LIGHT TO UNDERSTANDING

BEST OF KURT RICHEBACHER
September 1, 2005

It is now fully 14 months since the Greenspan team at the Federal Reserve started its rate hikes at a very "measured pace." Its short-term federal funds rate is up 250 basis points altogether, from 1% to 3.5%. If it were their intention, as we assume, to exert no restraint at all on borrowing, they have fully achieved this goal.

Notoriously, yields of 10-year Treasury notes, the benchmark rate for the long-term area, fell by 50 basis points over this period, from 4.7% to 4.2%, and sometimes lower. Yet looking for restraint, the critical aggregate is credit expansion. It has gone through the roof.

Bank credit has expanded $544.7 billion year to date, or 13.5% annualized. Among this total, security credit gained $145.6 billion, up 12.7% annualized. Commercial and industrial loans have surged at an annualized rate of 18.8%. Real estate loans are up at an annualized rate of 16.7%. Year to date, asset-backed securities (ABS) issuance is up $451 billion, i.e., 21% ahead of comparable 2004. Home equity loan ABS issuance of $286 billion is 24% above its growth in 2004’s same period.

Compare these stellar growth rates of credit with the reported real GDP growth of 3.6% annualized during the first half of 2005. Credit and debt is growing out of any reasonable proportion to real GDP. We hasten to repeat our regular proviso that owing to grossly understated inflation rates, we regard these reported growth rates as grossly overstated.

Another disquieting counterpart to this credit insanity is the protracted, sharp slowdown in money growth. M3 is up 5.4% at annualized rate over the last six months, and M2 only 2.3%.

Normally, credit and money grow together. But two things disrupt this connection: the huge and rising import surplus and the escalating Ponzi finance. Soaring interest expenses are increasingly met with new credit. What keeps the national Ponzi scheme going is the common illusion that rising asset prices are creating wealth.
A
nd there is still another critical point to see. While household holdings of liquid assets keep rising, they are collapsing in relation to outstanding debts and holdings of illiquid assets. The liquidity preference of private households is apparently deep in negative territory but is eagerly accommodated by banks and other lenders.

It is our long-held conviction that the U.S. economy has entered a new slowdown, as the prior massive monetary and fiscal stimulus has petered out. There is nothing in sight to generate self-sustaining growth. Essentially, this would have to be a capital-spending boom big enough to take over for the housing bubble. But that is totally out of the question.
Several major economic data have recently surprised on the positive side.

On closer look, we note that both the Bureau of Economic Analysis and the Bureau of Labor Statistics have recently become unusually aggressive in bending figures to show desired results.
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The world economy seems to be flooded with liquidity. But there are two diametrically different kinds of liquidity: earned liquidity and borrowed liquidity. The former comes from surplus income or savings; the latter comes from credit and debt creation.

In a country with virtually zero savings like the United States, any liquidity essentially arises from debt creation. This is really fake liquidity depending on permanent, prodigious borrowing facilities, presently the housing bubble. Once this bubble evaporates or bursts, the U.S. economy loses its chief liquidity source — with disastrous effects on asset prices.

The crucial question concerning the U.S. economy is whether it is slowing or accelerating. As explained in detail, we see a lot of fudge in the recent economic data. Our main critical consideration is that a self-sustaining recovery would absolutely require a strong rebound in business investment. But that is not in sight. On the other hand, the turnaround in the housing bubble is only a question of time. A fairly short time, we think.

The consensus expects that the U.S. economy has the "soft spot" behind it and will surprise positively. We expect shocking economic weakness. All asset prices, depending on carry trade, are in danger, including bonds.