‘Central Bankers of the World, Unite!’ That at least seems to be the theme from the central banker’s playbook. The US Federal Reserve, The European Central Bank and now even the Bank of Japan all seem to be in a mood to tighten the global money supply. What does this mean? We explore that thought and look at the US saving rate (or lack thereof), foreclosure rates and more.
The End of Japan’s Quantitative Easing
One of the more important aspects to global growth has been the ‘quantitative easing’ policy of the Bank of Japan. Basically, they have put about ¥30 trillion into the world since 1999, with ¥20 trillion of that coming since 2003. They have flooded the world with liquidity, at almost exactly the same time as the US Fed was aggressively lowering rates. Japan has been a main source of capital and savings for the world. Now that looks like it is going to change. My friends at GaveKal give us a succinct picture of what is happening. After that we will look at why you should care about Japanese bank policy.
‘As long-time believers in the huge importance of Japan’s zero interest rates for every financial market in every corner of the world, we have to sit up and take notice of the imminent tightening of monetary policy in Tokyo.
‘First hints and, more recently, explicit statements suggest that the Bank of Japan is about to abandon its policy of flooding the Japanese banking system with money so as to create excess balances of ¥30 trillion. Whether the BoJ announces this change at its next monthly meeting on Wednesday, or waits until the April meeting, is of little importance. What matters is that the policy of quantitative easing (QE) is clearly at an end.
‘But the imminent end of QE begs a crucial question, which seems to be confusing many investors and market analysts. Will the end of QE be followed quickly by the ending of the zero interest rate policy (ZIRP)?
‘Remember that the QE policy did not begin in earnest until 2003, four years after interest rates were reduced to below 10bp in 1999 and two years after they fell to absolute zero in mid-2001. Thus a gradual reduction in bank reserves from the present ¥35 trillion to ¥15 trillion (where they were in 2001) or even ¥5 trillion where they were in 1999 would be perfectly compatible with zero or near-zero interest rates.
‘Our view is that this combination of declining reserves and zero rates is exactly what the BoJ will try to achieve. We have long believed that the ZIRP would continue for at least another year or so and that Japanese interest rates would remain near zero (i.e.: below 50 basis points) for the rest of this decade. We believed this because the Japanese had a very plausible reason for sticking to ultra-low interest rates for the foreseeable future: Japan has the biggest government deficit and the highest level of public debt relative to GDP in the OECD.
‘Thus when the economy gets strong enough to withstand a deflationary impact, the Japanese will want to hit it with fiscal rather than monetary tightening. Tax increases are already in preparation for 2007 or 2008 and to make sure that they can be implemented without causing a 1997-style economic disaster, Bank of Japan and Ministry of Finance officials have agreed that monetary policy should remain ultra-loose for the foreseeable future.
‘This very plausible story has been supported by news reports which predict that the BoJ will accompany its statement about the end of quantitative easing with a public assurance that the ZIRP will be maintained. But strangely, the market seems to be taking the opposite view. All the discussion about ending QE seems to have persuaded many investors that the ZIRP is also about to be abandoned. The Japanese yield curve is now discounting a very aggressive increase in interest rates, with short rates expected to rise by 75 bps this year and 150 bps by the end of 2007. This seems to us very implausible.’
This week the European Central Bank raised interest rates and optimistically projected European growth to be higher. European Central Bank President Jean- Claude Trichet said, ‘…projections for the annual average rate of growth are in a range between 1.7 and 2.5% in 2006 and between 1.5 and 2.5% in 2007.’
While we should note that if the Bush administration made such a proclamation, it would be considered a disaster, this is actually an increase in the estimates for Europe. When combined with his recent and frequent use of the word ‘vigilant’ every time he talks about inflation, it seems to indicate that the ECB is not through with its rate increases. Cheap European money and credit is on its way out the door.
And with the recent strength in the US of the ISM numbers, it appears the US economy is going to turn in a very respectable GDP number this quarter. It makes a rate hike this month a lock, and increases the probability of a hike in May and maybe one more in June. I am not alone in that thought.
Market expectations (using CBOT futures prices) suggest that there is a 100% chance of a rate hike in March, a 78% chance in May, and a 67% in June. Futures pricing even suggest a better than even chance for a fourth rate hike in August!
Let me repeat what I said when the Federal Reserve began to increase rates in 2004. ‘History says the Federal Reserve will increase rates more and for a longer period than anyone now suspects.’ I also said I hoped I would be wrong, as the Fed usually stops when they have already inflicted enough damage to materially slow the economy. It looks like they are going to go too far this time as well, at least from my vantage point.
In short, all three major central banks, and a lot of smaller central banks, are going to either tighten their money supply or continue to raise rates or both. Yet, investors and banks continue to lend money and demand less risk premium. Such a combination does not usually end in happiness. It reminds me of Mad Magazine’s Alfred E. Neuman. ‘What? Me Worry?’ When central banks tighten simultaneously, bad things can happen. Think of the tightening in 1997 and then the Asian and Russian problems in 1998, or the serious tightening in 1999 and 2000 and the stock market corrections in 2001-2003.
Trouble in the Housing Market
Reduced liquidity and rising interest rates are slowly being translated into higher mortgage rates, slowing the rise in home prices and cash out refinancing. As I wrote last summer, the Fed is clearly bent on stopping a housing bubble in its tracks. They hope to be able to engineer something similar to what has happened in both the United Kingdom and Australia, where both countries experienced an even greater housing price increase than in the US, their central banks raised rates and yet did not see a falling of home prices or a bursting of a bubble. Home prices in those countries simply went flat.
Are higher interest rates having an effect on the housing market? The clear answer is yes. RealtyTrac (www.realtytrac.com), the leading online marketplace for foreclosure properties, today released its January 2006 Monthly U.S. Foreclosure Market Report, which shows 103,540 properties nationwide entered some stage of foreclosure in January, a 27% increase from the previous month and a 45% increase from January 2005. The report shows a January national foreclosure rate of one new foreclosure for every 1,117 U.S. households, continuing an upward trend in which the national foreclosure rate rose in every quarter of 2005.
An interesting series of stories on foreclosures in the Charlotte Observer in North Carolina illustrates the problem. As they report, FHA loans are failing in Charlotte at nearly twice the national level. But the reasons for failure are interesting. Many of the failures are on the lower end of the economic scale.
A new mortgage industry grew in the mid-1990s, offering loans at higher interest rates to people who don’t qualify for traditional loans. Such loans account for about 10% of all home purchase loans but result in at least 24% of local foreclosures, the Observer found. More than 40% of failed loans in Charlotte involved an arranged gift from a charity to cover the borrower’s down payment. It’s a practice the FHA is reviewing because such loans fail 76 percent more often. Further, more than 20% of foreclosures resulted from defaults on loans taken after the home purchase. The cash out financing was at such high interest rates that it pushed the families into economic problems.
Let me state that I am all for lenders willing to make home loans to riskier type accounts. The stability of an area is improved when you have more home owners, and I am all for people having a chance to own their own homes. But it will involve more defaults. In certain streets in Charlotte, up to 20% of the homes are in foreclosure. That does not help property values for the remaining home owners.
The Fed is going to get what it wants: home price increases are going to come down and then go flat. Let us hope they do not start to go down.
This week we learned that both new and existing home sales slowed last month. The inventories of both types of homes are rising to recent highs. Another 50 basis points in rate increases is only going to increase those trends. A large number of homes in hot markets have been bought by ‘investors,’ using adjustable rate mortgages with little or no equity. They intend to either flip the house or rent them. The increased cost of holding those homes is going to make it difficult for those investors who do not have some deep pockets.
Right now, in many of the hot markets like San Francisco, LA, New York, Miami, DC and Las Vegas, it is much cheaper to rent than to buy. According to an article in today’s Financial Times, the extra cost of ownership to renting in those markets is anywhere from 50% to almost 100% more!
Let’s recapitulate. Cash out refinancing is dramatically slowing down, and as interest rates rise, will slow down even more. Home price increases are also going to slow down and stop. The Fed is going to continue to increase rates until that trend is well and truly broken. Rising rates make homes less affordable so fewer homes will be sold. Since much of the recent growth in the US economy relates directly to housing, that growth is going to slow down. Consumer spending is also slowing as a result.
And then along comes Japan and suggests they are going to start to take away the world’s liquidity punch bowl. They will not do so rapidly, but do it they will. This will eventually have an effect on financing costs world wide. It helped while they were easing and it will have the opposite effect as they take that easing policy away. I wonder what the Japanese words for ‘measured pace’ are?
This is just one more reason why I think we are going to see a slowdown in the economy that latter part of the year. And it is one more reason why I think the broad equity markets are going to have a very difficult period.
By John Mauldin in ‘Thoughts from the Frontline’. You can email John here: John@FrontLineThoughts.com
John Mauldin is the creative force behind the Millennium Wave investment theory, author of the weekly economic e-mail ‘Thoughts from the Frontline’, and a New York Times best-selling author with a unique ability to present complex financial topics and make them clear and readable, with valuable insights into the current economy and hedge fund industry.
His latest book, Just One Thing, is out now. You can get your copy here: Just One Thing