Date created: 5/4/05
Last modified:5/4/05
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John Quiggin

Dog's bark will bite deep

Australian Financial Review

13 January 2005

In one of the most famous Sherlock Holmes stories, Silver Blaze, the crucial clue is the curious incident of the dog that did not bark in the night. Holmes infers that the burglary at the centre of the case was an inside job. The dog would have barked at an intruder, but not at a familiar person.

The dog that did not bark in 2004 was the international bond market, in its pricing of long-term US government debt, and particularly 10-year Treasury notes.

On all the standard rules, the rate of interest on 10-year notes should have risen substantially. The Federal Reserve increased the cash rate six times, reducing the margin between short and long rates. Inflation rates increased and higher oil prices seem likely to feed into more inflation in the future. The US dollar depreciated against the euro and, in view of the steadily increasing trade deficit, seems certain to fall further.

The long-term outlook for the US Budget deteriorated through the year and was greatly weakened by the re-election of the feckless Bush Administration, whose supporters assert that budget deficits either don’t matter or are a positive sign of economic strength. Such attitudes would normally merit severe punishment from bond markets.

Yet the dog did not bark. The 10-year rate was about 4.2 per cent at the beginning of 2004, rose to nearly 5 per cent at mid-year then fell back, ending the year almost exactly where it started. Conversely, the market price of 10-year notes fell somewhat, then recovered.

What are we to make of this? If the interest rate was being set by standard market forces, it would certainly have risen. So we must infer an inside job, with the rate being set by some form of manipulation.

Most attention has been focused on the demand side of the market. Private investors have increasingly pulled out of assets denominated in US dollars, selling both equity and debt. The slack has been taken up by Asian central banks, particularly those of China and Japan.

Some have called this pattern of intervention ‘a new Bretton Woods system’. But it cannot continue for long. To see this, it is only necessary to look at the losses the Chinese government will take on its dollar holdings when the peg between the renminbi and the US dollar is, inevitably, broken. With reserves of $600 billion, a ten per cent appreciation of the renminbi would cost the People’s Bank $60 billion, or about 25 per cent of the government’s annual budget. The more reserves are built up to defend the peg, and the further it gets out of line with market reality, the greater the eventual cost.

Much less attention has been paid to the supply side, but it is probably more important. The main reason that the price of long-term US notes and bonds has not fallen is that there are less of them on the market. This is a surprising observation, given that the US government is running large budget deficits.

The explanation is that, in the past few years, the US has drastically shortened the term of its borrowings. Just when the government went into deficit in 2001, the US abandoned the sale of 30-year bonds, although the interest rate on these bonds was historically low. More generally, long-term bond financing has been replaced by shorter-term bills and notes.

As New York University economist Nouriel Roubini has noted, the average maturity of newly issued US government debt has fallen from 90 months in 1999 to 34.2 months by September 2004. The average maturity of the total debt has fallen from about 70 months in 2000 to 55.1 in September 2004.

For any normal borrower, this kind of shortening of borrowings would signal an imminent rollover crisis, as creditors refused to renew the debt except at much higher interest rates. Even before this happened, speculators would be discounting the debt in secondary markets. The coup de grace would be a speculative raid similar to that by George Soros, which pushed Britain out of the European Exchange Rate Mechanism in 1992.

For the moment at least, few speculators are willing to take on the combined might of the US Federal Reserve and the People’s Bank of China. But no central bank, no matter how powerful, can hold asset prices up indefinitely. Sooner or later, US interest rates must rise, and anyone who is still holding US debt will be left to take the resulting loss.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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