Liquidity and Safety Are Two Pairs of Shoes

Monday, September 10, 2007

Long dated US Treasuries reversed part of their dramatic gains on Monday, dragged down by worries that foreign investors were actually dumping US debt paper in last week's run-up. According to a Bloomberg report America's creditors actively pursue a diversification of their assets, shifting away from the Federal Reserve Dollar. The next Treasury Inflow Capital data will bring more clues about the amounts moved.
Investors are correct by doing so. Last week's flight into US Treasuries was a flight into liquidity but certainly not a flight into safety unless one is satisfied with nominal and not real returns.
It appears a bit illogic to consider debt obligations from the biggest debtor the world has ever seen as a safe investment. Let us not forget that the AAA rating for US IOU's has never changed since debt has been rated. The paramount difference is, though, that the USA was the world's biggest creditor when it aquired its AAA rating. Now it is the biggest debtor and to keep the US economy as a going concern it needs foreign investments like a vampire thrives on blood.
It is true, the USA will always be able to pay off its debts as it is the only nation in the world that indebts itself solely in its own currency. The game of ever expanding credit can go on - as long as investors play along.
This is not very likely, now that the whole world has agreed on the fact that the financial system built on credit excesses is under severe stress and especially US debts have become the hot potato nobody wants to hold.
The seize up in interbank lending has provoked the Sunday Times to call the current mess oozing from mortgages into everything else "the worst crisis for 20 years." Banks have stopped lending to each other in order to allow a rollover of $113 billion in commercial paper due later this week. This is more demand than a month earlier when the liquidity crisis started. And the other big headache is still out there:
The prospect of serious market indigestion from maturing commercial paper is not the only headache for the banks. Globally, they have $380 billion of loans and bonds to be laid off from leveraged buyouts and other private-equity deals at a time when the markets have shifted sharply against them.
ECB Starts Panicking
Bankers on the continent are getting cold feet too. ECB president Jean-Claude Trichet warned in an appearance at the Bank for International Settlements (BIS) on Monday,
"There is a probability of fallout on the real economy in the USA."
We will have to follow very carefully what happens particularly in the USA. We will remain ... alert, (there is) no time for complacency,"
he added.
Trichet will testify at an extraordinary hearing of the European Parliament on Tuesday.
Trichet will not be in the loop of US Treasury secretary Henry Paulson who will meet with the recently installed new leaders of the Britain and France next week. A spokesman said Paulson had been trying to schedule trips to meet with Brown and Sarkozy since well before problems with U.S. subprime mortgages began roiling global financial markets last month.
China Changes Policy and Will Go Shopping
Paulson will need new allies in financing the unsustainable US deficits as China has announced major policy changes that will allow Chinese companies to invest abroad. According to, the central bank will scrap unnecessary controls on foreign exchange reserves to fund local firms'outbound investment. Governor Zhou Xiaochuan said,
"we will remove unnecessary restrictions on reviewing sources of foreign exchange funds, as well as on foreign currency purchase and profit remittance.
We will also allow domestic firms to use their own foreign exchanges or buy foreign funds with local currency yuan to invest abroad."
The governor noted the central bank will explore ways to buy shares in foreign banks so as to provide more convenient financial services for the overseas operations of domestic businesses.
"We encourage them to raise capital through various means including bank loans, stock listings and bond sales,"
he said, adding their domestic operations can provide warrants for the fundraising once they get official go-ahead.
It seems as China will propel itself to the #1 rank of international investors at the blink of an eye.
Other news that influenced my thinking today is the roundup of a widespread discussion of moral hazard at nakedcapitalism.
And there is a new blog on the block. Mark Shivers has started "The Talking Fed" and aims to cover all speeches by Fed members.


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