Yield Inversion Follow-Up

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February 19

Yield Inversion Follow-Up

A week after my last post, the yield curve is still inverted. A friend of mine sent me a link to the following Washington Post article abut the trade deficit. Towards the end of the article, it talks about a bond and real estate bubble created by the excess liquidity of other countries relative to developed countries such as the US.

http://www.washingtonpost.com/wp-dyn/content/article/2006/02/14/AR2006021402009.html

This article sparked something for me. If you look at the purchasing power parity of the dollar versus other currencies (like the Euro, Canadian Dollar, Yen, Yuan, Peso, etc. from both developed regions and under-developed ones), the dollar has always carried a premium (i.e. a dollar buys less in the US than a foreign currency in its respective foreign country/region). This implies that foreign countries are actually more efficient than the US in that they can buy (and thus produce) more for the same exchange-rate-adjusted amount of money.

However, these foreign countries are investing their excess surplus in dollars or dollar-related assets like US bonds, stocks, and real estate due to the historical stability of these asset classes. This is effectively a foreign-supported US asset bubble that will have to collapse at some point. Here's a sequence of events:

US economy has exceeded other economies in risk-adjusted growth in the last 50 years leading to a premium on US assets
Other economies are now catching up, aided by a discount on capital relative to the US due to the above premium on US assets
Other economies continue to invest in US assets, maintaining the US premium and fueling the catapult effect described in #2
As other economies maintain superior growth rates over the next few decades, the US asset bubble will burst at some point - i.e. investors will realize that the premium on US assets is no longer justified given a sustained trend of superior growth in other economies
Investors will sell off US assets, first in currency (we're already seeing this), then in real estate, bonds, and stocks. The later equity classes require the greatest economic, political, and other intangible forms of stability and thus will maintain premiums the longest before a sell-off as foreign economies will need longer to prove themselves in these asset classes.
US assets will settle into equilibrium with global assets and all will be well

This is basically a standard lag effect between the true growth rate of an asset class and investor valuations of that asset class. Unfortunately, even if I were confident that this is exactly what is going on (which I'm not), who knows how long such global macroeconomic trends will play out? In the mean time, I suppose a good line to walk is to look for risk-averse foregn assets to diversify into but not panic given the expected time horizon of any such macro-trends.

4:41 PM | Blog it

Comments (2)

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linguistwrote:

Thunderroad88 (nice site name - almost as good as mine :)), I think foreign money is definitely sponsoring US real estate, but I think there's also foreign investment in non-real-estate equity markets like bonds and stocks. That's why people blame foreign money for inflating long-term treasury prices and worry about the risk of an international run on the US stock market.

That said, I think you're right that while foreign money is creating an equity bubble, it does nothing for the core economy. In fact, it may endanger the core economy if bubbles start bursting.

Feb. 28

Aldrin Leungwrote:

One minor adjustment on your new view is that the US real estate market will be fueled by foreign investors like Europeans, Japanese and Chinese (as it has been for the past few years) in Florida, Las Vegas and alike because they brings foreign currency here to buy US real estate and the real estate prices is still relatively much cheaper than their home country (maybe except China). However they own sustain the US real estate market but not the core US economy.

Feb. 20

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