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Conundrum in Reverse

Ichiro Suzuki Federal Reserve Bank Chairman Alan Greenspan shook his head in early summer of 2003, looking at a steady fall in Treasury note yields. The U.S. economy was expanding, as numbers showed, almost two years after a recession in 2001 that followed a late 20th century boom. The war in Iraq a few months earlier was wrapped up quickly, as far as removal of dictator Saddam Hussein was concerned. Above all, the stock market was rising briskly after the S&P500’s painful 50% correction in 2000-02. Mr. Greenspan had feared that the U.S. economy was slipping into mild deflation for unforeseen reasons, in which Japan had been mired since the mid-1990s. As it turned out, it was Chinese buying of U.S. Treasury securities that brought down their yields to maturity. China was accumulating wealth fast and there were not many financial assets large enough to absorb such vast wealth. China was not a lone buyer. That year was the outset of the golden age of the emerging markets. On top of China, rapid wealth accumulation was progressing at that time in what is today called Global South. Commodity producers thrived amid surging demand from China, be they crude oil, copper and other minerals or agricultural commodities. Many countries, especially those in the Middle East, saw their surpluses surging as fiercely as China. Their sovereign wealth funds (SWFs) became major buyers of U.S. Treasury securities. The global economy had entered the age of savings glut, it was said. Those new buyers got into the market regardless of valuation of the T-notes and bonds in conventional relation to the U.S. economy’s fundamentals because they had to park their newly acquired wealth somewhere. There was and still is the only one asset class large enough to absorb trillions of dollars. It was U.S. Treasury securities whose market has always stood out as by far the largest and most liquid. It didn’t matter whether they are friends of America or not. Owners of newly accumulated wealth had to buy U.S. T-notes and bonds. Shunning them for political reasons can be done only at a great cost to them. Two decades after the conundrum, the U.S. Treasury market is witnessing a historic bear market. The end of a down-trend of long-term interest rates has been confirmed after four decades that began with Fed chairman Paul Volcker’s war on inflation. In 2021 long-dormant inflation was reawakened by massive stimulus packages in response to COVID-19. The Fed’s initial diagnosis on rising prices as ‘transitory’ proved to be wrong. Though inflation this time was originally triggered by policy-led demand boost and supply constraints, upward price pressure has turned out to have a staying power because of the strong labor market and a shift in inflationary expectations. Even though not likely to be as high as they were in the 1970s, expectations of higher prices are already well anchored in people’s mind. This was enough to cause a bear market for fixed income securities. In addition to inflation expectations, the rapidity of the rise in long-term interest rates implies another factor is in play. China’s fiscal conditions today stand in sharp contrast to what they were at the time time of the conundrum. The country’s currency account surpluses are down to more sustainable levels at around 2% of its GDP, way down from exorbitant double digits earlier in the 21st century. China is no longer in a position to buy Treasury securities aggressively. Instead, it has been reported that China has been reducing their positions on T-notes and bonds. It is not because of the intensifying Sino-American rivalry, but because of more fundamental economic reasons. One of the reasons is their burning desire to keep the renminbi (RMB) from falling amid a post-credit bubble economic slump. It is widely speculated that the People’s Bank of China is intervening in the foreign exchange market to stem the RMB’s fall. FX interventions to defend a currency against the U.S. dollar can be done only by selling the dollar out of the position that a country already has. For China to do this, they have to buy the RMB by selling the greenback out of their T-notes and bonds holdings. Besides the recent economic slump, China no longer provides foreign capital a hospitable environment to do business. Multi-national corporations have learned a risk of being too dependent on China and are redrawing their global supply chains. Frequent regulatory changes, always a step toward reduced hospitality, and sudden detentions of employees of MNCs are also driving them to cut back their investments in China. As opposed to the early years of the century when a wave of capital flowed into China, inflows of foreign capital are much thinner today, or worse, it is beginning to leave. Commodity producers are not faring as robustly as they once did. While SWFs of oil producing Gulf states remain in good health, fortunes for producers of other minerals have waned as China is consuming such commodities in a much less devouring and wasteful fashion than before. With their wealth no longer swelling exponentially, their pockets are no longer as deep as they once were. The age of savings glut is over, and the peak SWFs has been reached probably. Alan Greenspan’s conundrum was attributed to the dawn of the age of savings glut. Then, peak saving glut is giving rise to sharp run-ups in long-term interest rates, it seems. At the outset of the 2010s, Federal budget deficits and accumulation of debt were widely-held concerns on the Capitol Hill, after their sharp rise caused by responses to the deepest financial crisis in 80 years. A shared sense of crisis led to a bipartisan commission led by former Senator Alan Simpson and former White House Chief of Staff Erskine Bowles to tackle the growing problem. Though their recommendation was not turned into a law at Congress, the Simpson-Bowles Commission displayed the health of politicians’ mindset back then. Since then, Fed chairman Bernanke’s quantitative easing kept long-term interest rates ultra low. Aging of population increased demand for long duration assets thus keeping long-term rates from rising, it was believed. In this environment, Presidents Trump and Biden ran a loose fiscal policy to keep their voters satisfied, driving the Simpson-Bowles Commission into oblivion. A sudden surge of a pandemic drove the government to spend aggressively amid fears of an economic melt-down. Such profligacy didn’t affect long-term interest rates, until recently. Now, bond bears are reawakened. The Fed is slowly divesting their Treasury securities holdings that they accumulated in the last decade. The price of money is much higher than it was a few years ago. How would the bond market behave if the governments, not only in the U.S. but also in the rest of the developed world, keep spending as they did in the recent past?


About the author: Mr. Suzuki is a retired investment banker based in Tokyo, Japan.



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