After five consecutive 25-basis point interest rate increases by the US Federal Reserve in the second half of 2004 the year might have been expected to end with credit spreads lower, a sell-off in emerging-market debt and a slowdown of real-estate investments.
None of that has happened. Instead for now, much of the stress in financial markets is being felt in the foreign exchange markets. What the Asian central banks do next is of most immediate concern. With their mercantilist hat still on, and led by the Japanese and Chinese central banks, they have been buying dollar assets, especially US treasuries, as a way of supporting their export markets. With little domestic demand to speak of, exports have provided much of the growth for the Asian region. With the dollar weakening over the past two years, though, observers have started to wonder when the investment pain of buying low-yielding US assets with a poor exchange rate might prompt one or more central banks to cut their exposure.
There is little sign of this happening yet. The latest information on the US Treasury's TIC data, from October, which measures foreign holdings of US assets, shows continued interest in buying dollars. What others have noticed, though, is an increased desire to buy euros.
Since investors do not appear to be buying this currency as a substitute for their dollar holdings, some market participants have begun to to wonder whether it's the FX market's equivalent of the Texas hedge, a term that derives from the futures market and refers to taking a very risky position. The story goes that a Texas rancher, having explained that he'd hedged his cattle stock by going long cattle futures, was told that was in fact doubling, not hedging, his exposure. He replied: ?Them are Texas hedges.?
This time around it's the euro-yen trade that the central banks seem to be making, regarding it as being as near as they can get to an uncorrelated hedge for their dollar holdings. By their reckoning, pontificate sell-side traders, it is a less worse strategy than simply selling some or all of their dollars. That's for the simple reason that each of them holds too many dollars with poor yields at worsening exchange rates. Any large selling by one would almost certainly set off a panic of selling by the others, leading to an even steeper, and swift, plunge in the dollar.
A weaker dollar would hit imports and trip up the spending habits of the already retrenching US consumer. The sharp sell-off of US assets would set off a crisis in the US credit markets as spreads would widen, yields would rise sharply, and that would quickly be passed on to consumers who have little saved but much in the way of mortgage and credit card debt.
A US economy in trouble while Europe and Japan falter and China searches for a soft landing is in no-one's interest.
The Bush administration's blasé attitude towards the twin deficits represents the other side of the coin. President Bush's statement at the end of last year that he would present a plan to cut the budget deficit in half is all spin and no substance: election plans to make the tax cuts permanent and partly privatize social security will only make matters worse unless accompanied by a very large reduction in defence and homeland security spending as well as discretionary spending. None of that looks at all likely.
So the deficit will increase, paid for by foreigners, especially the Asian central banks, until they decide they can stomach the trade no longer. The money pouring in from abroad isn't financing a vibrant economy, it's going into low-yielding government debt. In other words, says Lehman Brothers economist Ethan Harris, it's like borrowing money every month to pay for the groceries.
An imbalance of this magnitude does not get solved by name-calling and finger-pointing. Last year we all blinked and nothing happened. But the longer the imbalances continue without a concerted effort on the part of policymakers around the world, the greater the chance that we all lose this game of nerve.