March 08, 2004

Quote of the Day and the Cost of the Dollar ("Pathetically Low Interest")

``It's a painful condition to be in -- but not as painful as doing something stupid,'' Warren Buffett, on having cash and wanting to do something with it, but not wanting to buy something that's over priced. Buffett is hedging his dollar risk, and fully expects more dollar selling. The proximate cause--the current account deficit, simply too much debt. The currency will have to adjust to the debt level. And it does that by falling, reflecting the impaired balance sheet of America overextended. What was interesting about today's news cycle is that it's not just the debt affecting the currency anymore, it's the currency affecting the debt, at least in terms of the quantity of dollar denominated debt issued. The Bank of International Settlements (crack dealer for data junkies) issued its quarterly review today. In the section on the international debt securities market, you can see the risk of owning a falling currency is lowering the total amount of dollar denominated debt issued. The market has a slackening appetite for debt issued by the world's largest debtor. And as you might expect, a lot of debt is being issued in one of the world's strongest currencies, the euro. BIS says (emphasis added mine), A striking trend apparent in both the fourth quarter and the year overall was the growth in euro-denominated borrowings, which accounted for more than half of all net international debt securities issuance in 2003. Fund-raising in the fourth quarter was well above the third quarter figure and more than twice as high as that for the fourth quarter of 2002; for the year as a whole, the net placement of euro-denominated debt securities, at $834 billion, was almost 60% higher than in 2002. By comparison, US dollar-denominated net issuance of $150 billion in the fourth quarter of 2003 was double that of the fourth quarter of 2002, while for the year as a whole it was only 10% higher, at $463 billion And take a look at the graph below. This is more evidence of the end of the dollar standard (although not necessarily of permanent euro strength.) In the fall of last year, euro and dollar denominated debt issuance was about even. Then, as the dollar fell, the euro debt market took off, so much so that total euro-denominated debt outstanding actually overtook dollar denominated debt outstanding by the end of the year. debteurodollar.bmp What does all this mean? We'll leave aside for the day a discussion of the growth in the "financial economy" and investor risk (although the BIS also released its derivatives numbers, which I'll look at tomorrow.) For now, the immediate issue is what the falling dollar may do to U.S. companies who a) must invest huge amounts of cashflow or b) depend on debt markets to finance other activities. In the first category you have your Berkshire Hathaways. Buffet's dollar risk forces him to go into the junk bond market for higher yields. By this point, it's hard to see what the difference between low-yield U.S. "junk" is and higher yielding Mexican, Brazilian, or Russian "junk." That aside, it's good for investors in emerging markets, especially emerging market bonds. In the land where cash is trash, yield is King. By the way, this has been good news for our long-term play on euro-bonds, GIM. At a current yield of 5.38%, it's better than owning a money market fund. And with rising emerging market bond prices and euro bond prices, you have the potential to reap a capital gain as well, although that's not the specific reason I recommend owning it. In the second category you begin to see trouble for Fannie and Freddie. Yes, I've been accused of seeing trouble for Fannie and Freddie everywhere I look. And that's because I do. Rising U.S. interest rates put the brakes on the U.S. mortgage and housing market. Bad for Fannie and Freddie. But now the vicious cycle has come full. Rates have fallen. The low yield and high U.S. debt are killing the dollar. And now, the ever-weaker dollar is putting a big fat crimp in dollar denominated debt issuance, which, incidentally, FNM and FRE do a LOT of. Both Fannie and Freddie came off the mat last week on the market's perception that the Fed would probably leave rates low for the rest of this year, based on the dismal February jobs data. But don't be so sure this knee jerk assessment gets it right. If Fannie and Freddie issue bonds paid off by debt-addled American homeowners, does that deserve any other classification other than junk too? And junk yielding less than you can get in a lot of other places in the world. Places with stronger currencies. Tomorrow....a look at derivatives.


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