April 15, 2005
The US Consumer May Be Done Carrying On
By Brady Willett

Taking in the pessimistic party line hook, line, and sinker, I speculated 1-year ago yesterday that ‘The Unwind May Not Last Long, But It Will Be Painful’:

“It may only take a few months for the Fed to gain back some much needed ammo. However, it could also be the case that the US economy will be unable to thrive inside of a higher interest rate environment, and that we are entering a prolonged period of interest rate uncertainty.”

As it would turn out - and regardless of the ‘interest rate uncertainty’ engulfing the financial markets today - the US economy has grew even as the Fed raised interest rates, and the major US financial markets have rallied (i.e. the S&P 500 is still up over the last 12-months).

Still Carrying On

With the Fed already 175 bp into its rate hiking campaign it would seem implausible that traders are still carrying on. However, while short term interest rates have increased since the Fed started tightening, long-term interest rates have declined.  Moreover, although the US yield curve has flattened, credit spreads (until only recently) have continued to tighten since early 2004.  In short, the Fed's tightening crusade that began on June 30, 2004 was supposed mark the end to the carry. It hasn’t, yet…

“What happens to these markets and to an asset-dependent US economy should the Fed actually complete its nasty task of taking its policy rate into the restrictive zone? It wouldn’t be at all pretty, in my view.  The main reason is that the Fed and its reckless monetary accommodation have fueled multiple carry trades for all too long…” The Test, Roach. March 24, 2005.

As Roach aptly and repeatedly demonstrates, you can’t keep a good theory down. Rather, when the next financial crisis and/or US economic recession arrives the Fed will be to blame (for allowing everyone to carry on for too long).  Bill Gross, who recently confessed that his mistake in forecasting Dow 5,000 was “underestimating the depths to which real interest rates would fall’, agrees with Roach wholeheartedly.   

“…since the lower and lower real interest rate spiral is basically over, the multiple expansions in stocks, housing, commodities, collectibles and bonds are over as well.” April Investment Outlook. Gross


There is no question that the Fed - along with a little help from their Asian central bank friends - has proven to be extremely adept at managing US interest rates.  Nevertheless, there is the risk that successful interest rate manipulation can go too far.  Greenspan suggested as much when he uttered the word ‘conundrum’ to describe why US interest rates were so low.

How is it possible that interest rates management can go too far?  In answering this question you need only remember the Austrian Business Cycle: unrelenting monetary inflation produces bad investments/bubbles, and – eventually - these ‘malinvestments’ (Mises) go bust.  Essentially this is what Roach and Gross are arguing: Fed success today means that a series of malinvestments will be exposed tomorrow. What the optimists contend is that tomorrow will never come.

The End of Carry?

Although it has taken significantly longer that anticipated, recent trends in stocks and bonds suggest that 'the carry' is in demise. This is the case not only because isolated shocks (i.e. GM) have served to increase volatility/widened spreads in the bond market, but also because stocks have hit a wall this year based upon the expectation that the best is over. 

Along with the increasingly risk-averse financial markets, the US expansion is showing signs of strain.  Indeed, many recent economic releases, including reports on jobs, retail sales, and industrial production, have been cool enough for ‘soft patch’ speculations to reemerge. In the case of industrial production, if you back out the increase in utility production, manufacturing production declined in March for the first time in six months.  As for April – the less followed Empire State Manufacturing Survey just registered its lowest reading in two years.     

While there can be no guarantee that recent trends in the financial markets and US economy will persist, that the Fed is still eying further interest rate increases does not bode well. Rather, so long as the Fed is tightening the financial markets will remain on edge, and carry trades will threaten to become less popular.

The Carry is Connected To The Consumer

For more than a decade it has been futile to forecast that the US consumer is going to stop spending and start saving.  When the pessimists ever learn?

The answer is – NEVER! Or at least not until the long-awaited consumer led US recession arrives.

The US consumer celebrated the 2000/01 recession by spending more money. The US consumer barely saves a cent. The US consumer spent the last 3-years taking record amounts of money out of their homes.

In short, the real threat to the US economy isn’t rising interest rates per se, but leverage.  More specifically, consumer leverage.

The end of carry means that the consumer’s ability to tap capital out of their increasing net worth will deminish.  Look out if stagnate or falling asset prices compels the US consumer to save more money.