Sky Blue Monthly (Feb. 2000)
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Feb. 1, 2000
In Jan. 2000 Issue of Sky Blue Monthly, we wrote: "Let us do a short conclusion: If yen appreciates against USD, US T-Bond will sink. Besides, it is possible for US T-Bond to tumble even without soaring yen; if US T-Bond (March 2000 contract) breaks 90-00 decisively and then heads south sharply, US stock market, particularly NASDAQ, will be in deep trouble. Rising interest rate (particularly rising real interest rate) is deadly to asset bubbles, including stock bubbles and real estate bubbles. Also, T-Bond won't bottom until stock market bottoms. In the next few weeks, we will glue to the monitor and watch T-Bond very closely. " As it turned out, T-Bond (March 2000 contract) broke below 90-00 but not decisively. So, what's happened?! As we have warned our readers again and again, rising yen and falling bond are deadly to the current American stock market bubble. In Jan. 2000, Japanese Yen went down and T-Bond had a nice bounce. So, have we passed the danger zone? Have we returned to the New Era? The answer would be "yes" only if yen and T-Bond "acted" on their own.
On Jan. 13, 2000, we saw this news on Bloomberg:
"Treasury Will Purchase Up to $30 Bln in First-Ever Buyback of U.S. Debt
By Vincent Del Giudice and Michael McKee
U.S. Will Buy Back Up to $30 Billion in Debt in 2000 (Update2)
(Adds latest financial market reaction.)
Washington, Jan. 13 (Bloomberg) -- The U.S. Treasury this year will launch its first-ever cash buyback of government debt and snap up as much as $30 billion in high-yielding securities to save money, Treasury Secretary Lawrence Summers said today.
The buyback -- aimed at issues paying as much as 13 7/8 percent interest, compared with a coupon rate of 6 1/8 on the most recently sold 30-year bonds -- will begin soon, with the Treasury conducting several purchases during the first half of the year. The total amount bought back will depend on investor willingness to sell the securities, and many investors might decline to dispose of such a secure source of income.
The federal government has recorded budget surpluses for the past two years and there's little sign the Clinton administration and Congress will agree on a package of tax cuts or spending increases that would prevent a third surplus in fiscal year 2000.
Note that this was the first ever cash-for-debt buyback of government securities. The date of this announcement came only days after March 2000 T-Bond broke below a major resistance level 90-00. March 2000 T-Bond rose 28 ticks on that day. Needless to say, this announcement was a boost to the bond market, at least psychologically, and T-Bond has retraced upward since then. We notice that $30 billion buyback is really a tiny number because there is about $3.3 trillion in publicly traded government debt. And remember that total federal debt is about $5.7 trillion. However, we will not dismiss the effectiveness of this scheme right away because it can be a major component in a larger cycle that is dynamic in nature.
As we have discussed in Jan. 2000 Issue of Sky Blue Monthly ( http://skybluemonthly.freeservers.com/sbm/sbm00f.htm ), increase in money supply will cause (1) CPI inflation; (2) asset inflation; or (3) capital outflow in form of carry trade. Case (2) is exactly what is happening in the USA. In the last quarter of 1998 and the last quarter of 1999, M3 Growth Rate skyrocketed. CPI inflation remained calm and stock market, particularly NASDAQ, blasted off. This showed most newly created money and newly created credit went directly into the financial market, not the retail market. If the Fed continues to ignore M3 Growth Rate, and if M3 Growth Rate continues to remain at such high level, US stock market will most likely be on the march upward again. However, T-Bond market will be under pressure if M3 Growth Rate remains high. If T-Bond sinks, stock market will get hammered. This means the party is over. Governments and central banks are the true friends of the current bull stock market. Therefore, the Treasury Department's "T-Bond Buyback Scheme" was born. This cash-for-debt buyback of government securities is possible only when the government is running a budget surplus. In order to have a budget surplus, the government has to (a) raise tax rate; (b) cut government spending; and/or (c) collect lots of taxes in a strong economy. Case (a) won't happen due to the opposition of Republicans. Case (b) won't happen due to the opposition of Democrats. This leaves case (c). If an economy is booming, business earnings are high and the tax revenue to the government will increase even if the tax rate is the same. In order to have a strong economy, we have to have a soaring stock market and hence the "wealth effect" will lift our economy. To help the stock market blast off, the cost of money has to be cheap and the liquidity has to flood the market. This was the reason that the Fed was not unhappy even when M3 was skyrocketing. Then again, the Fed's job is to keep CPI inflation from rising. Thus, we are not accusing the Fed for not doing its job. The Fed's job is not to pop a financial bubble.
Have you got the idea? The relationship described above is a dynamic relation: the cost of money is artificially lowered to provide liquidity to drive the stock market upward. The bull market creates "wealth effect" and consumers spend wildly. Hence, the economy is strong and the tax collected by the government soars. The government will have a budget surplus. Then, the Treasury Department uses the surplus to buyback T-Bond. (If the Treasury Department had not bought back T-Bond, T-Bond would have dived due to the fear of high M3 Growth Rate. The stock market would have been smashed because of the falling bond market. ) Due to US Treasury's buyback, T-Bond will rise. As a result, the Fed doesn't have to do anything on the high M3 Growth Rate. M3 Growth Rate can go even higher because bond market has been taken care of. The stock market continues to march upward. The "wealth effect" from this bull market helps US economy and a strong US economy results in even larger tax revenue. The budget surplus will be even higher. US Treasury can use this even larger surplus to buy back even more T-Bond. T-Bond will rise further. This "benign cycle" goes on and on. If you don't know the real meaning of the word "utopia", this is it!
If this "benign cycle" can last forever, it will bring up the question of a financial bubble of infinite size. Can a "benign cycle" last forever? Can a financial bubble be infinitely large? These are the questions that every economist wants to know. Being an economist is almost always a misery. Because you can only observe, but you can't do an experiment to prove if your idea is right. In Physics, for example, the unification of the electromagnetic and weak forces (the idea that these forces are indistinguishable at some high energy) predicts the existence of an electroweak force in terms of a symmetry involving the W and Z particles and the photon; the symmetry is broken in that the W and Z particles have mass while the photon hasn't. So, particle accelerators were built, such as CERN accelerator and Fermi Lab. The W and Z particles were discovered in 1983 (with the masses predicted by the theory) at the CERN accelerator. The discovery could be made only because of advances in the physics of building accelerators made at CERN. The electroweak theory was confirmed. In other natural sciences, such as Chemistry and Biology, experiments were carried to prove (or disprove) a theory. In Economics, this is almost impossible because millions will suffer if an economic theory is proven wrong in an "economic experiment". For example, if we want to know if an infinitely large financial bubble is possible, does it mean that we shall create an infinitely large financial bubble to prove it? Fortunately (or unfortunately if you are not an economist), the current financial bubble in the USA has the potential to be "the economic experiment". T-Bond is helped by US Treasury buyback and Japanese Yen is suppressed by Bank of Japan's (BoJ) interventions. We are not sure if governments want to create an infinitely large financial bubble. If they do, we are delighted, to say the least. Because this will be the experiment to prove if our theory is right or wrong. Our economic theory, FFEE, predicts that a financial bubble cannot be infinitely large because our financial market and our economy are connected. Obviously, our economy cannot be infinitely large due to the limitation of the capital goods.
Since we expect that the current financial bubble in the USA will burst sooner or later, we shall move on and discuss what will happen after the implosion of the bubble. A major problem will occur after the bubble bursts. Once a bubble has been created, the best thing to do is to pop the bubble right away. The longer the bubble lasts, the more damages it causes. The bigger the bubble, the more destructive its power. When a large bubble bursts, liquidity disappears because commercial banks refuse to lend; actually even the best business plan will not get the loan because commercial banks are already in hot water. Governments, usually, are pretty naive because bureaucrats believe that they can print money to fix this liquidity contraction. Brazil did exactly that in early 1980's and got themselves into a hyperinflation. Instead of one bank crisis, government actions created a series of bank crises. Why? We will use FFEE to explain it. The reason is that at normal time, increase in money supply will cause newly created money and newly created credit to flow into the financial markets first before they reach retail markets. This is better because producers and manufacturers usually get a hand on the new money and new credit first before the consumers do. Therefore, the total goods and services produced actually increase and hence inflationary pressure increases slowly and steadily. In some cases, the newly created money and newly created credit mostly flow into financial markets and the result is asset inflation, not CPI inflation. The current economic situation in USA and 1988-1989 Japanese economy are the best examples. After the bubble bursts, however, financial market is shell-shocked and the newly created money and credit bypass financial markets and flow directly into the retail market. Because of this, the total goods and services produced either remains unchanged or declines. Meanwhile, in the retail market, huge amount of new money is chasing this decreasing amount of goods and services. The result is hyperinflation. Thus, after the bubble bursts, there are only 2 possibilities: deflation or hyperinflation. There is nothing in between. We call this situation "Digital State" in the post-bubble era. Normally, inflation rate is in "Analog State".
We observed an interesting phenomenon during the G-7 meeting in Jan. 2000: European government officials and central bankers did not seem to care about the continuous depreciation of Euro. Euro depreciated against USD and it broke parity. And Euro is supposed to be the next "reserved currency" of the world! Think about it. Are they (European central bankers and government officials) losing face?! Why didn't they do something about it? If we were they, we would not care about the sorry state of Euro, either! There has been capital outflow from Europe to Japan and the US. These capital are going into the soaring Nikkei Index, Nikkei OTC Index, S&P, NASDAQ… etc. There is nothing wrong with European economies. They are solid. The cause of Euro depreciation has to do with the capital outflow, which are moving into Japan and the USA for investment opportunities. Therefore, European central bankers are not worrying, and we think they are absolutely right. In contrary, Bank of Japan and Japanese government officials worry a lot about the strength of yen. They insist that rising yen is bad for Japanese economic recovery. During the whole 1999, BoJ had bought $42 billion USD in 12 interventions in order to suppress yen. Remember that Japanese exports have a large import component, because Japan is poor in natural resources. A strong exchange rate discourages inflation: wages remain stable and the price of imports falls. When exports contain a large import component, like the situation in Japan, a nation can remain competitive almost indefinitely despite its rising currency. For example, since crude oil is priced in USD, a rise in yen means cheap crude oil for Japanese manufacturers. Then, why is BoJ worrying about the rising yen? Mainly because rising yen will cause Yen Carry trades to be unwinded! We have analyzed this again and again so we are not going to repeat it here. Go to Dec. 1999 Issue of Sky Blue Monthly for details. ( http://skybluemonthly.freeservers.com/sbm/sbm99z.htm ) Also, check out my economic article "Carry Trade and Its Consequence" for additional information. ( http://skybluemonthly.freeservers.com/thoughts/thcarry.htm ) Rising yen is fatal to the current American stock market bubble. Therefore, it is fascinating to see that Japanese officials are more worrying than the Americans are.
Back to our original discussion, our opinion is that $30 billion buyback of government securities by US Treasury is not enough to get the "benign cycle" going. However, since this relation is dynamic, we won't dismiss its chance either. The federal government posted its largest budget surplus in history in fiscal year 1999 -- $123 billion. That followed a $69 billion surplus a year earlier. If the government can resist spending more on its pet projects (we doubt it), then there may be more buybacks down the road. Also, if this buyback can get the "benign cycle" going, the Treasury Department's ability to buy back T-Bond will increase enormously in the future because this relation is dynamic. Well, that is a big "if". Currently, we still believe that T-Bond is in a downtrend. The current upward movement is simply a retracement. Unless T-Bond (March 2000 contract) closes above 95-06 decisively, T-Bond's downtrend remains intact. Japanese Yen is suppressed by BoJ's interventions. "How long will it last?" or "When will yen rise against USD again?" is still like a dark cloud over our heads. Rising yen and falling bond are deadly to the American stock bubble. These 2 factors are temporarily suppressed by actions from the BoJ and US Treasury. If US Treasury's buyback induces the "benign cycle", US stock bubble can expand on an immense scale. (We believe this scenario is unlikely mainly because $30 billion buyback is simply not enough.) Therefore, we remain bearish on US stock market and US T-Bond market, although we are not as bearish as we were due to US Treasury's buyback scheme. Even if this cash-for-debt buyback of government securities scheme works, in the long run, as we have discussed above, an infinitely large financial bubble is not possible, and it will implode eventually. (Supernova?) "In the long run, we are all dead. " (Keynes said this.) "Sadly, people have kids and the next generation will go through the 'supernova'. " (We say this!)
March 2000 issue of Sky Blue Monthly will be available by March 14, 2000.
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