E A D O F
A H
How has the global economy defied the inverted U.S. yield curve,
and what does it mean for financial markets?
•
funny thing happened on the way to the global
A recession. Actually, a lot of funny things hap-
pened. Despite sharply higher short-term interest
rates in Europe and the United States—and a fully inverted
yield curve on U.S. Treasuries—the global economy is thriving
(see Figure 1). Equity prices are up, merger and acquisition
activity is setting records, and debt creation is soaring. Hot
money is surging from one surprised recipient to the next, cre-
ating both fortunes and headaches—but mostly fortunes. For
dealmakers of every type, today’s world is one big candy store.
History says this should not be. According to research by
U.S. Federal Reserve economists Arturo Estrella and Frederic
Mishkin, an inverted U.S. yield curve, defined as three-month
Treasuries yielding more than 10-year Treasuries, portends
recession, not boom. “The yield curve has predicted every
U.S. recession since 1950 with only one ‘false’ signal, which
preceded the credit crunch and slowdown in production in
1967,” wrote the economists in a 2005 report.
The logic of the yield curve is quite simple: Banks, the
traditional source of liquidity in a modern economy, make
their money by borrowing short, via time deposits and certifi-
cates of deposit, and lending long for cars, mortgages, and so
forth. So, the more positive the “carry,” or spread between
long and short rates, the more profitable the banking business
and the more enthusiastically banks hand out money. But
FIGURE 1
U.S. YIELD CURVE (in percent, as of 16 January 2007)
5.2
5.1
5.0
4.9
4.8
4.7
4.6
4.5
1mo 3mo 6mo 1yr 2yr 3yr 5yr 7yr
Source: U.S. Treasury
44 CFA
BY JOHN RUBINO
invert the curve, and the carry trade dries up. Banks find
themselves paying more for deposits than they earn by lend-
ing. They pull back, and growth stops.
For the global economy, an inverted U.S. yield curve is
especially ominous because U.S. consumer spending fuels the
export-driven economies of Asia, Latin America, and the
Middle East. A credit crunch in the United States means a
world of pain for nearly everyone else.
Yet, here we are, with credit being created in myriad
forms and unprecedented amounts in every corner of the
globe (see “Liquid World” on page 46). What’s going on?
Recent (not very helpful) explanations have ranged from
“global savings glut” to “conundrum.” The most interesting
possibility is: The structure of the global economy has
changed in fundamental ways that render the yield curve in
any one country (even the United States) far less important
than it used to be and spawn new sources of credit that are
largely independent of the traditional banking system.
Consider:
The yen carry trade. An inverted yield curve is a problem for
financial players within a given market, but today, with nearly
frictionless capital movement among currencies, exchanges,
and instruments, virtually no one is restricted to a single mar-
ket. “The yield curve is not inverted from the perspective of
someone who has access to short-term money in Japan,”
where the overnight lending rate is 0.5 percent, says Steven
Saville, Hong Kong-based publisher of the Speculative Investor
newsletter. So, you can borrow in Japan, use the proceeds to
buy, say, British long-term bonds, and voilá, you’re once again
playing a steeply positive yield curve. And that’s the conser-
vative strategy. For real excitement, says Saville, “just borrow
in Japan and use the proceeds to ‘invest’ in Brazilian or
Turkish bonds.”
The yen carry trade goes far beyond global speculators.
“You’re getting a steady stream of Japanese retail,” says Sudesh
Mariappa, a bond fund manager with California-based Pacific
10yr 20yr 30yr Investment Management (PIMCO). That is, Japanese individ-
MAGAZINE / MARCH-APRIL 2007
THE CUR V E

uals, via local mutual funds and life insurance companies, are paper to satisfy China, let alone Japan, Saudi Arabia, and the
recycling their yen—which they may have acquired via, say, a rest of the trade-surplus world. The solution: securitization—
low-rate home mortgage—into global bond funds and the the bundling of heterogeneous and/or lesser-quality debt into
like, which snap up higher-yielding debt worldwide. “Japan is high-grade bonds.
a huge source of global liquidity,” concludes Mariappa. Securitization works like this: A packager gathers up a
So, the global yield curve remains very steep, with virtu- group of home mortgages, credit card balances, home loans,
ally free short-term money in Japan at one end and near- or corporate bonds and puts them into a legal entity called a
double-digit rates on emerging market bonds at the other. The “special purpose vehicle.” The SPV bundles the debts into
carry trade, as a result, remains wildly profitable. bonds and slices the bonds into tranches with varying claims
on the underlying debts’ cash flows. Tranches with the great-
Central bank buying. But the carry trade is only one, and not
est claims are sold to central banks and other institutional
the most important, of globalization’s liquidity effects. Far
buyers of high-grade debt. The riskier tranches are sold to
larger in real terms is central bank buying of U.S. dollar debt.
hedge funds and others willing to bet that defaults will stay
“Export-driven countries are accumulating reserves like
low enough to make their tranches’ high yields profitable.
there’s no tomorrow. The central banks of China, Japan, and a
Securitizers began with relatively straightforward issues
few of the smaller Asian export powers have, between them,
containing credit card and mortgage debt, but they have since
over US$3 trillion,” says Mariappa.
figured out how to mold pretty much any kind of debt (and
By and large, these banks have chosen to recycle their
debtlike derivatives) into a wide variety of bonds. CLOs,
trade surpluses back into U.S. bonds. Here’s how it works:
CBOs, cash flow CDOs, synthetic CDOs, CDO squares,
When a Chinese company receives dollars in trade, it goes to
CMOs, CPDOs—the product line is growing together with
the central bank of China (BOC) to exchange those dollars for
sales volumes. Even obligations without predictable income
renminbi. The BOC could turn around and sell those dollars,
streams, such as private equity interests, are now routinely
but doing so would depress the dollar/renminbi exchange
securitized, thus fueling the M&A boom.
rate, making Chinese goods more expensive for U.S. con-
Securitization’s impact on business practices in the finan-
sumers. So, instead, the BOC “sterilizes” the dollars by buying
cial sector has been seismic. Whereas a bank that wrote a mort-
U.S. securities. Japan does the same with its trade surplus.
gage or business loan in the past might have expected to hold
This “vendor financing” arrangement both allows
the loan until maturity, now the bank can sell it off immedi-
Chinese and Japanese companies to keep selling competitive-
ately and use the proceeds to make more loans. Banks have
ly priced goods to U.S. consumers and gives the United States
thus been transformed into suppliers of raw material for the
an effectively unlimited credit card with which to buy foreign
global securitization machine, which explains their continued
goods. “We believe that as much as 90 percent of foreign
willingness to lend in the face of a negative U.S. yield curve.
money buying U.S. securities—not only Treasury bonds, but
Corporations that once carried receivables and inventory on
corporate bonds, mortgages, stocks—is not private invest-
their books now monetize them instantly, gaining cash with
ment but central banks,” says John Succo, founder of New
which to buy back stock or make acquisitions (more on this
York–based hedge fund Vicis Capital.
later). And private equity firms can now instantly monetize
Securitization. Today’s trade imbalances have created a massive their leveraged buyout (LBO) and mezzanine debt, which
demand for high-grade debt. The question is how to supply it. allows them to jump right back onto the field for more deals.
The U.S. Treasury, after all, issues barely enough long-term

CFA MAGAZINE / MARCH-APRIL 2007 45

 LIQUID WORLD
It’s hard to grasp how widespread and multifaceted the global liquidity boom really is—until you see it all on one page.
So, here’s a somewhat random sampling of statistics from various corners of the global economy:

Global issuance of debt, equity, and India’s foreign exchange reserves rose Stock markets around the world
equity-related securities (excluding by US$32 billion in 2006. Its overseas surged in 2006:
derivatives) exceeded US$2 trillion in investment more than doubled.
Shanghai up 130.0%
the fourth quarter of 2006, the biggest
• Hong Kong up 34.0%
quarter on record. Issuance of high-yield
debt rose by 55 percent. Venezuelan vehicle sales rose Taiwan up 19.5%
by 50 percent in 2006. Singapore up 27.2%
•
• Vietnam up 144.5%
Bank underwriting fees rose 26 per-
Indonesia up 55.3%
cent—to US$23.9 billion—in 2006. The IPO of the Industrial and
LBOs generated about US$11 billion in Commercial Bank of China raised Malaysia up 21.8%
fees for banks. U.S. investment bank US$21.9 billion. Philippines up 42.3%
Goldman Sachs earned US$9.5 billion. Sri Lanka up 41.6%
•
Buyout firm Kohlberg Kravis Roberts India up 46.7%
alone paid more than US$837 million in The U.S. government’s December
Australia up 19.0%
fees to investment banks for deals. budget surplus rose to a record
US$44.54 billion. New Zealand up 20.3%
•
Ireland up 27.8%
•
Private equity buyers accounted for Portugal up 33.3%
nearly a fifth of all deals in 2006 and Australia’s unemployment rate fell to a Belgium up 23.7%
reportedly had US$700 billion available 30-year low in December.
Denmark up 12.2%
to do deals at year-end.
• Finland up 17.9%
•
Price inflation in the South African Norway up 33.6%
South Korea’s exports increased 13.8 house market was an annualized 13.5 Austria up 21.7%
percent, year-over-year, in December. percent in December.
Luxembourg up 33.0%
• • Poland up 41.6%
Philippine money supply grew 18.5 per- Kazakhstan’s economy grew by Russia up 70.8%
cent in November from a year earlier. 10.6 percent in 2006. Ukraine up 41.3%
• • Croatia up 60.7%
Slovenia up 37.9%
China’s tax revenue climbed California Governor Arnold
22 percent in 2006. Schwarzenegger proposed that the Estonia up 28.9%
state borrow another US$43 billion Morocco up 56.7%
•
for infrastructure projects. Namibia up 46.7%
Turkish exports rose 19 percent in Botswana up 74.2%
•
December from a year earlier.
Nigeria up 38.7%
Art sales at auction house Christie’s
• Kenya up 42.1%
International rose 36 percent in 2006
Argentina’s tax revenue rose 25 percent to US$4.7 billion. Mexico up 48.6%
in December from a year earlier. Brazil up 32.9%
•
• Argentina up 35.5%
U.S. office rents rose 10 percent, year
Chile up 37.1%
Hedge funds that specialize in over year, in the fourth quarter of 2006.
emerging markets earned an average Venezuela up 156.0%
•
of 20.5 percent in 2006. Costa Rica up 77.0%
Eurozone M3 money supply rose Colombia up 17.3%
at an annual rate of 9.3 percent in Peru up 168.0%
November, while private sector credit
Bermuda up 25.0%
grew by 11.9 percent.

46 CFA MAGAZINE / MARCH-APRIL 2007

Credit insurance. Institutional money managers who crave the
yields on these new bonds still have to justify them to superi-
ors who didn’t grow up in the age of securitization. So, the
final piece of the “unlimited liquidity” puzzle is a way to
insure against defaults on exotic loans. Enter the credit
default swap (CDS), a privately negotiated, bilateral insurance
contract through which an underwriter agrees to cover any
losses resulting from defaults by a given borrower. Banks can
use CDS to limit the default risk on a loan, for instance, which
leaves them only interest rate or currency risk to contend
with. The real market for CDS, however, is in structured
finance—to protect against the default of asset-backed securi-
ties (ABS). Here, their issuance has exploded (see Figure 2).
Once an instrument such as a CDS gains conceptual
acceptance, the real fun begins. Because they are tradable
instruments in their own right, CDS can be packaged into
asset-backed bonds. And because there is no regulator limit-
ing the amount of CDS written on a given company’s debt to
the actual amount of the debt, insurance can be written far in
excess of the underlying loan. By one estimate, in 2005,
US$25 billion of insurance was outstanding on US$2 billion
of Delphi Automotive Systems’ debt.
Hedge funds have discovered that writing credit insurance
is wildly profitable when defaults are low, like writing flood
insurance during a drought. They are lining up to offer the con-
tracts, thereby driving prices down and making bonds insured
this way that much more attractive on a total return basis.
The challenge with selling flood insurance during a
drought is, of course, finding people willing to buy it. But the
financial community is are up to the task, says Doug Noland,
market strategist with Texas-based fund manager David W.
Tice & Associates. Investment banks are offering cheap
financing to pretty much any company this side of bankrupt-
cy, which many companies gratefully accept. The banks pack-
age the loans, and hedge funds supply the credit insurance.
The resulting “high-grade” debt is then snapped up by risk-
averse institutions. “If it wasn’t for this huge demand to write
credit insurance, I don’t think we’d have this unlimited cheap
credit,” says Noland.
Buybacks and buyouts. Armed with cheap credit, a growing
number of companies are buying back their stock. Anheuser-
FIGURE 2
CREDIT DEFAULT SWAPS
40,000
35,000
(notional value, US $ billions)
30,000
25,000
20,000
15,000
10,000
5,000
2000 2001 2002 2003
Source: Bank for International Settlements
CFA
FIGURE 3
STOCK BUYBACKS (US $ billions)
500
450
400
350
300
250
200
150
100
50
0
2002 2003 2004 2005 2006
Source: Standards & Poor’s
Busch, for instance, recently announced a “more aggressive”
stance toward leverage in order to repurchase shares worth
US$2.5 billion in 2007. Wendy’s, Heinz, and Home Depot
have all made similar announcements, as have hundreds of
other companies. Together, companies in the S&P 500 Index
bought back more than US$431 billion of stock in 2006,
about three times as much as in 2003 (see Figure 3).
For large companies, stock buybacks support share prices
in the absence of compelling internal growth opportunities.
For small companies, leverage can be a preemptive strike
against the private equity firms that—armed with cheap debt of
their own—are prowling for LBO candidates. As in the 1980s,
potential targets are leveraging to make themselves less attrac-
tive to raiders. It doesn’t seem to be working, however, because
global M&A rose by 38 percent in 2006 to US$3.79 trillion.
While the leveraging frenzy is in full swing, the default
rate on speculative-grade corporate bonds is falling (because
even the most troubled company can get credit these days). By
year-end it stood at only 1.7 percent. “The market for distressed
debt has improved significantly in 2006,” noted the rating
agency Derivative Fitch in a year-end report. With even the
weakest borrowers apparently making good on their loans,
credit spreads—the difference between the rates on high-grade
and low-grade debt—have fallen by nearly half in the past year.
Are Central Banks Irrelevant?
oday’s global financial system can be thought of as a
T series of credit-generating feedback loops. U.S. con-
sumers borrow to buy goods and oil from Asian man-
ufacturers and Middle Eastern oil producers, which use the
resulting trade surpluses to buy dollar-denominated bonds,
thereby, in effect, lending to U.S. consumers. Securitizers turn
low-quality debt into ready cash, which lenders use to make
more low-quality loans. Hedge funds write cheap credit insur-
ance, which leads investment banks to underwrite more high-
yield debt, reducing the likelihood that borrowers will default
2004 2005
and increasing the attractiveness of credit insurance.
MAGAZINE / MARCH-APRIL 2007 47
 The result is a system in which such traditional central
bank tools as the yield curve and reserve requirements work
differently from the way they used to, if they work at all, and
in which governments are no longer in total control of domes-
tic monetary conditions.
If the yield curve is now global, then an individual coun-
try’s overnight lending rate (generally a central bank’s main
tool of currency management) has become far less potent.
Securitization, meanwhile, has made bank reserve require-
ments “irrelevant to contemporary credit expansion,” accord-
ing to Tice’s Noland. Today, a securitizer such as Fannie Mae
(the Federal National Mortgage Association) can issue com-
mercial paper (in effect, borrowing from money market
funds) and buy mortgage-backed securities from a hedge
fund, which deposits the proceeds with a money market fund,
which then buys more Fannie Mae commercial paper. “Fannie
Mae takes liquidity from the money market fund and replaces
it with IOUs,” says Noland. Although commercial banks are
required to hold part of each incoming dollar as a reserve
against future withdrawals, Fannie Mae and other packagers
of ABS face no such requirement. The result, Noland believes,
is a near-infinite potential for credit creation.
Meanwhile, the concept of “money” has changed beyond
recognition. Most transactions are now electronic, so anything
perceived to be safe and liquid can perform some of the func-
tions of money (medium of exchange, store of value). Today,
a dizzying array of instruments, including money market
funds, repurchase agreements, and ABS, have taken on aspects
of “moneyness,” according to Noland. “You can create as
many as you want and there’s insatiable demand for them,” he
says. This phenomenon, he notes, explains how the major
economies’ monetary aggregates can grow relatively slowly in
the midst of a global credit boom. “Looking only at the mon-
etary aggregates absolutely misses the real dynamic.”
Combine this new-age credit creation with spectacular
trade imbalances and the result is a unique set of challenges
for the world’s central banks. Imagine, for instance, that
you’re running the U.S. Fed. Your economy is generating an
alarmingly large trade deficit, and dollar-denominated bonds
are piling up in the accounts of your trading partners’ central
banks. In response, you’ve engineered an inverted yield curve,
which in the good old days would have been sufficient to
restore balance.
But this time, banks are still lending, speculators are still
speculating, and credit is still cheap. The global financial sys-
tem, it seems, has adapted to your gradual rate increases by
simply shifting out of mortgage lending and into M&A. “U.S.
financial conditions have actually eased tremendously this
year,” says PIMCO’s Mariappa. And the trade deficit remains on
its unsustainable trajectory. So, instead of cutting rates, you’re
contemplating raising them further. But will another quarter or
half point matter when the global yield curve runs from 0.5
percent in Japan to 8 percent and higher in many developing
nations? What will a bigger, faster increase do to an economy
48 CFA MAGAZINE / MARCH-APRIL 2007
with this much leverage? And as more and more dollars accu-
mulate in other, not necessarily friendly, countries, will effec-
tive control of exchange rates and credit conditions slip even
more beyond your grasp? Now that’s a conundrum.
The view from the other, surplus end of the global trad-
ing system is just as problematic. China and Japan are using
newly printed currency to soak up the dollars generated by
their export industries and then using those dollars to buy
U.S. bonds. To restrain its currency’s exchange rates, China
pegs the renminbi to the dollar, and it keeps domestic credit
in check by tightening bank regulation (still a useful tool in
China’s not exactly open economy). To manage its currency’s
value, Japan keeps interest rates artificially low, thus encour-
aging the carry trade, which puts offsetting downward pres-
sure on the yen.
So far, so good. The renminbi is up only slightly against
the dollar in the past year, and the yen is actually down. Trade
continues unimpeded. But this solution is, at best, temporary.
Neither country can absorb an infinite number of dollars. And
with China’s trade surplus now exceeding US$20 billion a
month and protectionist pressure building in the United
States, the end may be in sight for political reasons. In any
event, “If they keep creating renminbi [by buying dollars],
you’d expect inflation,” says Mariappa. Letting the renminbi
soar, however, might devastate crucial export industries.
Another conundrum.
Mega-economies, such as the United States, Japan, and
China, generally have time to deal with their financial imbal-
ances. For small countries, a global liquidity boom can become
a threat overnight. In Thailand, for instance, “foreign capital
flows into portfolios and loans in the first 10 months of 2006
more than doubled those in the entire year of 2005,” notes
Bank of Thailand Governor Tarisa Watanagase (see Figure 4).
By November 2005, the Thai baht was rising 1 percent a
week versus the U.S. dollar. Thai exporters were howling, and
the Bank of Thailand began searching for solutions. Cutting
interest rates to weaken the baht would have ignited inflation,
Watanagase decided. And it probably would have failed in any
event. “With a yen carrying trade where investors could earn
roughly 400 bps, even a 50 bp cut in our interest rates would
not deter this speculative trade,” she says.
FIGURE 4
THAILAND CAPITAL FLOWS (US $ millions)
2005 Jan-Oct 2006
FDI 7,412 8,042
Portfolio 2,645 5,308
Loans –1,308 2,097
Other item 2,200 –269
Capital movement 10,969 15,176
Source: Thail Central Bank
 So, the Bank of Thailand, opting for capital controls,
levied a tax on short-term foreign investment. Shocked, the
hot money headed for the exits, sending the Thai stock
exchange down by 15 percent in one day and generating fears
of another “Asian contagion” in which vulnerable emerging
markets are crushed by an exodus of global capital. Under
pressure, the Bank of Thailand reversed some of the curbs. By
mid-January, Thai markets had stabilized.
The lesson: The smaller and more export dependent the
country is, the harder today’s hot money is to handle. No pol-
icy silver bullets exist, and a crisis can appear suddenly.
Brave New World or a Major Correction?
ow for the trillion-dollar questions: Is easy money
N on this scale sustainable? Has modern financial
engineering removed the old frictions of national
monetary policy and banking regulation to produce a viable
system where capital flows to its best use and risk is efficient-
ly intermediated? Or are we heading off a cliff in a bus loaded
with debt?
Mainstream economic thought seems to favor a positive
outlook. Although most analyses are tempered with warnings
about the “twin deficits” and energy prices, January’s Blue
Chip Economic Forecast calls for steady growth in 2007, with
more jobs, less inflation, and a diminishing risk of recession.
Based on the top-line numbers, talk of a “Goldilocks econo-
my” seems appropriate.
Yet, under the surface, the imbalances keep building. The
U.S. trade deficit exceeded US$700 billion in 2006. And debt
keeps accumulating, especially in the United States, which
borrowed US$3.5 trillion in the past year alone. “Total debt in
the U.S. now stands at nearly 3.6 times GDP versus 2.8 times
in 1929,” says John Succo. “And the power of new debt to
produce growth is decreasing: 20 years ago, it took one dollar
of new debt to create a dollar of U.S. GDP; today, it takes five
or six.”
And believe it or not, the numbers Succo cites actually
understate the problem, says U.S. Comptroller General David
Walker. The unfunded liabilities of government trust funds
such as Social Security and Medicare (see Figure 5) are soar-
ing as new benefits are added and Baby Boomers start to retire.
Between 2000 and 2006, unfunded liabilities rose from an
already breathtaking US$20 trillion (that’s right, trillion) to
US$50 trillion. “We face a demographic tsunami that will
never recede,” says Walker. “The present course is absolutely,
completely unsustainable.”
As the United States—the largest single national econo-
my in an interconnected global economy—leverages itself
with abandon, a whole series of risks arise for other countries.
“We owe a lot of money to a lot of other countries,” says
Mariappa. “Our overseas assets used to be greater than our
overseas debts, but 18 months ago, we crossed over.” The
United States is now the world’s biggest debtor, a position that
in the past has caused a dramatic decline in the debtor nation’s
CFA MAGAZINE / MARCH-APRIL 2007
FIGURE 5
U.S. GOVERNMENT UNFUNDED LIABILITIES
(US $ trillions)
55
50
45
40
35
30
25
20
15
0
2000 2001 2002 2003 2004 2005 2006
Source: GAO analysis of Treasury data
currency. With the rest of the world now holding several tril-
lion U.S. dollars and depending for their exports on U.S. con-
sumer spending, a rapidly falling dollar would be more of a
nightmare for Japan and China than for the United States. As
John Connally, Secretary of the Treasury in President Richard
Nixon’s administration, said prior to the dollar crisis of the
1970s, “It’s our currency, but your problem.”
Meanwhile, much of the new debt that’s being created is
of lower quality than what came before. “Banks are only able
to make money in this [inverted-yield-curve] environment by
taking more and more risks, like trading, with the ‘free’ money
provided to them. We measure the risks dealers and banks
take, and it is increasing substantially,” says Succo. Reflecting
this migration up the risk curve, 71 percent of companies with
Standard & Poor’s credit ratings had junk-quality ratings in
2006; in 1980, the portion was 32 percent. Some 42 percent of
all companies with credit ratings were rated single B, the low-
est credit rating above imminent default.
As for derivatives, well, it’s hard to say anything with cer-
tainty about this unregulated market—except that the num-
bers defy rational analysis. The nominal value of outstanding
credit insurance alone is nearly the size of global GDP, and it
is growing exponentially. Much of it is held by hedge funds,
which don’t publish audited balance sheets. Moreover, the
whole concept of credit insurance may be flawed. “Credit
losses are not insurable risks because (unlike auto accidents
and fire) they’re nonrandom and nonindependent,” says
Noland. “By their very nature, they come and go in waves.”
From this list of potential problems, it’s hard to imagine
global leverage growing much longer without consequence.
Succo says, “The system cannot have infinite debt. It may be
tomorrow or may be years away, but a massive correction in
debt and derivatives is coming whose magnitude is only grow-
ing with time.”
John Rubino, a former financial analyst, is the author of How to
Profit from the Coming Real Estate Bust and Main Street, Not
Wall Street.
49