Treasury” and if they were forced to revalue, they would stop buying U.S. Treasuries. Since our country has no savings and a $550 billion government deficit to finance, when Asia stops buying, our mortgage market will no longer be able to finance equity extraction from homes. Moreover, since wages and salaries are growing at less than the inflation rate, home equity extraction is the only source of unending cash to the U.S. consumer. If the consumer stops spending, not only would it mean that George Bush might not be elected President in November, but the whole world might enter recession. America is the buyer of last resort. ...Link

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