Low Interest Rate: Good or Bad
The Good:
In general, low interest rates are good for anyone who wants to borrow money. Here are a few examples:
1. Individuals: When rates are low, it’s more affordable for consumers to borrow the money they need to finance homes, cars, education, and other forms of consumption. Keep an eye on interest rate trends to decide whether to choose a fixed or variable rate mortgage.
2. Businesses: Companies need readily available credit to invest in their businesses, pay their employees on time, and manage their cash flow effectively.
3. Governments: Most governments at all levels, whether municipal, provincial, or federal rely, to some extent, on the credit markets to finance their operations. With multi-trillion dollar stimulus programs in effect world wide, lower interest rates can reduce the cost of borrowing dramatically.
In general, lower interest rates are seen as stimulative for the economy, as consumers tend to buy more, businesses invest more, and governments can afford social programs.
The Bad
Low interest rates are usually not so good for lenders and savers like the following:
1. Older or Retired People: These folks usually want to avoid having too much of their money in higher risk assets like stocks, so they stick to fixed income assets like bonds, GICs, and savings accounts. Lower rates mean lower retirement income.
2. Risk Averse Savers: Some people naturally avoid risk. They have very low or no debt and they don’t like to invest in stocks, commodities or real estate. Low interest rate environments provide little or no reward for this kind of fiscal prudence.
3. Insurance Companies & Pension Funds: These large institutions need to achieve a certain level of return in order to ensure they have enough capital to pay out when they need to. They also need to mitigate risk for the same reason. Low interest rates make it very difficult for these institutions to achieve their goals.
Very low interest rates can lead consumers, businesses, and governments to take on more debt. They can also make it very difficult for retirees and other risk averse investors to achieve the returns they need.
The Ugly
Interest rates that are held too low for too long can lead to unintended consequences like asset bubbles, inflation, and other economic dislocations:
1. Real Estate Bubbles: Housing and commercial real estate prices can rise too high too fast, pricing some buyers out of the market. This can lead to a number of factors that might burst the housing bubble.
2. Commodity Bubbles: When inflation expectations rise (regardless of whether or not there is real inflation), investors tend to pile into hard assets like gold, oil, and base metals.
3. Equity Bubbles: Investors who are looking for higher returns may flock to stocks rather than fixed income instruments, causing equity prices to rise, perhaps out of line with reasonable valuations.
4. Debt Bubbles: Cheap money, especially when offered for extended periods of time, can lead borrowers to become complacent and take on more leverage than they can really afford.
Bubbles don’t become ugly until they pop. There are 2 main problems with any type of bubble: First, they always pop eventually. Secondly, we never know when they are going to do it.
Where Are We Now?
Personally, I’m not a big fan of low interest rate. Last week’s volatility and Bernanke’s “2 more years low interest rate” talk further discourage investors’ confidence and lead really pessimistic economic overview. The recoverage this time is painful, and everyone feels in the middle of nowhere. Let’s wait to see what Bernanke will say in his friday Jackson Hole speech. Hopefully, fed could give some hints and confidence. Somehow, lots of traders begin to talk $2000 gold, which sounds insane to me…
WEST SHUNS LIBYAN CRUDE
Sweet Tooth
Libya produces a highly desirable type of oil called light, sweet crude. See what grade of oil is produced in different countries around the world.
Morgan Stanley, which buys Libyan oil for its clients, has stopped buying because of sanctions announced last month, according to a person familiar with the matter. ConocoPhillips Co. said it isn’t exporting any of the 46,000 barrels a day of oil it normally produces in Libya. Exxon Mobil Corp. also said it is complying with the sanctions against Libya. A person familiar with BP PLC said the company wasn’t currently doing any new trading deals in Libya.
These moves are putting further strains on an already-volatile oil market, threatening to send gasoline prices higher around the world. Oil is already trading at its highest level in 2½ years as antigovernment protests sweep further across the Middle East, and worries increase that disruptions could spread from Libya to bigger producers like Saudi Arabia and Iran. Crude futures rose $1.02 per barrel, or 1%, to $105.44 at the New York Mercantile Exchange on Monday.
U.S. retail gasoline prices rose 4.1% over the past week to average $3.52 per gallon, the highest since September 2008, compared with a little over $3 at the beginning of the year, the U.S. Energy Information Administration said on Monday.
Libya’s normal oil production of 1.6 million barrels a day has dropped by about two-thirds since the uprising against Col. Moammar Gadhafi broke out last month, costing the North African nation more than $100 million in revenue each day. The sanctions could prevent some buyers from taking the remaining oil that is flowing out of the country, the world’s 12th-largest oil exporter.
WSJ’s Margaret Coker reports on major battles between forces loyal to Col. Moammar Gadhafi and rebel in key cities along Libya’s coast. Oil prices have breached $106/barrel as a result. Also, Jon Hilsenrath on demand for U.S. grain outpacing supply.
As Libyan government forces and rebels battled for control of the oil port of Ras Lanuf on Monday, fears of a protracted civil war grew and oil markets fretted about the prospect of a prolonged cut in crude shipments. The U.S. and its allies took steps on Monday to lay the groundwork for a possible military intervention, as members of Col. Gadhafi’s inner circle debated whether their leader should give up power to end the conflict.
“It could take months for this situation to play itself out,” said Peter Donovan, vice president of Vantage Trading, a New York-based oil brokerage firm. “It makes the market more vulnerable to any potential supply disruptions.”
Regional Upheaval
Crude-oil futures are up 25% in just three weeks, sparking worries about whether the soaring costs of oil will soon become a drag on the U.S. economy. Higher gasoline prices at the pump are taking a bigger bite out of consumers’ budgets.
The Dow Jones Industrial Average dropped 79.85 points to 12090.03 on Monday and is down 1.4% in the past two trading days amid worries about the impact of rising oil prices.
The Organization of Petroleum Exporting Countries has said it is ready to make up any shortfall in Libyan production, but the message from the oil-producers’ group Monday was that there was currently no need to increase output. In Doha, the oil minister of Qatar, Mohammed Saleh Al Sada, said OPEC was watching the situation in Libya and would step in if necessary, but there was “no need for nervousness” about supply. “[Oil] supply and stocks are at comfortable levels,” he said. In an interview in Houston, Angola’s oil minister, José Maria Botelho de Vasconcelos, said he is “concerned” by the higher prices, though he maintained that the oil market is well supplied.
Saudi Arabia, the world’s largest exporter, is so far the only OPEC member that has responded by saying it would pump more oil. But traders say the United Arab Emirates have also been ramping up production over the past three months, largely in response to growing Asian demand. The UAE was producing 2.2 million barrels a day in January this year and 2.3 million barrels a day in February.
Mr. Al Sada said OPEC, which produces more than a third of the oil the world consumes, was evaluating whether it needs to meet ahead of its scheduled gathering in June.
Part of the problem for markets is that Libyan oil is light and sweet—low in density and levels of sulfur—and is hard to replace. Light, sweet crude is more desirable as it yields more gasoline and easy to process.
Italy, France, China, Germany and Spain are the largest buyers of Libyan oil, according to the U.S. Department of Energy. Some refineries in those nations will have to search for new sources of supply to make up for the lost Libyan crude, which could send oil prices higher in other markets.
Even if the bulk of the lost Libyan oil is made up by production in Saudi Arabia, some refineries can only process light sweet crude and have to turn to a handful of other countries for supplies, including Nigeria and Algeria, which are themselves the subject of some popular unrest.
In Nigeria, for example, there are some doubts as to whether Africa’s biggest oil exporter can maintain exports at their current level of about 2.3 million barrels a day in the run-up to elections in April, which many observers warn could provoke unrest.
The U.S. is a small customer of Libya, but it is is a big importer of Algerian and Nigerian oil, and could face higher prices if demand for oil from those two countries rises.
Market observers are also becoming increasingly nervous about Saudi Arabia after the Saudi government banned its citizens from going ahead with a rally planned for Friday.
The United Nations, the U.S. and European Union have imposed far-reaching sanctions against the Libyan regime, including asset freezes, prohibitions of transactions related to Libya and restrictions on exports. Still, some companies are still trading with Libya.
Margaret Coker reports from Libya on the latest developments there, including an apparent rift among members of Gadhafi’s inner circle on what Gadhafi’s next move should be, including the possibility of stepping down.
Oil markets have been spooked by fighting that has tended to play out near oil facilities such as the Ras Lanuf oil terminal, in eastern Libya. The complex is currently in the hands of rebels, although Libyan warplanes have launched air strikes near rebel positions on the outskirts of the town, according to witnesses.
The fact that many of Libya’s key oil installations are in the hands of rebels creates a headache for oil companies already hit by the U.S. trade sanctions adopted last month against Libya. The violence is deterring tankers from loading cargoes in Libyan ports, and even when they succeed, it is unclear who they should be paying for the crude—the opposition forces or the Gadhafi regime.
“There are insurance and ownership considerations and they’re going to exacerbate the production problem the Libyans already have,” said Lawrence Eagles, an oil analyst at J.P. Morgan Chase & Co. He said until those issues are ironed out, oil markets will have to adjust to an export shortfall of about one million barrels per day. “Production could be disrupted for weeks, months, even years,” he said.
WALL STREET SEEKS MUNI-DEBT BOOST
Mounting concerns about the health of cash-strapped states such as California and Illinois has already resulted in increased trading of credit default swap (CDS) contracts on US municipal debt – the derivatives that increase in value when the chances of a municipal bond default increases.
However, the municipal CDS market is still in its infancy, reflecting the political sensitivity around derivatives and the opacity of the $3,000bn market for US municipal debt.
With hedge funds and other investors wanting to speculate on the health of US state and municipal governments – and banks wanting to hedge their exposures amid concerns over rising risks – efforts are being made to boost the CDS market.
“It is fair to say that the Street is eager to get this up and running,” said Christian Stracke, head of credit research at Pimco, which has used CDS contracts to take a bullish stance on municipal bonds even as fears of defaults have surged.
Municipal bonds are mostly owned by local US investors, lured by tax breaks. That makes them typically unattractive for large international fund managers to own and nearly impossible to short sell, in the hope of profiting from falling prices.
Political pressure has already stunted the growth in CDS contracts on individual states’ bonds. Bill Lockyer, California state treasurer, has demanded that banks underwriting its bond sales report their CDS trades and Illinois has followed suit. CDS contracts remain controversial given the role credit derivatives played in the financial crisis.
Nevertheless, CDS indices, which are linked to a basket of public sector borrowers, are slowly garnering more interest. This year, the value of positions on CDS indices created by Markit has risen to $4.4bn, up13 per cent from the end of 2010.
“The market is in a growth mode,” said a recent research report by Citigroup.
Banks are hoping to standardise muni CDS contracts and some are trying to devise investments linked to CDS.
Even so, trading in municipal CDS indices remains tiny relative to the broader CDS market. Markit calculates that it is just 1.7 per cent of all the current exposure to CDS indices.
I WONDER, WHAT KIND OF COUNTRY IS THIS?! PEOPLE CAN SERIOUSLY BET AGAINST GOVERNMENT AND HOPE IT GO DEFAULT!!! ARE WALL STREET PEOPLE ALL INSANE? THEY DON’T HAVE ANY PHILANTHROPIC HEARTS? IF SO, WHY MOST OF THESE FAT CAT ARE NAMED PHILANTHROPISTS??? IF CALIFORNIA REALLY GO DEFAULT, HOW TO DEAL WITH THE EDUCATION SYSTEM, THE STAFF PENSION FUND, THESE POOR PUBLIC SERVANTS, ETC.?
MORE AND MORE, I DON’T UNDERSTAND THIS COUNTRY. I FEEL IT SEPARATES TO THE EXTENT THAT, WHEN UPSIDE WALL STREET PEOPLE ARE ENJOYING THEIR BALLS, COCKTAIL PARTIES, ON THE OTHER SIDE, PEOPLE ARE SUFFERING FROM UNEMPLOYMENT AND PILING DEBTS!!!AND THE FUNNY PART IS, IT IS THESE RUTHLESS WEALTHY MODERN VERSION OF “ADOLF HITLER” LEAD TO ALL THESE FINANCIAL CRISIS! THE MAIN POINTS ARE NOT “STOCK MARKET PLUMMET” OR “BANKS’ LIQUIDITY ISSUES”, IT IS NORMAL PEOPLE WHO RELIES ON THEIR BASIC SALARY LOSING THEIR JOBS, DEFAULTING THEIR MORTGAGES, GIVING UP KIDS’ EDUCATIONS, RUNNING AWAY FROM EMERGENCY ROOM BECAUSE THEY DON’T HAVE MONEY OR INSURANCE TO PAY OFF BILLS!!!
COME ON!!! I KNOW I’M AGGRESSIVE, AMBITIOUS, AND MAYBE A LITTLE GREEDY, VERY TYPICAL FINANCIAL PEOPLE, BUT AT LEAST I HAVE MY “LIMITS”. I KNOW I CAN’T LIE TO THESE PEOPLE RIGHT IN FRONT OF ME! AND I HAVE NO IDEA THAT HOW GOLDMAN SACHS CAN ABET PEOPLE BUYING MORTGAGE BACKED SECURITY WHILE IT’S OWN TRADING DESK RIGHT IN THE 12 FLOOR OF THE SAME BUILDING ARE AT THE SAME TIME BETTING AGAINST THEIR LOWER STAIRS CUSTOMERS…
THAT’S THE HEARTBREAKING MOMENT OF 2007. AND NOW THEY ARE BETTING AGAINST CALIFORNIA, ILLINOIS, TEXAS…WHILE GOVERNMENT IS STILL WORKING ON HOW TO FIX THE PROP TRADING LOOPHOLE….
WHY WE CAN’T GET BOTH SOCIAL AND FINANCIAL RETURN? WHEN THESE WALL ST PEOPLE GET THEIR 6 NUMBER BONUS, HOW MANY FAMILIES BREAK APART? I CAN’T BE SO COLD AND CRUEL AS THEM, SO I GUESS WALL ST WILL NEVER BE A FIT FOR ME! AND EVERYDAY, WHEN WE ARE WORKING ON COMPANIES’ 10-K REPORTS, WE HAVE TO TAKE 120% CARE THAT THEY ARE TAKING USING OF SOME ACCOUNTING LOOPHOLES, BENEFITING THEMSELVES, WHILE AT THE SAME TIME YOU SERIOUSLY CAN’T SUE ON THEM, COZ, THEY WOULD TELL YOU A HUNDRED REASONS WHY THEY ARE AGGRESSIVE IN NUMBERS. AND THE EVEN FUNNY THINGS ARE, LOTS OF BIG NAME CORPS. ARE BUYING OUT STRESS COMPANIES FOR THE REASON OF DEDUCTING TAXES. AND WE, ANALYSTS, HAVE TO READ ALL SORTS OF DOCUMENTS, TO FIGURE OUT THEIR “NEW SKILLS”! THEY KNOW HOW TO FOOL US AND KEEP US BUSY!
WTF—THAT’S MY WORD FOR THIS MOMENT.
IS REGULATION BETTER THAN DEREGULATION?
Here it is.
● Banks are banned from trading for their own account and prop trading desks must be shut or sold.
● Market making and hedging will be allowed but disguising prop trading under these allowed categories will be made difficult by forcing banks to report quantifiable metrics.
● Trading that generates revenue from price movements rather than spreads, incorporates a high degree of risk, involves assets that are held in inventory for a long time and is initiated by traders rather than customers will be flagged as possible violations.
● Chief executives forced to attest publicly to the effectiveness of their compliance regime.
● Unspecified punishment for violators.
● Banks are allowed only a “de minimis” investment in a fund, representing no more than 3 per cent of the ownership of the fund and 3 per cent of the tier one capital of the bank.
● Possible exemption for investment in venture capital funds and possible widening of ban to include structures such as commodity pools.
● Banks banned from trading against the positions of their customers.
● Possible new information barriers within banks.
These are infamous “Volcker’s Rule” proposed since last year. And today, more tougher and tighter bank regulations seem like every day’s topic. Regulators never give up the power to freak out these “fat cats”. But the thing is, is regulation better than deregulation?
History can tell.
Back to 1929 Great Depression, bankers were notorious for underwriting corporate stocks, which artificially inflated the market. This culminated with the stock market crash, and all banks in the United States closed for four days, with over 4,000 never reopening. These sorts of large-scale bank runs literally brought us The Glass-Steagall Act, which prohibited banks from trading in corporate securities and created the Federal Deposit Insurance Corporation (FDIC) as the last land of deposits. When sad memory goes over, everything becomes the way it supposes to be. During the 1970s, a bunch of deregulations passed one by one, marking a new era of banking history. Probably since then, we were plowing the ground for sowing mega-banks.
Obviously, it seems hard to really separate power and wealth. I always have some senses of “balance” about our world—no matter it’s about the natural evolution, social development or individual life. To be more accurate, I should say “dynamic equilibrium” while power and wealth are two strongest forces keep everything “moving on”. Thinking about the 2008 financial crash, you can find hundreds of “best selling books” tell you different reasons, but the ultimate curses should belong to the pursuing of power and wealth—which reside in everyone’s genes. And history will just repeat again and again, probably with different formats.
The afterwards seem pretty predictable—depressions always bring out chaos and regulations. But this time, it seems too tight to be true. I’m not an ally of these mega banks. But Mr. Volcker proposed to shut down prop trading, to prohibit trading against their customers, to limit investing private equity and hedge funds, seems horrible for me. It’s like your kid gets bad grades, and you beat him, set rules for him and intend to prohibit a bad result again. But is that true stressful rules will bring you excellent performance? Not really. The more restriction, the more rebellion. He maybe simply decides to climb out of the window. That’s why we need “cultivating”, not beating. Same thing with the banking industry. Banks might like your naughty boys doing some bad jobs in the past couple of years, but beating him into the corner won’t be the best choice. Not even bother to mention the creativity and innovation of the banking industry.
The kind of feeling to me right now is like, we are in the battlefield, and playing around. And there is no end in sight.
Device Fingerprinting and Targeted Margeting: The Next Digital Privacy Battleground?
In one of the latest advances in what has been called “a technological arms race between tracking companies and people who seek not to be monitored,” device fingerprinting, a technology originally developed to prevent software piracy and credit card fraud, appears set to become a powerful new tool for online marketers. But recent calls to increase consumer control of personal information will likely impact how device fingerprinting technologies are integrated into marketing efforts and may slow its widespread adoption.
What exactly is “device fingerprinting”? Every time a computer or other mobile device connects to the Internet, it broadcasts information about its properties and settings (such as which browser is running, screen resolution, speed of connection, etc) in order to interact smoothly with websites and other computers. Device fingerprinting technology collects this information to build a profile that can identify the individual computer or device, and in some instances, the person using it.
Before its adoption for online marketing, fingerprinting technology was primarily used to prevent software theft, providing a means to confirm that the subject application was only used on authorized computers. Anti-fraud companies use the technology to identify devices that had engaged in fraudulent transactions to help them prevent similar occurrences in the future. Privacy legislation proposed this July even advocated its use to identify consumers who had opted-out of online tracking.
But device fingerprinting could also allow for much more effective tracking of online behavior than other current technologies. Where cookies can be blocked or deleted, it’s much more difficult to prevent fingerprinting or to delete a fingerprint after it has been collected. One study, surveying 70 million website visits, found that a fingerprint of an applicable device could be generated 89% of the time whereas cookies could only be used 78% of the time. One developer of device fingerprinting technology claims that it is even able to link the fingerprints of different devices that appear to be used by the same person. Eventually, the company plans on adding offline activity to the individual’s profile, using email addresses and names the user entered while browsing the web to pull information from other databases. By collecting, generating and selling this information to marketers, the device fingerprinting could become the basis to deliver targeted ads based on a consumer’s activity from their computer, mobile phone and other devices.
Fingerprinting and other forms of digital tracking are currently legal but both federal regulators and several members of Congress have warned that the government will intervene if the online-advertising industry does not start doing more to protect consumer privacy. Recently, the FTC recommended that a Do Not Track System be implemented if the industry doesn’t start coming up with its own solutions soon. The FTC proposal would require web browsers to implement a do-not-track setting directly in the browser to enable end users to block web service providers, marketers and advertisers from monitoring their online behavior. The FTC would then police companies that implement tracking technologies and tools to ensure that they comply with user requests. The ad industry’s current opt-out system only allows consumers to opt-out of targeted advertising, not tracking altogether.
The industry has taken notice. Some marketing firms say that they will create an opt-out function if they adopt fingerprint technology, though the details of how that would work are still unclear. Other initiatives include the “Open Data Partnership”, a service that would allow consumers to see what information has been collected about them, and opt out of being tracked by participating firms. The service is intended to be a response to the government request for more transparency and consumer control. Eight data and tracking firms have already committed for the service’s launch in January. Microsoft has also revealed plans for a tool to block tracking in its next version of Internet Explorer. The tool, once enabled, will allow users to block tracking attempts from specified web addresses used by tracking companies. But in order to use the tool, users have to direct the browser as to which tracking attempts should be blocked by selecting from lists compiled by privacy groups and other outsiders. There won’t be any default setting to block all tracking attempts. Additionally, the tool will only block tracking by certain technologies, such as cookies and beacons. It doesn’t address new technologies like digital fingerprinting and “deep packet inspection,” a form of monitoring which analyzes data as it travels from the internet to the computer.
While support for consumer protections are gaining ground, the $23 billion online advertising industry warns that an end to tracking could also mean an end to the free web content that is currently subsidized and supported by targeted advertising. And some members of Congress have expressed hesitation about any legislation that might hurt economic recovery. Data tracking has also enabled the customized web experience that many consumers have come to rely on. In order for any solution to be viable in the long-term, it will have to find some way to balance these competing concerns.
In the coming months, we will continue to monitor this and other developments in the ongoing debate over privacy on the internet
A DIP IN THE VALLEY
When Facebook was accorded a $50bn valuation in a private financing launched this month, it looked like business as usual in Silicon Valley. The suburbs strung out along the peninsula below San Francisco that comprise the heart of the US technology industry had once again turned out a groundbreaking company to take the world by storm.
To some industry veterans, however, eye-catching successes such as the social networking site – whose share offer by Goldman Sachs drew so much attention that the bank felt obliged to exclude US investors for regulatory reasons – provide little indication of the underlying trend in the country’s technological competitiveness. If anything, they help to mask a deeper malaise that threatens the American system of innovation.
Drawn by the quick profits from high-flying internet concerns, US technology investors have lost interest in the more serious work needed to sustain a lead in some of the world’s most advanced industries, says John Seely Brown, a former head of Xerox’s Palo Alto Research Center, once one of the Valley’s most renowned corporate research and development laboratories. “We’ve lost the will for patient investment. In the natural sciences, you don’t see ideas develop that fast,” he says.
Mr Seely Brown is far from alone. A deepening angst has gripped the US technology industry as the country has emerged from recession. If America is to create new, high-paying jobs, it is in the convergence of high science and entrepreneurial dynamism that much of the hope resides. But many leaders in the technology industry, which has been held up as a beacon of US economic leadership, no longer feel as confident of their own ability to deliver the goods.
When Massachusetts came up with $58m of incentives in 2008 to encourage Evergreen Solar to build a plant, it looked like the US state had found a new lease of life for a disused military base. Until last week, that is. Evergreen is shutting the facility with the loss of 800 jobs. The future location of Evergreen’s wafer making: a plant in Wuhan, China.
China’s solar lead has been built in current polysilicon technology. But photovoltaic materials that can be produced in thinner sheets at lower cost again promise to change the sector’s economics. US start-ups control much thin-film technology.
“I don’t know how many Facebooks you can build,” says Bill Watkins, a computer industry veteran. Like others in Silicon Valley, he has been drawn into the region’s latest boom industry: green technology. As chief executive of Bridgelux, a company that makes low-power lighting using light emitting diodes, he is at the forefront of a promising new field – but now warns that the LED industry is fast slipping away to Asia.
The US remains the clear leader in science and technology on virtually any measure – its share of global R&D spending stands at 40 per cent, while it employs 70 per cent of the world’s Nobel prizewinners and is home to 15 of the world’s 20 top universities, according to Rand, a US think-tank.
But the balance has been shifting. By 2007, the most recent date for which figures are available, Asia’s share of global R&D spending had risen to 32 per cent, up five percentage points in the previous five years, according to Unesco. On paper, the 1.4m researchers in China now equal the number in the US, though their output has been far lower.
Silicon Valley’s magnetic attraction for entrepreneurial talent from around the world is also less powerful than it was. About one-quarter of venture capital-backed companies in the US over the past 15 years were set up by immigrants, with a heavy bias towards technology industries, according to the National Venture Capital Association. That movement of talent in favour of the US does not look sustainable. With US venture capitalists redirecting more of their money to Asia, and start-ups from elsewhere winning support from American investors – new stock market listings by Chinese internet companies on Wall Street exceeded those by local American ones last year – many immigrant entrepreneurs are feeling an irresistible pull to return home.
For US tech companies, this is not necessarily bad news. Adept at crossing borders to take advantage of new markets and tap low-cost workforces and pools of engineering talent elsewhere, their ties to their country of origin have been growing looser. But for the US itself, the risk of losing out on the next big technologies would be far more severe. As Mr Watkins says: “What’s good for American stockholders is not necessarily good for America.”
In the popular psyche, American technological leadership seems almost innate. It is seen as the product of an ingenuity, a sense of risk-taking and a hunger for the new that could only have taken root in a country as democratic, socially mobile and close to its pioneer roots as the US. But such romantic notions have lately been taking a cold shower.
Forget the loss of electronics manufacturing to Asia, which began in the 1980s, or the shift of information technology services to India, which has been the story of the past decade: the R&D and design work that goes into many areas of electronics manufacturing – bringing with it high-paying jobs – has also been moving elsewhere. And in entirely new markets such as green technology, despite strong US scientific credentials and heavy investment from Silicon Valley’s venture capital investors, the centre of gravity has been moving to Asia.
The belief that American individuality and creativity somehow assure future leadership is “a clear exposition of the arrogance of empire”, warns Michael Moritz, one of the Valley’s leading start-up financiers. Freed of “the debilitating effects of affluence”, he adds, “the need to succeed is far greater in the emerging economies”.
Nor is there any inherent resource advantage, as information and talent flow freely. “We’re not smarter than they are,” says Mr Watkins.
Some of the trends that lie behind the erosion of leadership – such as the decline of the US share of the world’s R&D spending, and the inability of its educational system to turn out enough science and technology students to feed national demand – have been playing out for decades. But the current angst has a more pointed cause. It comes from a sense of relative decline: others are catching up. The rise of China, in particular, has had a powerful psychological effect.
In many ways, this unease is irrational. “Why should I be upset that other countries are lifting themselves out of poverty, whether that’s physical or intellectual?” asks Nathan Myhrvold, a former chief technology officer at Microsoft whose current firm, Intellectual Ventures, has amassed one of the world’s biggest portfolios of technology patents.
For all the concerns, the US still has a big global lead. But that does little to erase the doubts. “Relative decline is decline,” says Robert Atkinson, president of the Information Technology and Innovation Foundation, a US think-tank. Even optimists such as Mr Myhrvold concede that, as Asia rises, Americans find themselves in an unfamiliar position. “The US is the new Europe,” he says.
There is also a growing fear of absolute decline as more parts of the US technology industry move offshore. “A company that loses its ability to develop its own manufacturing is on the road to oblivion,” says Mr Moritz.
The concern stems from the close ties between design and manufacturing that characterise the evolution of new technologies. Developing prototypes and refining manufacturing processes becomes harder when the design and manufacturing of products takes place half a world apart. As a result, the US is losing “the capabilities to build serious, complex stuff”, warns Mr Seely Brown.
The US machine tool industry has already largely been lost to other countries. Applied Materials, the world’s largest maker of manufacturing equipment for the chip industry – and, increasingly, for solar cell makers – startled US rivals last year when it announced that its chief technology officer would move to China to be closer to the company’s manufacturing plants.
The failure of the US educational system to turn out enough engineers and others with needed technical backgrounds presents a second direct threat and has become a perennial subject of complaint for tech employers. “In the short run, you can fill gaps through immigration,” says Brad Smith, general counsel of Microsoft. “But you have to question whether that’s healthy and sustainable.”
The ability of the US to win the competition for talent is no longer taken for granted. Sophie Vandebroek, a Belgian engineer who moved to the US in the mid-1980s to train, says that at the time it was “the place to be – this was where the hot research was happening”. Ms Vandebroek stayed and eventually became chief technology officer at Xerox – in spite of the low status accorded to engineers in the US: “It’s kind of at the bottom of the professions.” Now, she and others warn, US immigration rules that make it harder for foreign students to stay, along with the availability of good jobs at home, are causing the country to leach much-needed foreign workers.
Concerns about competition are most heavily focused on new industries in which global leadership has yet to be established. The pressure is most acute in so-called green technologies. China and some other countries in Asia have adopted policies designed to wrest control of these industries even before they have become fully established, US executives and financiers warn
“We invented LEDs but we’re losing the business to Asia, and it’s the same with solar,” says Mr Watkins of Bridgelux.
The game is not yet lost. For now, in some industries that are still forming, the Valley boasts an impressive array of start-ups. In areas such as electric vehicles, advanced solar manufacturing and energy storage, it has established a technological lead, says Alan Salzman, managing partner of Vantage Point, a venture capital firm that specialises in green tech. “If this is the industrial revolution of the 21st century, then this is where the jobs are going to come from,” he adds.
If it is not to become left behind in businesses such as these, the industry’s leaders say, it is time for a policy rethink. “Simply put, the US needs to decide it is ‘open for business’ and willing to compete in the global marketplace for factories and jobs,” says Paul Otellini, chief executive of Intel. “Costs are higher here, not driven by labour rates but rather by lack of incentives or tax credits that are available to US corporations in most other countries.” Without education reform, there will be a “critical engineering skills gap [that] will ultimately translate into fewer jobs and inventions in this country”.
The administration of President Barack Obama has signalled its greater willingness to consider such calls, though it is not yet clear whether powerful tech companies such as Intel will get what they want.
Silicon Valley may still act as a magnet for the world’s engineering and entrepreneurial talent. It is the place where many of the brightest Indian, Chinese and European brains still congregate. Facebook’s success is evidence that “innovation is still kicking” and the American melting pot is still happening, says Mr Myhrvold. But for the country at large, it would not pay to take that much for granted.
VENTURE CAPITAL
Start-up finance falls off as Asia finds it can clean up
A steady flow of venture capital dollars has been the lifeblood of technology innovation in the US over the past half-century – and has made its entrepreneurs the envy of others around the world who are often starved of start-up finance, write Richard Waters and Chris Nuttall.
That picture is now changing fast. In the US itself, venture capital is facing its biggest test since the collapse of the tech bubble a decade ago. Last year, only $12.3bn of new money found its way into VC funds – less than half the level of two years before. With a broad retreat from private equity under way, American start-up financiers have been predicting a historic contraction in their industry.
At the same time, India and China have become magnets for start-up money – much of it directed at entrepreneurs returning to their home country after stints in the US, and coming from US venture capitalists who have started to hunt elsewhere for big ideas.
US venture firms have been looking increasingly to China to invest in areas such as clean technology, where the legislative environment at home is not as conducive to backing local companies. VantagePoint, one of the biggest Silicon Valley investors in this field, last year launched a $100m fund for emerging clean technology in China, making it one of the largest investment vehicles of its kind.
The shift is already starting to pay dividends. Sequoia Capital, one of the most prominent US venture firms, with names including Apple, Cisco and Google to its credit, has been making investments through local funds in China, India and Israel since the middle of the last decade. With few US tech companies pursuing a stock market listing, it has been companies from China and elsewhere that have been producing the initial public offerings for Sequoia’s backers – often through a public listing in the US.
That does not mean Silicon Valley is losing its edge, says Mike Moritz, a Sequoia senior partner, who describes the northern Californian region as still by far the world’s most active single area for tech innovation. But of his firm’s stake in countries such as China and India, he adds: “I’m immensely relieved we’ve positioned ourselves to invest in the tech companies of tomorrow.”
IBM READY FOR CLOSE-UP
Nearly 14 years ago, International Business Machines Corp. showed off the power of supercomputing when the company’s Deep Blue computer beat chess champion Garry Kasparov at his own game. Now, IBM is hoping for another gee-whiz moment with a new computer system, the “Jeopardy!”-playing Watson.
Executive Decision
And, once again, there is a business purpose behind the publicity. IBM Chief Executive Samuel J. Palmisano is making a big bet on a field called business analytics, which involves using software to mine huge volumes of data to help executives make decisions.
IBM wants to boost its business-analytics revenue to $16 billion by 2015 from $9.4 billion last year, but faces tough competition from market leaders Oracle Corp. and SAP AG. Mr. Palmisano hopes the “Jeopardy!” games due to air in mid-February will help the company connect with customers and stand out from rivals.
“People can watch the TV show and see what analytics really is,” Mr. Palmisano said. “It’s one thing if we’re talking to a government about some kind of fraud control. It’s another thing completely if you watch Watson and see how it interacts with human beings.”
IBM’s software, services and server sales will be in focus when the technology bellwether reports earnings Tuesday. Investors will be looking not only to see how IBM performs, but what its results say about companies’ willingness to spend on technology. Analysts surveyed by Thomson Reuters expect IBM to say its fourth-quarter revenue rose 4% from a year earlier to $28.26 billion, as earnings increased 14% to $4.08 a share.
The analytics business cuts across IBM’s big software and consulting groups and is crucial to cementing Mr. Palmisano’s legacy of pushing the company deeper into higher-margin, complex businesses and away from crowded fields where companies can only compete on price.
The company is counting on analytics to be a major source of revenue growth—an area where analysts often knock IBM. The company said its analytics operations posted annual growth of 14% in the second and third quarters, compared with overall revenue growth of just 2% and 3%, respectively, in those periods. Growth in IBM’s analytics business helped push its stock to a fresh all-time high last Friday, when it closed at $150.
IBM isn’t alone in targeting the field, which boasts high growth rates and $27 billion in 2010 revenue, according to an estimate by market-research firm IDC.
Over the past year, analytics has become one of the most competitive fields in business technology. Some of the technology industry’s fiercest bidding wars have broken out over companies that have a role in the market, including the takeover battle for 3Par Inc., a company that helps firms efficiently store vast amounts of data.
According to IDC, SAP is the leader in software that lets companies access and analyze data, while Oracle is the overall business-analytics market leader and tops in a segment known as data warehousing, computer software that stores and quickly serves up mounds of data.
One advantage SAP and Oracle have over IBM is that many companies have already made big investments in their enterprise-resource-planning software, which is used to manage back-office tasks such as finance—a market that IBM has largely avoided.
Brad Bowness, a director at Canadian power provider Hydro One, said the utility recently ripped out its IBM analytic software and installed SAP programs because it would be easier to connect an analytic system with an enterprise-resource-planning system from the same company, and less costly to run them. “Fewer technologies are beneficial,” Mr. Bowness said.
Microsoft Corp. is attacking IBM from below with off-the-shelf software, offering some free data-mining capability as part of its database programs. One new program, called PowerPivot, lets workers analyze reams of data in a spreadsheet-like tool without the help of consultants.
“It can take months to get it all done in the traditional IBM model,” said David Campbell, a technical fellow in Microsoft’s data-storage-platform division.
Mr. Palmisano has spent more than $14 billion over the past four years acquiring 24 companies in the field, including IBM’s $1.7 billion purchase of data-warehousing firm Netezza in November. The deals have enhanced IBM’s analytics capabilities in software and hardware. The company has 8,000 consultants working in a new analytics unit in its services business.
“They have all of the pieces,” said IDC analyst David Vesset. “It will take some time to put them together.”
Watson—named for Thomas J. Watson Sr., who built IBM— is the latest example of what analytics can do. The room-sized system, powered by 90 servers and 360 computer chips, was designed to quickly answer complex questions involving puns and wordplay by pouring through 200 million pages of content in less than three seconds.
After Watson beat two former “Jeopardy!” champions in a practice round last week, IBM research director John E. Kelly III said the company is already putting Watson’s computer code to use. The company, for example, is talking to university hospitals and other health-care providers about applications, including a version of Watson that doctors and nurses could use as a sounding board to make a diagnosis or suggest a treatment.
For the past year, IBM has been working on a $24 million analytics project with the New York City Fire Department to help isolate buildings most at risk of fire by mining data such as building-code violations.
The city originally planned to roll out the system to all of its fire companies by the end of 2010, up from the current six pilot companies. The deployment has been delayed in part by technology glitches. One problem is that the computer, overloaded with data, crashed a number of times.
Still, the FDNY intends to roll it out. “There are too many buildings and not enough resources,” FDNY Commissioner Salvatore Cassano said. “It’s time to overhaul the system.”
AMERICA PAYDOWN PROBLEMS
It was the most startling of warnings. If the US does not get its finances in order “we will have a European situation on our hands, and possibly worse”, claimed Paul Ryan, the new Republican chairman of the House of Representatives budget committee.
The consequences of not tackling the country’s mounting debt burden would be dire, he last week told an audience of leading budget experts and economists at a gathering in Washington. “We will have the riots in the streets, we will have the defaults, we will have all of those ugliness problems,” he said, referring to “French kids lobbing Molotov cocktails at cars, burning down schools because the retirement age will be moved from 60 to 62”.
As it stands today, the US borrows about 40 cents of every dollar it spends. Curbing the budget deficit has been the stated mission of Mr Ryan, a rising Republican star, for several years. But such calls for action have multiplied in Washington in recent months, igniting what some say is the fiercest debate over fiscal and budgetary policy in decades.
The risks are big. If the government rushes into austerity, cutting too much and too quickly, it could stunt economic recovery. But if the political system cannot forge some kind of consensus on steps to restore US deficits to sustainable levels, the danger is potentially even greater: a sovereign debt crisis in the world’s largest economy.
“It’s a weak period for the economy, so I don’t think you want to do serious deficit reduction anyway, but we are playing a dangerous game and we will start to pay a price for fiscal irresponsibility,” says Ethan Harris at Bank of America Merrill Lynch.
The big fear is that if no action is taken, investors might eventually punish the US for its fiscal laxity. That would raise borrowing costs for businesses and consumers, force severe austerity measures and risk social unrest. Not only America’s triple-A credit rating could be threatened; some point to consequences in foreign affairs and defence as well. Mike Mullen, chairman of the joint chiefs of staff, last year warned that the debt pile could limit the flexibility of the US in funding its military – in his eyes the “most significant threat to our national security”.
So far, capital markets have not reacted much to the dismal long-term outlook. The 10-year Treasury yield, for instance, has been trading this week well below 3.4 per cent, close to historical lows although it has risen in recent months. Still, a growing number of voices are calling for a deal to address America’s strained public finances, even if it means tackling programmes such as retirement benefits and healthcare for the elderly that have long been protected.
Yet whether this anti-deficit rhetoric translates into a meaningful turn towards austerity in the coming months – and leading into the 2012 presidential election – is much in doubt, for two main reasons: severe political divisions and the continuing fragility of the economic recovery.
“It’s not urgent but at some point it’s going to become more urgent,” says Phillip Swagel, who was a senior economic official in the George W. Bush administration. “Clearly the markets don’t think we’re Argentina, but we should send them a signal that they are right, that we will address the issue.”
A deal extending Bush-era tax cuts and unemployment benefits in December failed to send that message, adding $858bn to long-term deficits without any commitment to reductions in the future, even though supporters argue that if the measures boost growth, America’s budgetary position will improve too.
But more big tests of America’s commitment to fiscal discipline are looming. On January 25, President Barack Obama will lay out his legislative priorities for 2011 in his State of the Union address to Congress, and measures to reduce long-term deficits are expected to be on the agenda.
Some policies have already been flagged. In December, the president announced a two-year freeze on pay for civilian government workers, a nod to the need for budget cutting to begin at some point. The Pentagon has also been trying to get ahead of the game: last week it announced that it would trim its annual budgets of more than $500bn by a combined $78bn over the next five years compared with earlier projections.
These measures will be incorporated into the White House’s proposed annual budget, to be presented in mid-February. Other steps could also be included, such as possible additional plans to cut discretionary spending across government agencies, start tackling social security reform and set a framework for tax reform.
Much attention will be paid to both the scope of these proposals and how specific they are, and to signs of the seriousness of the administration’s commitment to deficit reduction.
Mr Obama’s new economic team certainly bodes well for fiscal hawks, including as it does Jack Lew as budget director and Gene Sperling as head of the National Economic Council. The two are back in the same roles they held under Bill Clinton in the 1990s, when the US reduced its deficit through negotiations between a Democratic White House and a Republican Congress. Mr Clinton left office with a budget surplus.
Few expect the administration to take the aggressive approach sought by some prominent Democrats such as John Podesta of the Center for American Progress, a think-tank with close ties to the Obama White House. This would involve cuts to large programmes such as Social Security and Medicare, followed swiftly by a move towards tax reform. But it is unlikely to happen, because it could expose the administration to a barrage of attacks from both its Democratic base and from Republicans.
Nevertheless, Mr Lew maintains that the administration’s resolve on deficit reduction is clear. “We need to have a bipartisan effort, which will address the serious fiscal challenges before us while at the same time promoting an agenda that will build the foundation of the American economy in the future, which to us means continuing to invest in education and innovation even while we make reductions in other places,” he says.
But Republicans, who gained control of the House of Representatives in elections last November, partly on a message of fiscal rectitude and opposition to government spending, have other things in mind. They envisage spending cuts on a much larger scale than what is palatable to the White House or many congressional Democrats – and could resist any attempt by the administration to press ahead with new stimulus measures.
Many Republicans have shown little willingness to consider tax increases as part of any deficit reduction package – which many economists believe to be an essential component of a deal. The result could easily be gridlock, with both parties and the White House trading accusations, and investors and businesses growing increasingly nervous about America’s ability to deal with the debt problem.
Meanwhile, a deadline that will force the two parties to engage – and probably battle – on fiscal issues is close. Any time between March 31 and May 16, the Treasury estimates, US debt will hit its congressionally mandated limit of nearly $14,300bn. If the administration and Capitol Hill cannot agree on a deal to raise that threshold, the US would have to shut down the government and default on its international debt obligations – potentially triggering the debt crisis that for the moment seems so distant.
Many Republicans have insisted that a higher debt ceiling should be tied to their aggressive spending cut targets, setting the stage for a big political showdown as the date approaches.
The administration does not believe the debt limit should be used as a bargaining chip to extract concessions. “Our view is a clean debt bill is the only responsible thing to advocate – and we’re clearly going to have to engage in Congress on this,” says Mr Lew. “We have no alternative but to raise the debt ceiling and it would be irresponsible to use the need to raise the debt limit as a way to force a crisis that could undermine the US economy and its standing in the world very severely.”
Lawmakers as well as analysts expect in general that over the next few months a limited agreement – possibly on its own, and possibly involving the enactment of some deficit reduction measures proposed by the administration plus some new ones – will be reached. But while such an accord could placate investors in US debt for some time, it will probably only delay America’s reckoning with its unsustainable public finances rather than correct the course.
America’s budget deficit in the year to last September amounted to about $1,300bn – the second highest on record. Over the next several years, as the economic recovery advances and the impact of emergency spending measures taken during the recession start to wane, the country’s deficits are expected to shrink naturally.
But the relief will be temporary: because of the retirement of the baby-boomer generation, which starts in earnest this year, the cost of government healthcare and pension programmes is projected to soar. According to a report issued last month by an 18-member bipartisan commission on fiscal responsibility, by 2025 tax revenues will be sufficient to finance only interest payments – which are projected to soar from their current $200bn a year to more than $1,000bn – and entitlement programmes, with no room for anything else.
“Every other federal government activity – from national defence and homeland security to transportation and energy – will have to be paid for with borrowed money,” it warns. By 2035, rising debt could reduce gross domestic product per capita by as much as 15 per cent. That would imply a harsh reduction in Americans’ standard of living.
This gloomy picture is what could eventually cause a crisis in international capital markets. It is also what drove the commission, led by Erskine Bowles, former White House chief of staff under Mr Clinton, and Alan Simpson, former Republican senator from Wyoming, to attempt what had rarely been tried before in Washington: to craft a detailed template to solve the country’s budget woes, offering Americans and their lawmakers a concrete glimpse of what it would take to correct the problem.
The plan recommended a total of $3,900bn in deficit reduction by 2020, with a three-to-one ratio of spending cuts to tax increases. The commission proposed raising the state pension age, curbing government healthcare and limiting popular tax breaks such as the ability to deduct interest paid on mortgages.
Some potential options to cut the deficit – such as a consumption or value added tax, or a tax on carbon – were sidelined as politically infeasible. That contributed to a surprising level of agreement on the recommendations, with 11 panellists voting in favour of the package, including six sitting lawmakers. Still, this was not enough to force a vote in Congress on the measures, which would have required a 14-member majority.
The failure of the Simpson-Bowles commission to reach the required threshold is what left America’s fiscal fate in the hands of the ordinary political process, from the White House to congressional leaders such as Kent Conrad, chairman of the Senate budget committee, as well as Mr Ryan. Turning back to Europe’s debt woes, Mr Ryan declares: “This is not who we are, and this is not the fate that we want to have.”
However avoiding that fate – and ushering in a new era of US fiscal responsibility – will require a level of political harmony that, in spite of a growing awareness of the problem, still seems elusive.
AUSTERITY AMERICA
Cuts start to hurt as states seek to balance the books
While the US may take steps this year to curb its deficit, large-scale fiscal retrenchment on a federal level is not widely expected until after 2012. Many Americans, however, already have a sense of what austerity feels like.
State and local governments, run by both Republicans and Democrats, have been busy slashing public programmes – and in some cases raising taxes – to plug huge budget shortfalls brought on by the recession.
Some measures have been extremely painful: states have narrowed the eligibility of low earners to government healthcare programmes; public university tuition rates have increased as financial aid for students has been cut at state level; and an estimated 400,000 state and local workers – including teachers and firefighters – have been fired since August.
Others are happening this year. On Tuesday, the Illinois state legislature raised its income tax from 3 per cent to 5 per cent, and the corporate tax rate from 4.8 per cent to 7 per cent. The budget proposal unveiled by Jerry Brown, California’s new governor, includes $12.5bn in cuts. Among them are a 10 per cent pay reduction for state employees; $1.5bn less funding for CalWorks, an employment programme for the poorest residents; and $1bn in cuts for higher education, including the University of California system.
“What states face is their worst budget year ever because revenues are still down and the need for services is up and federal aid is running out,” says Nicholas Johnson of the Center on Budget and Policy Priorities in Washington. Paul Krugman, economist and commentator for The New York Times, has said the US is suffering from the actions of “50 Herbert Hoovers – state governors who are slashing spending in a time of recession”, in a comparison with the US president in office during the Great Depression.
The reason these tough measures are being taken on a state level is that every state – except Vermont – is required by law to balance its budget every year, a fiscal straitjacket that does not bind the federal government.
If some states and local governments fail to meet this requirement, jeopardising their ability to pay creditors, it could seriously damage municipal bond markets, a cornerstone of US capital markets, potentially precipitating a new financial crisis.
For this reason, there has even been talk of possible federal bail-outs of the largest and worst-off states, though that seems unlikely at present. Republicans in control of the House of Representatives are resistant; and Ben Bernanke, Federal Reserve chairman, has said states should not expect loans from the central bank.
HOPES FOR GROWTH PUSH OIL TO WITHIN REACH OF $100
Oil has risen to within reach of $100 a barrel for the first time since the 2008 price spike amid mounting optimism that global economic growth will boost demand.
But the sharp rise has also heightened concerns about the impact of soaring commodity prices on the global economy, particularly in emerging countries, as it comes on top of high costs for agricultural commodities and metals.
The oil surge also comes on the back of supply disruptions such as this week’s outage in a pipeline in Alaska and strong investor inflows in commodities.
Traders said there was a growing consensus that the Organisation of the Petroleum Exporting Countries was comfortable with prices near at $100 a barrel. In the past, Saudi Arabia, the cartel’s de facto leader, had said it would work to keep oil prices at $70-$80.
Brent crude, the global benchmark, hit an intraday high of $98.8 a barrel on Wednesday, the highest since September 2008, when oil prices were in the midst of a collapse from their $147-a-barrel record.
“Brent can hit $100 any day now. There’s a lot of upward momentum,” Michael Wittner, at Société Générale, said.
The cost of premium quality crude varieties in the physical market, such as Tapis of Indonesia and Bonny Light of Nigeria, surged on Wednesday above $100 a barrel.
The strength in the rebound in oil consumption last year surprised many, with demand growing at a rate of 2.3m barrels a day, the second-highest in three decades. And oil traders and investors have begun the new year in bullish fettle.
“The consensus demand forecast for 2011 is creeping up day after day,” a senior trader said.
The International Energy Agency, the western countries’ oil watchdog, forecast that consumption would grow this year by a slower 1.3m b/d, but analysts and traders believe it would be much higher, with some pointing to 1.7-2.0m b/d.
But analysts cautioned that Brent could be overbought. While it is flirting with $100, West Texas Intermediate, the US benchmark, is languishing.
On Wednesday, WTI was trading more than $6.50 short of Brent prices at $92.39. The widening gap between the two benchmarks is due to a build-up of inventories at Cushing, Oklahoma, the landlocked delivery point for the WTI contract.
As Cushing has few outlets to evacuate surplus oil, a glut tends to depress the price of WTI relative to other US and international benchmarks
GERMANY CATCHES EURO BUG
When the European periphery sneezes, the German economy does not even blow its nose. Growth has been roaring ahead, ignoring the spread of the Greek disease to Ireland and Portugal. Yet, dig beneath the surface, and some investors are clearly worried that Germany could be infected.
The cost of insuring German debt against default using credit default swaps soared this week to its highest level since the global crisis peaked in 2009. Relative to the US, Germany is the least creditworthy since CDS were created.
This is not because Germany is at risk of defaulting on its debt, unlike Ireland or Greece.
Rather, Germany seems likely to be principal financier of a eurozone fudge to rescue the periphery – hurting its credit. That should be bad news not just for German CDS, but for Bunds, 10-year government bonds, too. Their yields have not risen enough to reflect potential rescue costs.
There are two ways the periphery could avoid taking German money. The first, default, would spark a German banking crisis, again pushing up Bund yields.
The second, rapid economic growth, is highly unlikely but could allow the periphery to outgrow its troubled finances. This would raise both the prospect of eurozone inflation and the chances of the European Central Bank raising rates, either of which would push Bund yields up.
There is one plausible resolution of the crisis where German yields do not rise. But if Germany pulled out of the euro it would be a disaster for almost everyone, German bondholders excepted.
Before rushing to sell Bunds, remember Germany is still Europe’s financial haven. Yields are highly likely to rise eventually but could easily go sharply lower first. The latest eurozone patient, Portugal, was accepting visitors on Wednesday after a successful bond auction. Next time it is rushed to intensive care, Bunds will benefit from a flight to safety, and yields will fall.
The Audacity of HOPE 