"Eeyore versus Tigger"

I have lost count of the number of times that colleagues at various investment management companies have attempted to build their careers on the destruction or collapse of the US economy. Each time they have been thwarted by America's ability to reinvent itself and move on. This is where Europeans, in particular, get the US wrong. We would wallow in our own sense of hopelessness and self-pity when faced with their problems, whereas they see the 'opportunity'. If you were A. A. Milne, the author of Winnie the Pooh, you would have distinguished the two psychological positions by asking the question 'Are you Eeyore, the morosely pessimistic donkey, or Tigger, the wildly optimistic and unique tiger?' It's a good question to ask oneself.

The creation of the new sink fund in which to dump underperforming US mortgages is a great example of how 'a problem defined is a problem half solved'. It's a trick first pulled off in the early-1990s when the invention of the government-owned Resolution Trust Company created a vehicle whereby insolvent savings and loans companies could dump real estate assets and mortgages into a convenient corral. This then cleared the way for economic reconstruction that had its zenith later that decade with Dot.com mania.

So let's not get carried away here with the idea that the effects of sub-prime are an insoluble and intractable problem. For certain, there is a problem in the US housing market, but the US economy is much more complex these days than just a couple of realtors losing their jobs. Sub-prime is about 11% of the total mortgage market and if 10% of them disappear in a puff of financial smoke, then you are only looking at 1% of defaults spread across the entire system. America should be able to handle that.

If the effects of sub-prime are contained we should be asking what the combined effects of all the summer's interest rate and currency movements have been on economies. Using our tightness indicator which compares currency and interest rate conditions today with what was happening a year ago, we can see that there are some interesting effects. For example, the decline in the US dollar has over-compensated for any tightening in money markets, and conditions are somewhat looser today compared with a year ago (see chart below).

Contrast this situation with Europe, where LIBOR rates have risen and the euro has appreciated against just about every major cross currency pairing in the world (see second chart).

Year on year, the combined effects have been equivalent to a 1.8% increase in interest rates. It is now easier to understand why members of the ECB have been squealing about the inexorable rise of the European currency and the effects it could have if left unchecked and unmanaged.

The problem for Europe is that there is good evidence to show that international investors are deserting the US, and that there is a gathering funding crisis. The recent release of data on long-term capital flows (shown below as three months cumulative), no matter how you want to spin it or add it up, shows that there has been a significant change of heart with respect to the ongoing funding needs of the US. There have been, for example, outright sales of US bonds (not shown here) out of the Far East. If this continues, the US dollar has only one way to go in the long-term and that is down; which means that the euro will continue to rise. This spells trouble for Europe and international relations are set to become very strained over the matter of currency alignments.

Everybody accepts that if sub-prime problems have had real economic effects in the US, then the Federal Reserve will continue to cut interest rates. But if financial theory works, then in order to maintain the attention of international investors, returns (yields) in the bond markets will have to rise in the US. The result will be a steep yield curve at the very least, if not higher outright bond yields. So, if Alan Greenspan's Conundrum was that, no matter how much he increased interest rates he couldn't get bond yields to rise, then Ben Bernanke's Conundrum could be that, no matter now much he cuts interest rates, he won't be able to get bond yields to fall.

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