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CONNECTING
THE DOTS
by Ernie Mardaga
February 4, 2005
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Bolstering
the Buck
Much has been made of the foreign exchange (forex) intervention of
foreign governments, especially in Asia, to support the dollar. They
use their currencies to buy dollars, which are then primarily
invested in Treasury bonds, keeping our bond prices higher, and bond
yields lower, than they otherwise would be.
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It’s
the Yuan, Silly
It just may be that this foreign dollar support is a side effect of
efforts aimed at maintaining the value of China’s Yuan, which is
pegged to the dollar. This makes sense from an Asian perspective
because it is China that is eroding their exports, not the U.S.
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WTO
Woe
If [ever faultier] memory serves, China’s entry in the World Trade Organization
(WTO) required an “adjustment” in the yuan in, or before, 2007
– and I’m sure that someone will correct me if I’m wrong on
this point. Just what this “adjustment” might be
(convertibility, exchange rate flexibility, etc.) is debatable.
Assuming a 2007 “deadline,” our guess is that the yuan
will start rising in value against the dollar (and most/all other
Asian currencies) by late 2005 or early 2006, because China will not
wait until the last minute to initiate action. When – not
if – this adjustment happens, there will no longer be a need to
support the dollar in order to drive-up the yuan. Reduced
dollar-supporting capital inflows from foreign Central Banks
will likely cause the dollar and bond prices to fall, and bond
yields to rise. We don’t need to discuss the ramifications of potential
capital outflows (asset liquidation and dollar selling), do
we?
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A
Trillion Here, a Trillion There
As mentioned in a recent
piece by Jim Puplava, an estimated near-70% of U.S. federal
debt will mature by early 2007. This would see the Treasury
rolling-over trillions of dollars in debt over two years! Add
to this other major borrowing by the federal government and …
well, you get the picture.
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The
Long and Short of It
Rising long-term rates, including fixed-rate mortgages, will be bad,
if not calamitous, for housing. Moreover, we believe, higher
long-term rates could force short-term rates higher (including
Adjustable Rate Mortgages – ARMs) – despite Fed
efforts to maintain a “measured pace” in raising short-term
rates – as
money moves from short-term paper to long-term, in search of yield.
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Dis-ARMed
Rising ARM rates would likely cause some, if not many, borrowers
with ARMs to convert to a fixed rate mortgage rather than risk the
uncertainty of ever-higher ARM rates. And, as Mike Hartman recently
noted, a shift from, say, a one-year ARM to the higher rates of
a 15-year fixed rate mortgage, would cause an immediate increase
in monthly payments.
-
Gee
DP
Consumer
spending will almost certainly take the brunt of higher mortgage
payments because, as others have noted, Americans have pretty much
abandoned traditional savings in recent years – and they still
have unprecedented debt. And, gee, consumer spending is some
two-thirds of Gross Domestic Product (GDP).
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Dot,
Dot, Dot …
If this thesis is right, there will be more dots – but we have
enough for now.
Connecting
the Dots
Trillions
of dollars of Treasury debt rollover in a two-year timeframe will likely
drive bond yields higher. And, if this massive refinancing comes
at a time when Asian governments – already drowning in dollar reserves
– are no longer buying dollars to drive-up the yuan, bond prices could
decline even more sharply, with bond yields rising proportionally.
Sharply rising rates would burst the mortgage-finance/house-price
bubble, impairing the world’s consumers of last resort.
Paraphrasing
Bogart’s closing line in The Maltese Falcon – It’s
the stuff that nightmares are made of.
©
2005 Ernie Mardaga
Editorial Archive
CONTACT
INFORMATION
Ernie Mardaga
Columbia, MD USA
www.yourmutualfunds.com
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