Markets react to news. News, as well as expectations of news, makes them money. Lots of it. They don’t like surprises.
The Obama administration is transparent. News media does not like the Republicans and conservatives in preparation for 2012 yet. They prefer the incumbent and his status quo until a new status quo is coherently apparent. That the debt ceiling would be raised was a foregone conclusion on the inside (the box).
To those on the inside, outside the box was not sufficiently tested yet because of its incorruptible naivete. The forecast of the Great Depression beginning somewhere in 2006 is perpetually coming true even in 2011, to prove mainstream economics and conventional finance “correct.”
The echo chamber promptly behaved as it should from Boston to Washington as soon as Washington finished working up to the eleventh hour like college kids cramming for their test the night before to do the obvious: keep borrowing more.
Obama’s debt deal had been blessed by economists at Harvard and MIT, reacted to by traders in New York who spent the morning in the New York Stock Exchange (NYSE) flying to the safety of fresh government paper going both ways, new money from the Fed buying new bonds from the Treasury after having a few drinks with their buddies at the Federal Reserve Bank of New York the weekend before.
The Congress and the White House understood their priorities well: borrow first and then cut spending over a decade while leaving the elbow room to pay-as-they-go before 2022. The president’s budget deal has no cap and balance. It has cuts that may not materialize.
Pay-go is a wash. Ultimately it is the arithmetic of the beginning and the end that really counts. They finally managed to get the political packaging right, thanks to the president, before they could go home to rest during the working week when all hell can break lose.
The calm before the storm is always pleasant. Yields are low, bond prices are high because they are in demand. Markets around the world, averse to the risk of upsetting the American apple cart, chained forever in their minds to the inertia of the stability the US economy provides, despite some occasional potholes (the American Recovery and Reinvestment Act, ARRA, took care of the potholes and rusted bridges on borrowed money) and the straining shock absorbers of financial innovation (derivatives) in New York and London (the Fed is still trying to repair those strains by giving away money for nothing) breathed a sigh of relief because the United States decided to borrow more.
On balance, in their minds, the foreigners are a bigger risk to themselves than the United States is to them. They would rather fulfill their lives at a pace acceptable to America than grow to their fullest potential as a risk to America, serving the interests of 300 million Americans rather than their 6 billion own. All because they have been educated, American or not, in the Shanghai 10 to believe in America – as marketed around the world, not as it is – more than to believe in themselves (Shelling: Micromotives and Macrobehavior).
The economics of low yields is simple but revealing of the government’s strategy as had been clear for quite sometime: the Fed’s Quantitative Easing (QE) of expanding money supply beyond its normal operational confines of the Federal Funds Market (overnight borrowing and lending between banks with reserve accounts at the Fed) was to increase the demand for bonds to lower the returns on those bonds (yields) to investors. Doing so would reduce the interest burden on the Federal budget (rather than the more difficult political task of capping and balancing the Federal budget).
US financial institutions on Wall Street have the short term incentive to react as the government wants to the Fed’s policy of QE as long as inflation is low because of the US economic slowdown and unemployment (short run Phillips Curve. Higher energy prices are more than offset by the rising unemployment and downward pressure on wages because of income uncertainty albeit at persistent downside risk to consumption): cheap money at zero borrowing cost from the Fed can be invested anywhere in the world for a higher return. After all, the dollar is still king despite its woes, counting on the low-self esteem of foreigners induced during the Clinton economic miracle in the 1990s by the United States doctrine of economic shock a.k.a economic globalization.
Those with Sovereign Wealth Funds (SWFs) and other non-SWF government reserves containing US government bonds and dollar cash reserves around the world (can be obtained by adding up the forex reserves of non-US countries as published in The Economist magazine) do not want to dump the United States. So, America has every incentive to keep on borrowing and spending and take its time to turn around its economy even if its overall debt could be double its income at some point in time.
If you are on the inside, you make millions, no matter who you are: American, Chinese or Indian. If you are on the outside, you could be unemployed, no matter who you are, American, Chinese or Indian. This is the paralysis of the status quo despite the diminishing returns in US capital markets. To Americans, US capital markets are a hedge and so are they to foreigners in the major emerging markets as well as to the G8 (including Japan, China and Russia). But foreign investors are not as welcome in the United States as are Americans elsewhere.
The truth for the outside is that dumping America could be worth billions. If only it can believe in itself and let go of its American addiction. And this is the surprise in waiting for the inside.