Zero per cent interest rates started it. A weak dollar fuelled it. Speculators fanned it. And famed forecasters see it everywhere they look.
There’s only one problem with the claims that the dollar-carry trade — borrowing dollars cheaply to invest in higher-yielding assets abroad — is inflating bubbles across the globe: There is no visible credit expansion, at least in the US, to support them. (The same can’t be said for China.)
US banks are hoarding all the reserves the Fed creates when it buys securities outright or lends to various banks and institutions. Currently, the banks are sitting on $1 trillion of excess reserves, the amount of cash over and above what they are required to hold against their demand deposits.
Prior to the crisis, excess reserves of commercial banks in the US averaged $1-2 billion. The crisis put a renewed premium on cash, even as the rate paid to hold it fell, as a protection against deposit flight and insurance against government interference.
There is no sign of excess credit creation on US bank balance sheets. From October 2008 through October 2009, bank credit fell 5.3 per cent. That reflects an 8 per cent decline in loans and leases and a 3.4 per cent increase in securities. Within the securities category, Treasuries were the clear winner, with a 13 per cent increase. Ever ask yourself why?
QUESTION ANSWERED
Maybe it has something to do with the fact that banks need capital, and Treasuries don’t tie any up.
Banks are required to hold capital in proportion to the perceived credit risk of their assets. Treasuries are comparable to cash and carry a zero weighting. Commercial real estate loans are in the 100 per cent risk category.
When I hear folks like New York University Professor Nouriel Roubini talk about asset bubbles and “money chasing commodities,” I want to ask, what money? Where is all the money chasing stocks, commodities, high-yield bonds and emerging-market stocks coming from if it’s sitting in banks’ accounts at Federal Reserve banks?
Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago, thinks he has the answer: portfolio shifts.
“Investors, rather than borrowing dollars, are selling US Treasury securities they own, ultimately to capital-concerned/constrained banks, and are then investing the proceeds in higher-yielding foreign government securities,” not to mention lesser-quality stocks and bonds, Kasriel writes in his November 13 Economic and Interest Rate Outlook.
WORRY NOW, LATER
That would explain both the weak dollar and the lack of new credit creation as banks pare their loans faster than they are acquiring Treasuries.
What about credit created outside the banking system? If a non-bank wants to make a loan to an investor, it has to sell another asset. The quantity of credit stays the same. Kasriel says worries about a new credit bubble from a dollar-carry trade are “much ado about nothing.”
I’d like to rephrase that. It’s much ado about nothing now and some ado about something in the future. There is no disagreement about the risks of holding the nominal federal funds rate at zero for “an extended period,” as the Fed likes to say. If cash is trash, investors are encouraged to move out the maturity spectrum and the risk curve.
PAID TO BORROW
When investors are being paid to borrow —— when inflation-adjusted interest rates are negative, as they were in the 1970s, from late 2002 to 2005, and again last year — they are less discerning about what they buy. Credit is misallocated. Bad things happen.
They don’t happen immediately. Following the mother of all credit binges, the US has gone on a restrictive diet. For the moment, the need to slim down is greater than the urge to eat, although rock-bottom interest rates act as a disincentive to savers.
That’s where we are now. The excess credit creation from those dollar-carry trades is MIA. It doesn’t mean it will stay that way, but it’s not an issue yet, as Kasriel points out. One of the Fed’s chief concerns, in addition to preserving its independence and retaining regulatory control over banks, is how and when to withdraw the stimulus. The challenge is to do it before bank credit explodes and after the threat to the financial system has passed.
Banks in other developed countries are facing similar capital constraints as those in the US. In the euro zone, for example, M3 money supply growth has ground to a halt.
Not so in China, where credit has expanded by $1.3 trillion this year, money growth is close to 30 per cent, and stock and property prices are booming.
Investors may be chasing higher-yielding assets in Asia’s emerging economies, but they aren’t doing it with a slew of newly created dollars from the US.
