Foreigners can no longer sustain US economic expansion


“When sorrows come, they come not in isolated spies, but in battalions.” Claude in Hamlet, Act IV Scene V

You know those bells that are supposed to never ring to signal a turning point in the market? Well, they started ringing on September 27 and 28. On Thursday and Friday, just before the end of the third quarter, the interbank market “basis swap” between the euro and the US dollar rose by 30 basis points. Over the same period, the cost of yen-dollar basis swaps increased by 46 basis points.

It was the end of foreigners paying for the economic expansion of the United States. It also probably marked the end of the real estate recovery.

The effect of these changes in basis swap rates was to make it unprofitable for European or Japanese investors to purchase US Treasury bonds and hedge currency risk.

That such deals are possible would seem to violate the “no-arbitrage principle” of financial economics, but then America usually gets a free lunch from the rest of the world.

Foreign buyers of US securities, particularly Treasury bonds, would arrange through their banks to have their Treasury holdings covered by purchases of dollar derivatives. The banks of the foreign buyers would in turn acquire the dollars needed to cover part of the hedge by setting up swaps with American banks.

All of this allowed non-US institutions to hold large bond positions that paid a positive interest rate without incurring currency risk. It may seem like some kind of financial magic, but currency risk hasn’t gone away. It simply continued to grow as an irradiated part of the banks’ derivatives portfolio that had been hidden in plain sight.

In September last year, however, central bank researchers had estimated what they called “the missing external debt” that had funded the relatively strong US recovery. According to a special report by the Bank for International Settlements, the “missing” debt exceeded $10.7 billion in spot market valuations.

The BIS estimated in 2016 that “the missing debt amounts to around $13-14 billion, but the implications for financial stability are quite subtle and require an assessment of currency and maturity mismatches”.

To sum up these “subtle implications”: the United States had borrowed about an additional $14,000,000,000, and the foreign exchange risk assumed by the foreigners who lent this money had been mainly covered by the American banking system, which had underestimated how dangerous it could be.

The BIS has studied how these derivative bonds have formed since the recovery from the global financial crisis. After all, as its report states, “obligations incurred through foreign exchange swaps/forwards and cross-currency swaps are functionally equivalent to secured debt.”

Previously, the BIS warned: “Even strong institutional investors can run into trouble. If they have trouble rolling their hurdles because of issues between dealers, they could be forced into sellouts.

Over the next 12 months, the BRI study made its way into the regulatory community. Anecdotally, as we approach the end of the third quarter of this year, regulators poring over the big banks’ trading desks have indicated that it would be good to reduce all swap exposure.

This cautious adjustment came at the same time as the Federal Reserve’s tightening message hit home. Some, like President Donald Trump, now think the Fed has “gone crazy.” Others think the adjustments are just what is needed to tame nascent inflation.

Someone other than foreign exchange-hedged foreigners will have to buy those bonds, along with the additional trillions that will be generated by large and growing US deficits. It seems likely that these new buyers, likely some US commercial banks, will need much higher rates to be tempted to bid as the Fed unwinds its own positions.

This is bad news for American manufacturers. They needed more years of low interest rates to meet the demand from millennials who were forming families and looking for homes.

Robert Dietz, chief economist at the National Association of Home Builders, points out, “Affordability is at a 10-year low. It’s not just double-digit increases in the cost of softwood lumber due to tariffs. “We have been suffering from labor shortages for three or four years. Now the builders say the lot provides [land approved for building] are weak.

Therefore, even if there is a strong recovery in home building activity, the underlying demand is not satisfied. Housing starts in August only reached an annual rate of 1,282m, well below the pre-crash peak of 2,273m in January 2006, not to mention the March 1973 rate of 2,365m of homes built in a much smaller country.

This underproduction is a failure of the financial system just like the last financial crisis. This is a consequence of the artificial constraint of housing construction by federal lending rules and local land use regulations. It postponed weddings and stuck labor in quicksand. Now potential buyers are facing high rates caused by the unwinding of these covered Treasury transactions.

Don’t talk to me about post-crisis “reforms”.


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