During Q3 2004 the excess of U.S. imports over exports (the “trade deficit”) delivered a net $616.7 billion (annual rate) to the Rest of the World that, in turn, used $370.9 billion of these funds to buy U.S. Corporate Bonds, mainly $390.3 billion in bonds issued on Asset Backed Securities.

Issuers of Asset Backed Securities, in turn, used most of these funds to buy Mortgages, mostly residential mortgages.

U.S. Households borrowed a net $796.9 billion (annual rate) on residential mortgages, while investing only $577.9 billion in residential fixed assets.

Consequently, about $219 billion of funds were raised through home mortgages for other purposes, primarily current expenditures and consumer durables.

Therefore, the ubiquitous Ditech.com advertisements on American television, that persuade consumers to mortgage their homes to consolidate credit card debt or pay for a child’s college education are funded, in the last analysis, by the U.S. trade deficit.

How the trade deficit supports bond prices

Since the U.S. dollar has been declining against the euro (See: U.S. Trade Deficit Increases 10% in October 2004), it hardly seems plausible that foreign investors are buying U.S. bonds purely for investment merit as is sometimes claimed.

Rather, the motivation seems to be that foreign exporters to the U.S. are constrained to choose the dollar as their trading currency and, incidentally, invest surplus dollars in more conservative securities available on the U.S. market.

(See: The Trade Deficit and Dollarization)

This shows one peculiar result of the endemic inflation in the U.S. Instead of inflation fear driving down bond prices, as one might expect in an “efficient market” , inflation is reflected in higher real estate values that provide a basis for further borrowing with home mortgages.

(See: Fiddling the CPI)

(See: The Non-Efficient Market)

Much of this mortgage borrowing is not for new residential construction, but for spending on consumer durables and other things, often imported from abroad. Easy money in the U.S. tempts foreign producers to sell goods for dollars to keep their factories running and people employed (even at low wages).

The dollars thus generated go into the U.S. bond market, primarily into home mortgages rather than industrial bonds, keeping interest rates down, stimulating further consumer borrowing as real estate prices rise. Round and round the money goes, seemingly to the benefit of all.

If the trade deficit continues to grow, thereby exerting downward pressure on bond prices, and if Baby Boomers begin to move out of equities into fixed income investment, as befits an aging population cohort, downward pressure on bond prices may continue for some time.

However, we also have the still unknown effect of the proposed Securitization of Social Security to consider.

This entry was posted on Thursday, January 13th, 2005 at 10:10 am and is filed under Corporate Bonds. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

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