by Dick Lepre
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“Get to Know How the Fed Affects Rates,”
“The Bond Market as Crystal Ball,”
“Viewpoint: Lessons from
Lehman Brothers 10 Years Later,”
“Stay Informed and Ignore the Buzz on Rates,”
<< Markets continued from Page 94 “To have a sense of where mortgage rates
are going in the U.S. in the near future, pay
attention to what is happening with the
economies of Iran, Turkey and Argentina.”
that nation’s currency will lose value relative to other
currencies. This makes imports more expensive and is
part of what causes inflation. At present, the best example of monetary policy gone badly is in Venezuela.
The problem is not merely with central banks. There
are two types of money: state money and private
money. Central banks produce state money, but commercial banks activate or put into play private money
when they make loans.
During the post-2008 recovery, federal regulation coupled with the Basel Accords, which address
lender risk, stifled bank lending in the U.S. Conversely,
if a government is too loose in its regulation of bank
lending, banks can produce too much money as well.
This too-rapid expansion of money supply, both by
central banks and private banks, results in inflation.
Some emerging-market nations have such serious
economic problems, such as Venezuela, that capital
starts to seek out safer havens. Some of that will move
to U.S. Treasury and mortgage-backed securities debt.
As nations default on debt, and as companies
in emerging markets go bankrupt, the contagion
can spread. It may infect the EU banking system, for
example, which could create counterparty risk and
slow down the economy of Europe.
Interestingly, the problems of each emerging nation
have somewhat different causes yet certain similari-ties. Causes include vigorous government spending
on infrastructure, which suddenly stops as governments can no longer borrow to support spending;
irrational exuberance by banks and other lenders
seeking high returns; and business seeking to expand
and borrowing so much that they cannot pay it back
and wind up going bankrupt.
The likely consequence of this capital flight will be
that investments in emerging-market nations will
be reduced. Some of the money withdrawn will be
re-invested in the U.S. The bulk of bank lending in
emerging-market nations has been from European
banks. Consequently, the effect on U.S. banks should
Repeating the past
This capital-flight risk is occurring at a time when the
Federal Reserve is moving short-term interest rates
higher, thus making the U. S. an attractive place to park
money departing emerging markets. It is better to
get a 2.5 percent return on your money than to take a
10 percent loss on an investment gone bad.
The last time something such as this occurred was
the Asian currency crisis of 1997-1998. That situation
was similar to the one that appears to be mounting
now. Money, both in the form of equity investments
and loans, initially flowed into those Asian countries
because rates of return were higher than elsewhere.
Trouble started, however, when Thailand — which
had previously pegged its currency to the U.S. dollar —
dropped the peg and floated its currency. Currency
devaluation ensued, and it became difficult for
Thailand to service its dollar-denominated debt.
The effects of the Asian currency crisis were dra-
matic. Indonesian President Suharto resigned. On
Oct. 27, 1997, the Dow lost 7.2 percent of its value, and
the yield on the 10-year Treasury fell from 6. 9 percent
in April 1997 to 4. 4 percent by October 1998. Those
changes in equity and Treasury prices reflected the
fact that hot money was running from risky assets to
the safety of U.S. Treasury debt.
The U.S. banking system suffered very little damage
from the Asian currency crisis. On Christmas Eve 1997,
the New York Fed met with the U.S. banks with the
largest exposures to South Korean debt and got them
to voluntarily commit to roll over their short-term
loans to medium-term debt.
The number to pay attention to in emerging markets is the inflation rate. As of this past September,
these were some of the out-of-control annual inflation
rates, according to the Hanke Inflation Weekly report:
Venezuela, 48,072 percent; Iran, 260 percent; Argentina, 122 percent; Sudan, 103 percent; Turkey, 90 percent; and Yemen, 66 percent.
Bad monetary policy can work in the opposite
direction. A chilling example that we should never
forget is India’s recent decision to remove 86 percent
of its currency from circulation — overnight and without warning. In order to combat crime, including tax
evasion, India eliminated large bills and reduced its
money supply. Unlike the U.S., which is a credit card
nation, India is a cash nation, and elimination of that
much currency seriously jolted the nation’s economy.
Emerging markets also have relatively little transparency in the reporting of data. In the U.S. and EU,
investors demand answers and question authority. This
leads to relative transparency.
We are seeing economic issues in Europe, China, and
Turkey as well as a reduction in willingness to invest
in emerging markets. Inflation is high and currencies
are becoming useless in Venezuela, Argentina and
Iran. All of this could translate into flight-to-quality
buying of U.S. Treasurys and mortgage-backed securities debt. While the euro remains strong, the EU has
members with weak economies, such as Italy, Portugal,
Spain and Greece. How the financially stronger EU
nations deal with this emerging problem is largely
The path ahead
To have a sense of where mortgage rates are going
in the U.S. in the near future, pay attention to what is
happening with the economies, and particularly the
currencies, of Iran, Turkey and Argentina. As the values
of these currencies deteriorate on foreign exchanges,
it will become more difficult for those nations to
One number everyone should pay attention to, even
after the dust settles, is the exchange rate of the U.S.
dollar versus the euro. It is believed by many that a
weak dollar stimulates economic growth because it
makes exports cheaper, imports more expensive and
lowers the trade deficit. That is not the entire case.
While a strong dollar generally increases the trade
deficit, it makes businesses more confident about
investing and increasing productivity. This investment
helps expand gross domestic product — the value
of goods and services in the U.S. — to a much larger
degree, and those investments are long-lasting.
The extent to which the backflow of money from
emerging markets will lower Treasury yields and mortgage rates is unknown, given no one has a good idea
of just how troubled some of these foreign economies
are. The one certainty is that U.S. Treasury debt remains
the world’s safest investment. n