Thursday, September 18, 2008

Waiting for the Other Shoe to Drop

As bad as it has been in U.S. financial markets, Ken Rogoff reminds us that it could be, and may yet become, worse:
One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America’s flagship financial sector, the public and private sector’s massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.
In other words, in spite of the financial meltdown going on in the United States foreigners continue to fund the United States living beyond its means as evidenced by the strength of the dollar. (Click on graph to enlarge.)

As Brad Sester notes, though, this foreign financing as of late is (1) coming only from the public sector in foreign countries and (2) even they are running from assets other than safe U.S. treasuries. On this latter point Brad points to a disturbing development reported in the Treasury's TIC data:
[The TIC data] tells a simple story: demand for risky US assets disappeared in the month of July. That continues a long-standing trend. But that trend intensified significantly. And I suspect its intensity increased even more in August.

Among other things, the TIC data challenges the common argument that sovereign investors have been a stabilizing presence in the market. Best I can tell, sovereign investors joined private investors in retreating from all risky US assets in July, and thus added to the underlying distress in the market. I don’t fault sovereigns for limiting their risk. It has proved to be a sound financial choice. But I also find it hard to square their (inferred) actions in the market with many claims about their behavior.

The TIC for July pains a very clear picture: Treasuries were the only US asset foreign investors were willing to buy. Foreigners bought $34.3b of long-term Treasuries, while selling $57.7b of Agencies, $4.2b of corporate bonds and $5.2b of equities. On net, foreigners sold about $25b of long-term US assets.
So even though foreign monetary authorities continue to support the dollar through purchases of U.S. securities they are doing so in a increasingly selective manner. As bad as the markets are now, it could get dramatically worse should this source of foreign financing dry up. It does not take a very imaginative mind to wonder how long before this other shoe drops too.

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