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Uncharted waters ahead for U.S. economy

While most people might think of an economist’s work as being mind-numbingly boring at times, this is possibly the golden era of challenging times for economists. Never has the ship of the economy been rushing full speed into a more complex myriad of challenges and uncharted waters than it will face in 2009.

President -elect Obama is projecting trillion-dollar deficits for years to come, and many wonder just where all that money will come from. Traditionally, deficits are financed by the sale of treasury bills to investors, and generally most of the money comes from foreign investors. China and Japan have been the two largest creditors of Uncle Sam, holding hundreds of billions in our debt.

In the last five years, China has spent as much as one-seventh of its entire economic output buying foreign debt, mostly American. In September, it surpassed Japan as the largest overseas holder of treasury notes. But now Beijing is seeking to pay for its own $600 billion stimulus ” just as tax revenue is falling sharply as the Chinese economy slows. Regulators have ordered banks to lend more money to small and medium-size enterprises, many of which are struggling with lower exports, and to local governments to build new roads and other projects. (Does this sound hauntingly familiar to our own situation?)

All the key drivers of China’s treasury purchases are disappearing ” there’s a waning appetite for dollars and a waning appetite for treasuries, and that complicates the outlook for interest rates. The lower the demand for treasuries the higher the interest rate will have to go to attract buyers.

In addition, the Chinese have been buying mortgage backed securities, which dictate home mortgage rates. A decrease in demand for mortgage securities means rates on home loans will have to increase.

The U.S. is banking on its good name to allow it to borrow almost unfathomable amounts of money, but what happens if buyers suddenly go away? Treasuries (and many would argue, mortgage backed securities as well) are in a bubble that has got to pop. They may not happen simultaneously, but it is going to be something to behold when it does happen. Rates will rise dramatically within days, and could remain unstable for months.

As a example of how thinly insulated the market is from ups and downs the past week in mortgage backed securities market saw a dramatic increase demand and subsequent improvement in mortgage rates fueled by a relatively small action by the Federal Reserve purchasing about $10 billion in mortgage backed securities. That amount of money is peanuts compared to the $12 trillion in mortgage backed securities floating around, yet it was enough to absorb supply, push up the prices these securities were selling for and tamp down rates.

Imagine what might happen if things went the other way and China pulled out twice that much money from the mortgage backed securities market? Mortgage rates would likely have soared a quarter-percent, a half percent, or more.

If foreign buyers shy away form buying US T-Bills and mortgage backed securities the U.S. Treasury could, in theory just print more dollars and buy these securities themselves. That is what they did last week in the mortgage markets and have vowed to continue to do at least for the next several months, but the overwhelming danger to that would be the U.S. dollar would lose value and respect, possibly fueling runaway inflation.

Many would argue that the impact would be mitigated by the tremendous loss of wealth that has occurred in the last 18 months as commodity, stocks and real estate have plummeted. In theory, replacing wealth that has been recently lost would put the entire picture back to zero, at least initially.

There are no easy answers, very few predictable outcomes and a mountain of uncertainties out there. Let us hope that somehow the U.S. economy comes through this storm better than most of the world’s economies do and that we remain the preferred haven for stable investment. And let’s not forget, all that borrowing will have to be paid back someday by all of us.

Chris Neuswanger is a mortgage loan originator with Macro Financial Group in Avon and can be reached at 970-748-0342. He welcomes mortgage-related inquiries from readers.


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