Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Print Print Cite Cite
Style: MLA APA Chicago Close


It is hard to bet on curve flattening when the curve is already flat

by Brad Setser
January 30, 2006

Or spread compression when spreads have already compressed.

As David Altig kindly noted, I was quoted in Clint Riley's Wall Street Journal story about the impact of a flat yield curve on bank earnings:

There is a very flat yield curve globally for different reasons, even in some emerging markets," said Brad Setser, head of global research for the Roubini Global Economics Monitor, a New York-based economics Web site. "I really don't see where the easy money is. No matter how sophisticated you are, you can't get away from the basics of banking: Borrow short, lend long."

Why no easy money?   Here is what I see:

A flat yield curve in many advanced economies.  There is no money to be made borrowing short and lending to the US government, for example.   The globally flat yield curve probably has a thing or two to do with oil – with oil at $65, the big oil exporters could earn something like $830 billion on their oil exports this year (assuming OPEC and Russia produce about 45 mbd of crude and similar product, and consume maybe 10 mbd, leaving 35 mbd in net exports).  And a lot of that money is being saved, not spent. 

Thin credit spreads.  Last year, William Pesek spoke of Kate Moss thin credit spreads.  That hasn't changed much.    Low spreads mean that the banks cannot make much money by taking on additional credit risk – and are exposed to losses should credit spreads widen (if they mark to market).

A flat yield curve in many emerging economies.   There is no money to be made taking in short-term deposits in say Brazilian real and then buying longer-term real denominated bonds.    Yes, you can make money if long-term real rates fall.  But it not so easy to make that bet when the Brazilian yield curve has inverted, and you lose money waiting for long-term spreads to fall.  Brazil's over night rate is 17.25%, one-year Brazilian bonds yield 16.1%.

Where is there money to be made?   Well, by taking on a bit of currency risk.

Borrow short-term in dollars, euros or yen, and buy high yielding Brazilian real, among other things.  

But there are limits (one hopes) on the banks' willingness to take on currency risk.  Commercial banks are not central banks.

Still, there is a reason why money poured into Brazil in 2005, and earlier this month.

The scale of these flows to a range of emerging economies is rather remarkable.   As is the scale of the resulting increase in the reserves of many emerging markets.

By my rough calculations Brazil added something like $25 billion to its reserves in 2005.  A bit more actually.  See Gray Newman.  The central bank's intervention does show up in Brazil's headline reserves because Brazil paid back its entire IMF loan last year.  But Brazil's net reserves (reserves – IMF loans outstanding) soared from $27.5 b to roughly $54 b during the course of 2005.   And it looks like Brazil added another $3 b to its reserves this January.

Turkey's net reserves increased by something like $23 b in 2005.  And Turkey, unlike Brazil, is running a current account deficit – which makes its reserve increase all the more impressive.

Argentina added something like $13 billion to its net reserves in 2005.  That's why it was able to repay the IMF.

All told, the net reserves of Brazil, Argentina and Turkey increased by about $60 billion in 2005.   For comparison's sake, that is just about as much as the IMF lent out to these three countries in 2001 and 2002.    And those were very big loans by the IMF's standards. 

No doubt, the fundamentals of these countries have improved.   All have far better fiscal stories now than in 2000 – or 1997.   But it is also hard to avoid the conclusion that these recent flows have been driven in large part by developments in the advanced economies.   Right now, there is no shortage of appetite for emerging market paper.

All three countries needed to build up their net reserves, which were on the low side.  They are not China.  But looking ahead, they will have to balance the benefits of higher reserves against  the costs.  Those costs are higher — or at least more visible — if local interest rates are high. Brazil's central bank loses money when it sterilizes its growing reserves even if the real/ dollar stays stable. China's central bank only loses money if the RMB appreciates.


  • Posted by Dave Chiang

    The flat bond yield conundrum that you describe can be attributed to foreign Central Banks and leveraged Hedge Funds purchasing a record amount of Treasury debt. This is always heralded as still more good news by the “happy talk” Economists. The spin was that this unprecedented increase in foreign lending indicates growing foreign confidence in America. This is analogous to a credit card junkie celebrating a record month of charging as as proof of continued bank confidence in his creditworthiness.

    The only “good’ news is that the absence of strong foreign demand for Treasuries would be an even bigger short-term disaster. With little in the way of domestic savings to pick up the slack, waning foreign demand would cause treasury prices to collapse, sending interest rates soaring, asset prices tumbling, and the U.S. economy into a severe recession. The news that foreigners continued to spike America’s punch bowl merely assures that our ultimate financial bubble hangover will be that much more debilitating.

  • Posted by realist

    so david, where are you putting your money?


    you talk about argentina’s turn around. didn’t they accomplish that by paying back foreign creditors with dimes on the dollar? let’s talk about the unthinkable. the u.s. has done a lot of unthinkable things, lately. it has alienated most of it’s allies, spied on it’s citizens, got itself into an almost bankrupting war under false pretenses, has run up the highest twin deficits in history, and is destroying its own envirment. why would one think the present u.s. rulers incapable of pulling an argentina on the rest of the world. they could come up with lots of justifiable reasons. why pay the chinese back, aren’t they communists that steal our jobs? why pay the arabs back? after all, they hate us. the french and germans are sissies. the japanese can’t survive without selling to us. and, after all, countries are still doing business with argentina.

    maybe i’ll just put my money in new zealand three month notes at 5.75%.

  • Posted by psh

    Lotsa currency risk in NZ, since S&P called their current account deficit unsustainable at about, I dunno, a percent more than ours

  • Posted by realist

    then again, sir john templeton says:”More Factors: The Weakening Dollar and What Are Good Currencies?

    Let’s not use the word “good.” Let’s say “less risky” currency. The less risky currencies are probably South Korea, Singapore, India and NEW ZEALAND.”

  • Posted by malabar

    Asset markets are in a melt up. Equities in Brazil up 13%, Russia up 22%, Turkey up 13%, Iceland up 15%, Mexico up 6%. Commodities from Oil to Coffee to Sugar up. Precious Metals up.

    Liquidity rules.

    The only markets under any kind of pressure it seems are US Treasury’s and RE.

  • Posted by realist

    interesting, and scary, perspective on america’s future economy:

  • Posted by dryfly

    That first post by realist sounds like a guy running for public office… dump the debt on the ‘other guy’. LOL.

  • Posted by Fewlesh


    the best place to put cash in a global liquidity gusher is gold/oil. Gold is on a hockey stick now. Look at what happened in 1981. Once a gold bull gets on an exponential kick, the central backers are going to have a very hard time taming it.

    Central bankers will eventually have to squash the gold, otherwise it will become the currency of choice.
    Unfortunately, for them, they have waited far too long.

    I could replace this with any commodity, but gold is a very good example:

    because gold is a resource where it is easy to control the scarcity:

    do (buy gold with borrowed money) until (interest rates on borrowed money are higher than the appreciation on gold)


  • Posted by Guest44

    I agree with realist. The prez has already more or less said that financial “paper” is meaningless. A few years back who would have expected that we would invade Iraq with no justification other than some hyped up fear-mongering. Who would have thought we’d be hearing justification for nuking Iran. If we have some sort of financial “incident” I think this administration would be easily capable of convincing us that it was imperative to disown treasuries owned by the Chinese, oil sheiks and maybe others. Besides, Americans don’t like to be inconvenienced, and paying our foreign debt is going to be one very big inconvenience.

  • Posted by psh

    Interestingly, ICPHX, one of Templeton’s old funds, has lightened up on NZD, figuring, I spose, that the terms-of-trade/commodity-price bounce is mostly behind them.

  • Posted by psh

    Yeah, disturbing, that Gulf News piece — they’re going to stockpile crude on Hainan, China’s Hawaii? So much for the vaunted tourism there. That’s some really nice beach and you know they’re gonna wreck it.

  • Posted by bsetser

    Realist — Argentina’s debt was denominated in dollars, which it couldn’t print. and the $/ peso appreciated at the wrong time for Argentina. US debt is denominated in dollars, which the US can print. I doubt that those buying long-term treasuries at 4.5% will get a great real yield, at least in terms of their local currency. but the US can reduce the real value of its external debt through depreciation, an option that Argentina never had.

    I found the Gulf news article a bit over optimistic on the potential for India and chinese domestic demand to take over from the US. I certainly hope that is the case. But i agree with Roach — the hand off won’t be easy. And just cause China and others accounted for a lot of domestic demand growth in the past couple of years doesn’t mean they will in the future. China’s surge in investment explains that, and even in my best case scenario, a surge in consumption only keeps Chinese domestic demand growth from falling off its current pace, as consumption replaces investment. I don’t see a big acceleration.

  • Posted by realist


    you say, “the US can reduce the real value of its external debt through depreciation”. that’s true, but in a world in which china and the u.s. compete for foreign investment capital, a depreciated dollar is going to attract far fewer foreign investors than a dollar-pegged, or un-pegged, yuan, from a strong economy. we all agree that the debt-ridden u.s. consumer domestically-driven economy is living on BORROWED time (pun intended). and that, aside from housing units, pretty much the only other domestic product that can be bought in america is a politician. china, on the other hand, has a booming export-driven economy, and a fast growing domectic economy. why would foreign investors continue to invest in a weakening u.s. economy, where the consumers will have had to put a lid on their consumption? the more the dollar depreciates, the more the interests rates must appreciate. high interest rates will put an end to all this liquidity, and throw the u.s. into recession.

    you have referenced “dark matter” often. this is where the u.s. makes more from its forein investments than foreign investors make on u.s. investments. isn’t it probable, that once we have a recession, foreign investors will also discover, that their money will realize a greater return elsewhere?

  • Posted by realist

    it’s safe to say, that foreign ivestors are moving heavily into the asian markets. in korea, “foreign investment now accounts for 40 percent of the local capital market, compared to just 11.9 percent 10 years ago.” this appears to be a growing trend.

  • Posted by Dave Chiang

    Reply to Realist,

    So where should we be investing our money? Certainly not in real estate. Definitely not in bonds. Absolutely not in the general stock market. What’s left? Well, there is cash (at least you won’t lose your shirt if you hold it in something other than U.S. currency); gold bullion which performs well in such a chaotic environment (and by extension mining company shares and/or their warrants) and also energy stocks because of the political climate being the way it is in the Middle East. Pay off your debts, build up your savings and invest accordingly and you will be protecting yourself from what could well become our country’s (and the world’s) worst nightmare.

  • Posted by realist


    this,, gives your gold play validity (if foreign gold reserves aren’t dumped to support currency), but what do you think will happen to energy stock prices after “our country’s (and the world’s)worst nightmare” ensues?

  • Posted by DF

    There is one easier explanation of the inverted yeld curve.
    THe market knows that the debt/GDp ratio is too high, it knows deflation is bound to come, it knows that whatever growth in 2006 it is going to be higher than in the future years. It knows that whatever default rates in 2006, they will be higher in future years.
    Hence inverted rates.

  • Posted by Charlie

    Dave Chiang,
    Is your first response copied and pasted from every response you make regarding China?

    If Asia didn’t interfear in the foreign exchange market at a rediculously high level, the US Current Account problem would have self corrected as it should have. The asian central banks are the ones who created this mess with their currency protection policies, not the US consumer. In the end, China will find out that all the stuff they’ve created over the past few years didn’t make a profit and they’ll be stuck with a bunch of citizens who have nothing to show for all their hard work.

    Brad is right that the US can print their way out of debt and those holding a lot of USD (China et al) will be the big losers if the US decides to take that route. China will have a big pile of USD and a country seriously depleted of resources for all their efforts.

  • Posted by malabar


    I have noticed that many folks believe what you stated – “the more the dollar depreciates, the more the interests rates must appreciate.”

    Is this some kind of truism?

    But I am curious why the Fed would want to defend the dollar. They gain two obvious benefits by a depreciating dollar – dollar debt gets devalued and US exports become more competitive. The only folks who have fought dollar depreciation in recent times are foreign central banks like the Japanese and Chinese. So if they continue that policy then one can expect market rates to not rise.

  • Posted by realist


    you state: “But I am curious why the Fed would want to defend the dollar. They gain two obvious benefits by a depreciating dollar – dollar debt gets devalued and US exports become more competitive.”

    what u.s. exports are you talking about? we are an importing nation. large american corportations do export jobs to asia, so that they can import inexpensive foreign goods and informantion technology back into the u.s. if the dollar devalues, the costs of these goods and info will go up, causing americans to buy less. this hurts the bottom line of large american corporations and of the retail stores that sell those imports. retail and real estate drive our economy. kill those things, and you’ve killed main street and wall street.

    a large percentage of the liquidity in this country, comes from foreign investors. if the dollar drops, they get a much lower yield on their investments. the only way to give them a competitive yield, is to raise interest rates to compensate for what they are losing in the currency exchange. so, if we raise interest rates, americans buy less. if we don’t raise interest rates, foreign investors stop funding our debt. either way, we are headed into recession.

  • Posted by Dave Chiang

    The global trade imbalance is boosting the odds of a long, deep downturn in the entire world economy whose consequences both China and US will not escape. Asian Central Banks are stockpiling US Dollar financial wealth that will never be honored for the welfare and enrichment of their citizens – a Ponzi scheme. China and India do not have the scale to compensate for a loss of US consumer demand. The bottom line is that an imminent slowing of the American consumer probably spells a weakening of global consumption and world GDP growth.

  • Posted by Charlie

    The US is the world largest exporter. Not by much and China will probably surpass us in the next few years. The US trade deficit is due to the US being, by far, the worlds largest importer.

    In economic theory you are correct that a falling dollar should cause interest rates to rise, but theory, as recent history has shown, is thrown out the window when dealing with foreign central banks. CB’s aren’t interested in making a profit so they won’t be as concerned with currency losses as a private citizen or private company. They loan dollars to the US so they can get a better return than the 0% they would get by just sitting on the money. The only way the falling dollar could effect interest rates is if the dollar depreciates at a greater rate then the yields it pays. So long as it keeps pace with yields, interest rates will be OK or not too badly effected.

  • Posted by Guest

    Just a small correction:
    Currently Germany is the world’s largest exporter.
    2004 data: Germany (900 bln), USA (800 bln), China (600 bln USD)

  • Posted by malabar


    My contention is that the Fed has no incentive to defend the dollar. Asian central banks do. And they are non-economical actors. The Japanese central bank has massively intervened in the past. You are correct that if the dollar depreciates foreign private investors would be less likely to invest in dollar assets and imports would cost more. However, whatever little the US exports would become more competitive. We went through this cycle in the 80s when Jim Baker forced dollar devaluation using export competitiveness as the rationale. I just don’t think it is a given that if the dollar depreciates market rates would rise. And imported manufactured goods need not rise even if the dollar depreciates as the Chinese may be willing to accept less or even no profits to keep their employment going in the name of national stability. Yes, US companies with offshore manufacturing will make less but in any case they are using their current record profits to buy back stock not invest in new plant and equipment. On the other hand, their foreign earnings would be magnified on a converted basis.

    I do believe that we are trading at the lows of the interest rate cycle and although consensus opinion is for further rate declines as the economy slows due to consumption declines, market rates could rise. I think there is even a decent probability for a stagflationary environment and a steeper yield curve.

  • Posted by realist


    in these pump and dump days, all to often, a company buys back its stock to get its insiders out. the ordinary stockholders are usually the loosers.

    the currency arbitrage can is a big deal. honda, which had a booming sale’s year, actually saw its profits fall 12% y/y, by misjudging the strength of the dollar. it should be better off betting on a weak dollar by the end of this year. i hope you and brad are right about seeing only moderate rate increases this year. i still have some real estate i need to sell.

  • Posted by Charlie

    I don’t know where you get your data, but I was under the impression that the US has been exporting over $100Billion/month in 2005 and I think in 2004, total exports were over $1.1Trillion. The problem is we’re currently importing something like $170Billion/month.

    Maybe you’re strictly looking at goods and not including services.

  • Posted by malabar


    I believe the the yield curve will steepen by the end of this year. Long rates rising and Fed rates declining. My biggest concern are low risk premia across the spectrum of securities and complacency as seen in volatlity. I don’t believe the markets have adequately priced in any kind of shock that impairs the current goldilocks confidence.

    If buyers don’t show up this spring, RE should have tough sledding the remainder of the year and that could seriously impact confidence.

    My big bets right now are increase in risk spreads and volatility.

    I too feel like you and others that our country is on the wrong track, but until the rest of the electorate feels the same and acts, we’ve got to live with what we have.

  • Posted by bsetser

    Guest’s data is goods only. It is also a bit dated — most notably for China, which exported $ 750 b of goods in 05 and now exports (at least in q4) just about as many goods on a monthly basis as the US. admittedly, china’s exports peak in q4 for seasonal reasons, but there is little reason to doubt that Chinese goods exports are just about to surpass those of the US. that is a huge change from say 2001.

  • Posted by HZ

    “Reply to Realist,

    So where should we be investing our money? Certainly not in real estate. Definitely not in bonds. Absolutely not in the general stock market. What’s left? Well, there is cash (at least you won’t lose your shirt if you hold it in something other than U.S. currency); gold bullion which performs well in such a chaotic environment (and by extension mining company shares and/or their warrants) and also energy stocks because of the political climate being the way it is in the Middle East. Pay off your debts, build up your savings and invest accordingly and you will be protecting yourself from what could well become our country’s (and the world’s) worst nightmare.
    Written by Dave Chiang on 2006-01-31 07:52:22”

    Funny. Did you (Dave Chiang) write the following also:

    or did you just copy and paste from that site?

  • Posted by Guest

    dave, dude, you are like sooo busted by HZ.

  • Posted by Anonymous

    And so what of the dead flat yield curve (speaking of busted)? Can banks survive in this desert of zero spread? How do the hedge funds work around zero spreads? Is this likely to be a short duration phenomena? If you were about to buy a house would you opt for the 1yr adjustable or for the same rate, the 30yr fixed? If you could see nothing but an increasing debt/GDP ratio in the future and hence an increasing likelihood of serious currency debasement via higher rates, wouldn’t you opt for the 30 yr fixed? Won’t the demand for long term money escalate and push that yield curve back out?

  • Posted by DF

    gee my post got lost.

    Anonymous your conclusion is really strange. Rising debt/GDP ratio means 100% certitude of future defaults, hence endogeneous debt based money destruction hence deflation and lower rates.

    THere s a high chance that a major recession in the USA would solve most of it’s deficit problem and most of it’s need for foreign capital.

  • Posted by DF

    Realist, investing in china will be the last thing to do once the US market stops to absorb chinese products.
    China is the heater of the world economy, its growth has been more intense hence it’s depression will be too, just like US and germany suffered more in the 30’s

  • Posted by realist


    i’m not an advocate of investing in an country with an economy as rigged as china’s. i am an advocate of (and have put my money where my post is) investing in energy stocks. i started when bush first got elected, and see no reason to stop now.

  • Posted by DF

    well coal liquefaction, nuclear, solar and wind energy should do great, but I would not bet much on oil.
    OIl will suffer from dwindling reserves, dwindling production. Of course peak oil ensures oil producers A monopoly advantage.
    Anyway, I can’t see how you can beat cash in the coming years, except by shorting the markets.

  • Posted by HZ

    If you believe in deflation is coming it is rather strange that you want to be in cash. Even at zero inflation the current long dated Treasuries are great rewards. In comparison TIPS only yield 2%. You could short TIPS and long Notes and make a bundle.

  • Posted by DF

    HZ agreed. I should have said any cash like investment.

  • Posted by OldVet

    Realist, you got in oil stocks in 2000? Wish you’d been advising me! I let my personal politics get in the way of investing in US oil companies out of pure stubborness, and I’ve forgone the stellar results over the last six years.

    David Chiang, I don’t see the aversion to non-US equities, though. There are going to be business cycles till the end of time, due to lead/lag behavior in investment and the cycle of overbuild/underbuild, which is famous in the agricultural sector. If you’re riding short term waves, you might be leery of foreign equities. But longer term, it’s just investing in the future. Like with Realist’s bet with oil stocks.

    Cash is not a bad place for the very conservative investor – just not US cash. I personally favor Thai Bhat and Canadian dollars right now, most Asian currencies in the longer term. Not much of a liquid market for Indian rupiah or Korean Won, unfortunately, but they’d be good over the longer term too. Korea’s reforming their financial sector and it’s going to pay off, as are its exports and investments in China, a market they exploit skillfully. NZ and Australian currencies are pumped with commodity sales which might decline in a real-economy slowdown in Asia.

    Probably the best short term currency play is Icelandic currency paying 8% in CD’s short term, though I’m not in it. I’m holding emerging market equities right now, and think they’ll be good in 2007. Going to keep a very very close eye on them, however. I can’t tell whether Indian and Chinese and Russian and Japanese consumption increases can make up for shortfalls in US, but Brad Setser’s been obviously scoping out the situation and has come down on the side of “not.”

    Gold? Shoot, I wish I could be a believer, but I’m not, and it’s just a prejudice on my part. Oil – I think investing indirectly through Russian and Canadian equities is okay if not perfect.