Fixed Income? Part III.
Jarrod Wilcox, June 7, 2004

Skirting the Storm

Background

Part I (March 12, 2004) in this three-part series on interest rate risks in 2004 described a scenario of economic imbalances created by a) the shock of increasing productivity within emerging markets that is resulting in increased low-priced imports of goods and services into the US together with b) the stimulative efforts of the Federal Reserve to combat unemployment and prevent deflation that would be painful to debtors.  The symptoms of this scenario have been low short-term interest rates, a weakening dollar, and low inflation despite strong corporate profit recovery and despite a huge government budget deficit.

Part II (April 4, 2004) identified in more detail three troubling imbalances that were asserted to lay up fuel for a possible, though still perhaps unlikely, firestorm of interest rate increases.  The first is a large and growing holding of US debt by foreign countries, particularly by Japan and China.  This appears to be a transient response to current conditions rather than to a long-term faith in the dollar as a reserve currency.  The second imbalance is a historically low relative price of imported oil, combined with the growing energy appetite of developing economies such as China and with increasing difficulty in adding to oil reserves to replace consumption.  The third imbalance is a bubble in housing prices, creating credit risk, combined with an expansion of mortgage-backed securities focused on Fannie Mae and Freddie Mac.  In trying to control their own duration risks, these firms create liquidity risks for much of the bond market.

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