Friday, June 22, 2007

Remember interest rates?...

While our economists and politicians work to ignore our growing (albeit a bit more slowly) deficit, other countries are trying to figure out where to invest surpluses. Up until recently, one of the assets of choice has been American debt: T-bills and bonds.

Maybe not for much longer. Sovereign wealth funds (SWF) may total as much a $2.5T and they have been looking for a bigger bang for those bucks. All the more so with inflation heating up.
The result has been a torrent of money into a finite pool of assets. There is no precedent for such fortunes suddenly to find their way into global financial markets, and they help explain the waterfall of liquidity that has driven up the value of risky (and less risky) assets of all descriptions around the world. The world's entire supply of shares is $55 trillion, and bonds account for a similar amount. Sovereign-wealth funds could soon become the most important buyers of such assets, and many others besides. If so, the world will witness the intriguing spectacle of its largest private companies being owned by governments whose belief in capitalism is often partial. [More]
Our interest rates have been underwritten by the fanatical devotion of Chinese and Japanese governments with US debt instruments. Without those ready buyers, the Federal Reserve may have to raise rates to entice new buyers - even if they are not alarmed about inflation.
The growing importance of SWFs and diversification into other markets is beginning to attract both worry and criticism.

First, there is the impact on U.S. Treasury bonds. The IMF estimates that central bank buying has depressed yields on long-term U.S. Treasury bonds by between 30 and 100 basis points. Sudden portfolio adjustments by, say, China's SWF, could lead to a collapse of U.S. bond prices, making it more expensive for the United States to finance its debt.

Second, there is the issue of transparency. Few SWFs give details of their operations. If monitoring the currency and asset compositions of official reserves is difficult, tracking the investments of SWFs is nearly impossible. Only Norway provides anything close to transparency. The Abu Dhabi Investment Authority (ADIA) seems to be the model for most SWFs. ADIA has a reputation as a highly professional organization with a diversified portfolio and a cadre of talented managers. Yet despite managing $875 billion, there are next to no public details on AIDA's operations. It makes the most secretive hedge funds look like an open book. [More]
If this strikes you as mildly concerning, you are not alone. Consider this futuristic fable from an business observer:
All of that borrowed money had to come from somewhere, and most of it came from Asia. When China stopped turning up at bond auctions in 2007 and started investing directly in companies instead, alarm bells should have rung. They didn't....

...Lots of the banks had sold insurance on those IOUs and on a bunch of other stuff that they bundled together into derivatives called collateralized debt obligations. When those investments started to blow up, we all realized that nobody knew who owed what to whom. And banks and hedge funds had become such a big part of the global economy that they dragged everything else down with them. [More]

I'm not as pessimistic as the writer, although he makes good points, but I do think the days of cheap money, like cheap oil and cheap corn are probably over for some time. It also means the Fed may become less of a news source than during the Greenspan days.

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