Thanks. Interesting studies showing classic adjustment theory at work. Among other things, it's a good illustration of how economic policy is a whole lot harder for the policymakers in emerging markets than in the larger and more developed economies. If you've had an overvalued currency for a long time, the benefits of devaluation are indeed considerable. Just think mid80s and the relief felt by US manufacturing (or what was left of it) after the end of the Volker high interest rates period. Although there was a great deal of effort put into the "soft landing" process in the Louvre agreement etc -- James Baker, Treasury Sec'y, remember? That's part of why even the WSJ editorial page was anxious about the Snow reappointment. Another argument for something other than a rout of the dollar is that we've already had considerable decline in the dollar against some currencies. There's also the factor of oil still being traded at least in good part in US dollars, so even as the cost of oil is rising, the dollars in the hands of the oil producers also keep rising, and they've got to be recycled somehow via dollar-denominated financial assets. The currency and trade factors taken by themselves might be indeed manageable as outlined in the studies. I'd be interested to see what they have to say about the demand side. We always have the problem in these adjustments of where demand is going to come from -- again the whole debate in the 80s about Europe and Japan taking over the "locomotive of global growth" role. But in prior adjustments I don't recall US consumer credit being such a key (and potentially vulnerable) engine of the real sector globally. The purpose of the post, however, wasn't really to focus on the trade deficit & the dollar right now. I wrote the post simply because there are some market indicators that aren't going to show up in the macroeconomic forecast models but that are nonetheless rather telling -- and they don't require that you have a particular theory about the pros and cons of the particular macroeconomic policies or variables that have produced them. Nor do you have to have a specific theory for the likely adjustment mechanisms this time, or how fast or gently they will work their way through the system. I leave all that to the experts to disagree about. I also should have made clearer that I wasn't suggesting that it was the dollar itself that was necessarily going to cause the trouble. Though remember that currency stability is a two-edged sword. Leaving aside the trade adjustment process, the more stable the dollar, the greater the change in price/yield likely to be required to get the less liquid asset markets such as commerical real estate to clear. And then you find yourself pushing on a string (like the Japanese have been doing for the past 15 years though for reasons other than currency valuation). The US is lucky that it has extremely liquid asset markets, which make these sorts of adjustments easier. That being said, it may require some intervention to get the markets working again as in the S&L crisis -- hence the concerns expressed about the condition of Fannie & Freddie to be buyers of last resort. I'm just spotlighting the excess liquidity problem. When investors are madly chasing yield anywhere and everywhere around the world, there are few good places to hide, and some bad times in the capital markets are around the corner. The problems can be found across asset markets. Here's an increasingly typical comment from the WSJ, this one on March 4 re hedge-fund managers less optimistic about corporate debt:

Nowhere is the evidence more compelling that investors are underpricing risk than in certain segments of the investment-grade market. There, many bonds trade at a price suggesting little can go wrong, says Boaz Weinstein, head of credit trading at Deutsche Bank.

Here's the March 2 FT:

A $1bn asset-backed bond deal has been awarded the best-ever pricing, in the latest sign of investor appetite for higher yielding assets. Investment bankers forecast pricing could become even tighter as demand showed no sign of letting up. Prices on a wide range of bonds have risen as yield spreads, or the premium offered over government bond rates, have fallen to record low levels. That has been particularly true of riskier assets as money managers have sought to put their cash to work. [...] The one-year slice of the deal yielded a record low of only 7 basis points over one-month Libor (London Interbank Offered Rate), inside expectations of 8-9bp and less than the 10-11bp seen in deals last week. The weakest paper priced at 30bp, less than recent deals, and the three-year tranche priced at a yield of 17bp; the lowest since June 1998. "That was a different time with different deal structures," said Peter diMartino, ABS strategist at RBS Greenwich Capital. "We've never seen this in the modern-day market."

And the March 3 FT on the junk market -- seems that Sarbanes Oxley is actually doing what it was supposed to do, throw a bit of sand in the way of some quality disclosure in the gears of speculative markets. But with the yield demand so high, it's probably going to spill into the leveraged buyout business:

Last year, issuance in the US reached an all-time record worth about $140bn as companies took advantage of low interest rates. Investor enthusiasm for junk bonds helped narrow spreads – the premium the paper offers over US Treasuries – to record lows despite the surge in supply. This week, spreads were hovering just 300 basis points over Treasuries, according to JP Morgan. Traders said this week that the market was “crying out” for new paper. Analysts have warned that much of last year’s issuance was related to companies refinancing costlier, older debt, and that this would naturally dry up this year as interest rates rose. “That was the easy stuff that could be rolled out quickly and by names that investors were comfortable with,” said Kingman Penniman at KDP Investment Advisors. Robert Hedlund, at Lehman Brothers, said he expected less refinancing volume, but this would be offset by an increase in merger and acquisition-driven issuance. Leveraged buyouts, for example, usually offer high yields and have been popular recently.

Any bets on the quality/viability of those LBOs that are the final ones done before spreads widen again and the window shuts? And as for my other indicator, what's been happening with emerging market debt?

Emerging market bond prices on [Feb 18] hit a record high in comparison with US government debt as investors, struggling with low interest rates, continued to diversify into higher-yielding securities. Yield spreads on emerging market government bonds fell to just 3.45 percentage points over US Treasuries. This represents a fall of 13.5 percentage points on JPMorgan's EMBI+ index from their record level after Russia's 1998 financial crisis. Jerome Booth, head of research at Ashmore Investment Management, said: “There is a huge amount of money going into the asset class.”

I'm not suggesting 2005 is 1998 -- a lot of these emerging markets credits have really cleaned up their acts on default risk and are now investment grade or close thereto. On the downside, however, another difference from 1998 is this time the instability looks to be coming from the markets in the world's most important currency. Just saying that when you have one market after another breaking records on spreads, there's way way way too much money chasing after assets. That money is going to be wrung out of the system sometime, somehow.