roach on the us econonmy

Global: Warning Shot

Stephen Roach (New York)

It’s a nightmare scenario, even for me. Sharply rising real long-term interest rates are the last thing an economy on the brink of deflation needs. Such an outcome would depress an already weakened state of aggregate demand, conjuring up notions of the dreaded deflationary spiral. The extraordinary correction in the bond market over the past seven weeks tells us not to dismiss such a possibility out of hand.

On the surface, it’s hard to conceive of a more bizarre outcome -- rising long-term interest rates in a deflation-prone economy. The experience of Japan suggests it can’t happen. After all, nominal yields on 10-year Japanese Government Bonds fell from 3.7% in early 1995 to a mere 0.4% in early June 2003. But there’s an enormous difference in the internal financing capacities of America and Japan. Awash in saving, Japan has long had the world’s largest current account surplus. As a result, it funds its economy largely on terms set by domestic investors. The United States, by contrast, is a saving-short economy running a chronic and ever-widening current account deficit. As such, it is dependent on the good graces of foreign investors to fund its economy -- on terms set largely in international capital markets. So far, those terms have been favorable. There’s no guarantee that will continue to be the case.

Therein lies the potential of rising long-term interest rates for an economy on the brink of deflation. There comes a point in every current account deterioration when enough is enough -- when foreign investors demand a premium to keep funding a saving-short economy. History tells us that such a breaking point usually occurs when the current account deficit hits 5% of GDP. That’s the threshold that typically triggers the classic current account adjustment process -- characterized by a weaker currency, higher real interest rates, and slower domestic demand that sparks a rebuilding of national saving (see Caroline L. Freund, “Current Account Adjustment in Industrialized Countries,” Board of Governors of the Federal Reserve System International Finance Discussion paper #692, December 2000). America is at that threshold right now. Its current account deficit hit 5.1% of GDP in 1Q03; in dollar terms, that equates to some $544 billion annualized, requiring foreign capital inflows of around $2 billion per bu.

siness day. Moreover, the outlook is even more disconcerting. Courtesy of large and expanding federal government budgets deficits, the US external gap seems likely to rise into the 6.5% to 7.0% range by the end of 2004; that would require capital inflows of nearly $3 billion per business day.

Never before has the world had to finance an external deficit of this magnitude. Strains on existing financing arrangements are already showing up. In our monthly Global Capital Flows Chartbook, Rebecca McCaughrin underscores the increasingly important role played by US fixed income instruments in attracting foreign capital. With foreign demand for US equities down sharply from its bubble-induced peak in early 2000, Treasuries, corporate bonds, and agency paper have more than picked up the slack. As of 1Q03, foreign investors held approximately $3.2 trillion in fixed income instruments -- fully two and a half times their $1.3 trillion of equity holdings. Within the fixed income universe, foreign investors currently hold about 32% of outstanding Treasuries, 23% of corporates, and 12% of agencies. In other words, with America’s external financing having been skewed so heavily toward bonds, it seems perfectly reasonable to expect a disproportionate share of the current account adjustment to show up in the
form of a relative interest rate arbitrage.

It’s hard to know if that is already happening. In recent weeks, the flows going through Morgan Stanley trading desks around the world have tilted away from bonds back toward equities -- a pattern not inconsistent with a US current account adjustment that is beginning to be vented through the interest rate channel. Moreover, as private sector foreign inflows into dollar-denominated assets have slowed, central banks -- especially those in Asia -- have stepped in to fill the void. But that’s not necessarily a given either. There has also been discussion about growing concerns in the foreign official community about US agency debt -- hardly surprising in the midst of a sharp bond market correction that puts considerable pressure on the mortgage financing mechanism. As I speak with investors around the world -- both in the private and in the public sector -- mounting concerns over America’s current account financing dilemma come up repeatedly. That stands in sharp contrast with discussions I have with a
relatively complacent US investor community. “You’ve been warning of this for a long time,” is the typical response. Point well taken -- and yet quite similar to the critical responses I heard in the late 1990s when I dared to question the bubble.

Meanwhile, whatever the reason and despite the lingering perils of deflation, long-term US interest rates are now on the rise -- and not just in nominal terms but even more so in real terms. After hitting a low of 1.6% in September 2002, the inflation-adjusted yield on 10-year Treasuries currently stands at around 3% (nominal yield of about 4.5% as of the July 31 market close, less a core CPI inflation rate of 1.5% y-o-y). Moreover, with core inflation having slowed to just 0.9% in the first six months of 2003, the risk to real long-term interest rates remains very much on the upside -- even if nominal yields don’t back up further. That risk hints at the toughest outcome of all -- the potentially lethal combination of low and falling inflation in conjunction with a back-up in nominal interest rates. Needless to say, should America’s current-account adjustment begin in earnest as the US continues to slide down the slippery slope toward deflation, the real interest rate outlook could be exceedingly treach
erous. And that would be terrible news for a nascent recovery in the US economy -- raising the risk of a relapse in the interest-rate segments of aggregate demand that could lead to an intensification of disinflation and an even sharper back-up in real rates. It would be the ultimate vicious circle for US economy that is already close to the brink of deflation.

All this underscores the exceedingly precarious state of a US economy facing the twin perils of deflation and a current account adjustment. While the pace of economic recovery now appears to be quickening, the growth impetus is not nearly strong enough to arrest increasingly powerful disinflationary pressures that have the potential to morph into deflation. Meanwhile, America’s current account conundrum is going from bad to worse -- underscoring the distinct possibility that foreign investors will seek some form of compensation for investing in dollar-denominated assets. Up until now, low real interest rates have been the glue that has held America’s post-bubble economy together -- providing atypical support to consumer durables and residential construction and fueling a “refi cycle” that has provided even broader support to personal consumption. Absent the real interest rate prop, a deflation-prone US economy could well be in serious trouble. In my view, the recent sharp back-up in long-term nominal
interest is a warning shot that should not be ignored.