The fall of Lehman Brothers is more than one year ago and the financial tsunami become part of our history. and the financial market has been stabilized. If we just focus on the stock markets, the major stock markets have recovered most of the lost from the March 2009 low. People’s risk appetite for investment products reaches the highest level since the financial crisis happened. It looks like the tsunami is finally over and the world is in peace again. However, I have some thoughts would like to share with you.
I believe the crisis is not over yet. Why? Do we really fix the problems? Let us take a step back to find out what causes the financial crisis. Subprime?
Subprime is not the main reason for the financial crisis. The credit bubble is the main reason for the crisis. The US interest rate was understated for so long due to foreign investors provide cheap financing for both US government and consumers. The cheap dollar creates the subprime bubble. After housing bubble burst, the Fed and the US government provide cheap dollars to the financial system. I think they are not solving the problem; they are just trying to solve one credit bubble by creating another credit bubble.
Why the US government creates a new bubble to solve the old bubble? The people who are running the Fed and the Treasury department are not stupid and they are probably the smartest people in the world. There must be reasons behind what are they doing now.
First of all, the Fed doesn’t have a choice if Mr. Bernanke does save the Wall Street by slashed the main interest rate almost to zero and pumped $1 trillion into the banking system to unfreeze credit markets. Second, the Fed launches asset-buying, or quantitative easing, program that this program has led the central bank's holdings of agency debt and mortgage-backed securities to grow to more than $1 trillion, the balance sheet rise to the record. The Fed becomes the largest lender in the US. Finally, The banking system is currently flooded with excess reserves — over $1 trillion. Historically, that figure has been around $1 billion or less. Thus far this has not led to inflation because of the declines in velocity and the money multiplier. However, It is only a matter of time before confidence re-emerges and banks start lending these excess reserves.
When this happens, monetary policy will have to respond by draining these reserves from system. If the Fed doesn’t response to the problem accordingly, the inflation may be going out of hand. Before the inflation become problematic, monetary policy will have to respond by draining these reserves from system. It is possible to do so in one of two ways. The first way is to sell bonds through open market operations. The second way is the raise the interest rate that the Fed currently pays on reserves. Either way will have a negative effect on the pricing on the US Treasury and it will push the yield curve upward.
What will happen to the US national debt if the rate hikes?
As of March 22, 2010, the US national debt is over 12.6 Trillion. The National Debt has continued to increase an average of $4.05 billion per day since September 28, 2007. Each citizen’s share of this debt is $ 41,100. The national debt has risen from 5.7 trillion in 2000 to the present level of 12.6 trillion dollars. I feel very surprise that the US Treasury yield is very low. For example, 10 yr yield is 3.70%, 20 yr yield is 4.41% and the 30 yr yield is 4.58%. The interest rates are not making any investment sense for such a high debt nation. I don’t think investors will keep buying the US treasury at such low yield. What happen if foreign investors and central banks buy less or even reduce US treasury position? First of all, the balance of payment account will not be balance anymore. Unless the US export increase rapidly or domestic consumer buy less import products which will turn the balance of payment account positive. Otherwise the options will be devalued of the dollar or increase the US interest rate to attract foreign capital invests in dollar assets. Both options will drive up the US interest rates. Devalue of dollar will bring in import driven inflation.
What happen to the US if the interest rates increase? The US government needs to pay more interest to its new debt. With such big debt, I don’t think the US government can service its debt in long-term. The Taxes income cannot services the national debt. In the worst scenario, the US treasury may be downgraded by the rating agencies. It may happen in the future if the US cannot reduce its debt and deficit. If US government is a real person, he/she may already bankruptcy. It is a no way out situation for an individual but there would be a solution for the US government to pay-off its debt which will also help the US dollar to maintain its position as the world currency.
How could the US government solve the US national debt problem?
The US national debt is increasing at a rapid rate due to Obama administration’s injecting money to save the Wall Street and also avoid another great depression occurs. However, both the trade deficit and national debt are at the dangerous level, these policies are only pain reliever and would hurt the US economy in long-run (The market adjustment will be longer).
Many countries like China, Russian and other oil-rich countries in the Middle East are skeptical the future of US dollar. They will not trust the US treasury in long-run either.
I think both the Fed and the Treasury department know what is going on and understand the clock is against them. They need to do something to turn the table around before the US dollar lost its world currency position. In order to save the US dollar and pay-off the national debt. The US government will depreciate the US dollar and increase the US interest rate to a record level. I agree that it will kill the US economy in short-term but it can reduce 50-70%of the US national debt. The 10, 20, 30 year US treasury are paying very low yield. Their market value are very close to par. Since the long bond prices are very sensitive to the interest rate movement. The bond price will collapse if the US interests move higher than 10%. I believe the long bond prices will only be 20-30% of the current market price. Then the Fed just print some money and buy the US treasury from the open market. The national debt problem will be solved. In addition, the US dollar has become the funding currency since last year. Investors borrow US dollar and invest in other currencies. The net shorting positions are huge for the US dollar. If the USD interest rates rise, the cost for borrowing USD will also increase. The easy profit will disappear and the short recover position will make the US dollar appreciate. That will solve the import driven inflation. The US will solve the national debt and maintain the greenback’s position. Do you think it would happen?
How do we anticipate and capitalize this opportunity?
First of all, I believe the Fed will keep the interest rate relatively stable. There will be no major movement until the US Government Issue most of the new debt which will be financed the financial crisis. The interest rates will not have big movement until the end of 2Q 2010. I suggest that we should consider shorting the US treasury with 10+ years maturity. We can short sell the US treasury through future or option. The down side risk is quite low due to the US treasury offer very low return. Maybe consider those equity sectors which are interest-rate sensitive.