The biggest puzzle of the past two years lies in the behaviour of intermediate and long-term US interest rates. They have stayed at their unusual lows in the face of general economic euphoria and a 300-basis-point uplift by the Federal Reserve.
As a consequence, the yield curve has flattened much earlier than expected. While the consensus does not seem to worry, it is a fact that in the past this has always signalled an impending recession. Why not this time?
Without offering any explanation, Fed Chairman Alan Greenspan recently argued that a flat yield curve would not act as a recessionary signal this time, while incoming Chairman Ben Bernanke sought to provide an alternative benign explanation with his "global savings glut" speech in early 2005.
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The search for sound and logical reasons continues. Many see a main reason in the large bond purchases of Asian central banks. Mr Greenspan, in particular, has argued that the low longer-term interest rates reflect the Fed's eminent policy posture over the past few years, leading to the low core rate of inflation and sharply diminished risk premiums.
None of these explanations holds water. Without question, the US bond purchases by Asian central banks help to keep US longer-term bond yields down. Yet they are grossly insufficient to accommodate the credit deluge flooding the US economy and its asset markets at these low rates.
In the United States, it is the popular assumption that long-term interest rates are fundamentally determined by inflation rates and expectations. The additional new feature now is diminished risk premiums. Past experience may suggest this connection, but past experience is pretty worthless under the present diametrically different conditions of exploding credit and collapsing savings.
To have cheap money, it definitely requires more than just a low inflation rate and confidence in the central bank. It requires a sufficient flow of money to accommodate the ongoing credit expansion, including the bond purchases. What has happened in the United States in the past four or five years is an unprecedented money and credit deluge holding short-term and long-term interest rates at record lows.
The first decisive question to ask in the face of this extraordinary development is the source of all that money accommodating the credit deluge. Principally, there are two possibilities. The difference is of crucial importance. The one source is the limited supply of savings; the other one is possibly unlimited inflationary money and credit inflation.
It happens that in the United States' case, the identification of that source is particularly easy. With savings in collapse, credit accommodation must essentially have come in total from inflationary money and credit creation. Implicitly, this applies equally for asset purchases, whether housing, stocks or bonds, for which the steep yield of the last few years was the ideal condition.
After Treasuries, the leveraged speculators turned to higher-yielding investment-grade corporates. Then it was junk bonds, then emerging debt and then structured credit. What has lowered US longer-term interest rates and squeezed the risk premiums was manifestly the unprecedented credit excess going into carry trade, engineered by the Fed.
This talk of diminished risk premiums as the cause of the low long-term interest rates virtually puts the truth on its head. As yields fell across the board, the speculators had to incur rising risks in order to maintain their spread in carry trade.
For us, Greenspan's reference to low-risk premiums as an explanation for the low long-term rates just serves as a diversion from the all-too-obvious true cause: the greatest credit excesses in history.
Recognition of these facts has to be the starting point for any assessment of the future course of US longer-term interest rates. A total collapse of the carry trade, a sure consequence of an inverting yield curve, would send long-term rates soaring.
While Mr Greenspan has argued that the yield curve no longer plays the same crucial role for the economy as in the past, we think that under these conditions it matters more than ever, both for the economy and the financial system.
All the more puzzling is the stubbornness of the low long-term interest rates, defying the yield curve's actual flattening. One possible explanation is a major shift in the financing of the carry trade to a cheaper euro and, in particular, yen. Strikingly, the growth of financial credit - i.e. by financial institutions other than the banking system - showed a steep plunge in the third quarter.
In the end, though, one has to assume that leveraged speculators stick to their bond holdings or even add to them, expecting that a weakening economy will force the Fed to sharp new rate cuts.
Although strongly sympathising with the downbeat forecasts for the US economy, we have trouble with the optimistic assumptions of still lower long-term interest rates. The starting point for our doubts is the preposterous pace of credit expansion shown in nonfinancial credit, despite 12 rate hikes, with no sign of the slightest letup.
So far, there has been zero monetary tightening. The just-published Flow of Funds Accounts of the Federal Reserve shows a rise in nonfinancial credit for the third quarter of 2005 to a new record-high annual rate of $2,296.6 billion, of which, also a record high, consumer credit was $1,235.9 billion.
To understand the problem of credit excess, it needs a historical perspective.
These numbers make horrible reading in two respects. One is the sharp acceleration in the speed of credit growth over the years, and the other is the stunning contrast between exploding credit and collapsing savings.
Now compare the credit figures of the 1990s with those since 2000. Even in the boom year of 2000, nonfinancial credit expanded by just $864.7 billion. During the first three quarters of 2005, it has - after rapid acceleration - been expanding by $2,202.2 billion at annual rate.
The difference is shocking. Even more shocking is the extremely poor job growth resulting from this unprecedented credit deluge. During the first four years of the recovery after the 2001 recession, decried as a "jobless recovery," employment grew by 7.6%. For the current recovery, it is 2.6%.
There has, in short, been a dramatic deterioration in the traction of credit growth on economic activity. It was in the early 1990s, actually, already much lower than in the earlier decades of the postwar period.
It should be clear that this has serious negative implications, if this disconnect becomes structural. Closer investigation of the underlying causes compels us to the conclusion that, in fact, it is structural, and this for obvious reasons.
Money and credit growth do not have determined economic effects. It is decisive to whom and for what purpose credit is extended. In this respect, the past 20 years have witnessed substantial changes in all industrialised countries. But these changes have mainly been most drastic in the United States for two reasons. One reason is a general growing propensity toward consumption; and the other reason is an obsession with shareholder value, at the expense of organic capital investment.
In earlier years, credit generally financed spending in the economy. Businesses borrowed for capital investment, and consumers borrowed for purchasing durables and housing. All this borrowing impacted national product and incomes directly and positively.
But starting in the 1980s, new credit in the United States increasingly went into two other outlets outside the national product. One was soaring imports, as reflected in the ballooning US trade deficit, and the other was asset purchases in the domestic and global markets.
One of the results is a general confusion about inflation. Historically, American policymakers and economists in general only recognise one single kind of inflation - rising consumer and producer prices, particularly the former. To understand inflation, however, it is necessary to distinguish between cause and effect.
There is always one and the same cause, and that is excessive money and credit creation. But depending on possible different uses of the borrowed money, there can be very different effects. By the early 1980s, a sharply accelerating money supply in relation to GDP aroused great fears of a comeback of consumer price inflation that tenaciously failed to materialise. Even for the experts in the central banks, it took some time to realise the obvious, that credit excess was fuelling inflation in asset prices, instead.
A trade deficit, in turn, implicitly reflects the fact that a country spends in excess of its production. For this to happen, it inexorably needs credit, enabling people to spend in excess of their current income. From this perspective, it, too, is manifestly an expression of inflation.
People borrow to spend. Observing a sharply accelerating credit expansion, it is, in general, easy to identify the target of this spending. There cannot be the slightest doubt for anybody that the credit deluge of the past few years in the United States has mainly flooded into housing - boosting its prices. Yet policymakers and many economists dare to flatly deny the direct connection.
In his first speech as Fed governor (October 2002), Mr Bernanke said, "Another possible indicator of bubbles cited by some authors is the rapid growth of credit, particularly bank credit. Some of the observed correlation may reflect simply the tendency of both credit and asset prices to rise during economic booms."
It certainly needs a lot of courage to discard such a blatantly obvious causal connection as merely coincidence.
By Dr Kurt Richebcher for The Daily Reckoning
Former Fed Chairman Paul Volcker once said: 'Sometimes I think that the job of central bankers is to prove Kurt Richebcher wrong.' A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr Richebcher's insightful analysis stems from the Austrian School of economics. France's Le Figaro magazine has done a feature story on him as 'the man who predicted the Asian Crisis...'
