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Middle East/North Africa
Currency Union ­— Disunited They Stand
June 15, 2007

By Serhan Cevik | London

With deepening cracks, currency union in the Gulf looks like becoming an unattainable aspiration. On the surface, the six countries of the Gulf Cooperation Council — Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates — represent an ideal group for a common exchange rate regime and monetary unification. However, turning the idea of the ‘United States of Petrodollars’ into reality is proving to be easier said than done, even as these countries keep enjoying enormous gains from the global commodity boom. Officially, there is (as yet) no change in the launch date — January 2010 — for the common GCC currency, and indeed central bank authorities are working around the clock to finalize the (draft) proposal by the end of this month. Nevertheless, we see deep-reaching cracks throughout the region that may well delay (if not shelve altogether) the planned monetary union beyond 2010. The first fracture occurred when Oman opted out of monetary union, admitting its unwillingness to meet the convergence criteria. And then, Kuwait moved ahead, in a unilateral fashion, with de-pegging its currency from the US dollar — a common feature of all GCC economies that is supposed to be the exchange rate platform prior to the launch of the new regime. In our view, these developments highlight the extent of fault lines challenging the establishment of a viable currency union.

Kuwait’s move to abolish the dollar peg could become the trigger for a comprehensive adjustment. Kuwait’s decision to remove its exchange rate peg to the dollar and revalue its currency is an important policy shift, in our view, even though we think that the adoption of a new peg to an undisclosed currency basket is not enough to bring necessary adjustments. Until Kuwait’s (marginal) move, GCC authorities had not focused on economic imbalances and had dismissed the case for currency revaluation. This is why we think that Kuwait’s decision to drop the dollar peg, coupled with Oman’s resistance to the convergence criteria, may encourage other GCC countries to push forward in a more comprehensive manner. Indeed, although Kuwait’s unilateral move to abolish its dollar peg is a sign of policy divergences — coming just a couple of years before the planned monetary union — it could also become the trigger for a region-wide adjustment initiative. After all, we think that the enormous increase in export revenues alone — raising the region’s cumulative current account surplus from 5.4% of GDP in 2002 to 24.6% last year — justifies the revaluation of GCC currencies (see The Case for Revaluation, May 15, 2007). However, macroeconomic imbalances have moved beyond exchange rate misalignments and broadened throughout the Gulf region.

High and variable inflation rates present an immediate threat to monetary unification. Other GCC members have so far refused to follow Kuwait’s first steps in dealing with currency misalignments, but that does not mean the problem doesn’t exist. Abundant liquidity and expansionary economic policies have fuelled economies with inflationary consequences, just like a perfect ‘Dutch disease’ script. The average inflation rate has already increased from 0.1% from 1998 to 2002 to 4.5% at the end of last year. Although official price indices — underestimating inflation because of measurement errors and administered prices — give a misleading picture, the inflation problem is spreading out every passing month. In Qatar, for example, consumer price inflation surged from 3.2% at the end of 2003 to 11.6% in 2006 and then to 15% in the first quarter of this year. Fiscal and monetary expansion may be at the heart of the problem, but we should not ignore the role of undervalued currencies. Despite the massive oil windfall, GCC currencies pegged to the dollar have depreciated and become a source of imported inflation (see Pegged Pains, February 20, 2007). In short, we think that the abundance of petrodollar liquidity, accommodative economic policies and undervalued currencies create a dangerous triangle threatening the sustainability of convergence criteria for the planned monetary union and, more importantly, economic development in the longer term.

Correcting currency misalignments would help in uniting the GCC and addressing global imbalances. On our assessment, the GCC does not meet the preconditions for monetary integration and still faces structural shortcomings that are likely to challenge the sustainability of currency union in the long run (see What Would Mundell Say?, April 3, 2007). However, we think that Gulf countries can also turn these bottlenecks into an opening for structural progress and economic diversification. Of course, the first building block of any kind of structural adjustment programme must be macroeconomic stability, and this is why we hope that the authorities focus on the immediate threat of inflation. Across the region, inflation is on the rise, reaching as much as 15% in the case of Qatar and 13.5% in the United Arab Emirates. The abundance of petrodollar liquidity and the resulting spending boom may be the original culprits, but undervalued exchange rates are also exacerbating inflationary pressures. Therefore, since these countries lack financial depth and sophistication to effectively sterilize excess liquidity, we think that anti-inflation strategies must utilize the revaluation of currencies to normalize inflation dynamics. In our view, correcting exchange rate misalignments would help in uniting the GCC and addressing global imbalances.

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Misalignments, Manipulation and Intervention
June 15, 2007

By Stephen Jen and Luca Bindelli | London, London

Summary and conclusions

We believe that the core cause of currency misalignments may be financial globalisation.  Specifically, the extraordinarily rapid pace of financial globalisation, which, in turn, was fueled by buoyant financial markets and low implied volatility, may have pushed most G10 exchange rates far away from the fair values (FVs) implied by traditional valuation models that are centred on real economic fundamentals. 

This idea we have has several policy implications.  First, exchange rates are likely to remain misaligned as long as financial markets remain buoyant.  Only if we experience a violent bout of risk-reduction would the G10 exchange rates move back to their FVs.  Second, a ‘Plaza-like’ intervention effort to wrestle the exchange rates back toward their FVs may not be successful, since central banks would need to counter the structural forces, rather than fickle speculative flows, of global capital.  This means that the shift in focus in US legislation on exchange rates from currency manipulation to misalignment will likely encounter significant obstacles in practice. 

Exchange rate fair valuation

We have updated our quarterly FV calculations; there were no major changes to these estimates from the previous set.  Specifically, EUR/USD, GBP/USD and USD/JPY remain grossly overvalued.  EUR/JPY is still the most misaligned cross in the G10 space.  The three commodity currencies, the AUD, NZD and CAD, also remain meaningfully mis-priced.  Like the JPY, the CHF is also undervalued. 

Currency misalignments are here to stay?

The G10 exchange rates have been misaligned for so long that we are starting to wonder if we are missing a part of the story, i.e., there may be important qualifications we need to acknowledge when interpreting the traditional approach to currency valuation. 

We have the following thoughts: 

·   Thought 1.  Financial versus trade globalisation.  Most valuation frameworks, including ours, are centred on different aspects of the real economy.  For example, productivity growth, the terms of trade and fiscal positions are all concepts that are more closely related to the real economy than to the financial markets.  While equity and bond prices should indirectly reflect these fundamental features of an economy in question, large cross-border capital flows, which could be driven by factors other than the real fundamentals, could have substantive effects on exchange rates. 

Two good examples are the JPY and CHF.  It is remarkable that the currencies of two of the largest net savers in the world are also the weakest in the world, despite the fact that Japan’s 1Q growth was 3.3% — faster than any of the G7 countries except for Canada — and Switzerland’s 1Q growth was 3.2%.  Further, both of these economies are growing above potential. 

EUR/JPY is another example.  Most valuation models suggest that this cross rate is extremely overvalued.  However, the trend from 2001 has been powerful and definitive.  Our ‘Global Funnelling Hypothesis’ is a capital flows framework, divorced from the relative economic fundamentals of Japan and Euroland. 

The fundamental variables that used to dictate currency trends — and are key input variables to our valuation framework — for the time being no longer seem to have the same impact on exchange rates that they used to.  Instead, capital flows and nominal variables (such as cash interest rates) seem to dominate.   Importantly, during the sharp risk-reduction in February/March, all of the G10 exchange rates we track moved toward their fair values!  This suggests to us that capital flows, not economic fundamentals, somehow dominate the currency markets, and have played a critical role in pushing exchange rates into territories that are considered ‘misaligned’ relative to the real economies. 

·   Thought 2.  The US Senate Finance Committee’s proposed bill is not bad.  In the bill put forward on Wednesday by Senators Baucus, Grassley, Schumer and Graham, it was proposed that, if currency misalignments resulting from distorted policies (the ‘malign’ type of currency misalignments) are not resolved after 360 days, the US Treasury, in consultation with the Fed, could consider outright currency intervention.  We have these thoughts: 

First, this bill is not nearly as protectionist as it could have been, as it does not contain automatic triggers for countervailing duties.   

Second, it does not mandate but only allows the Treasury to decide on outright currency intervention.  Assuming that the US Treasury tries to do things in the best economic, not political, interest of the US, it would not hastily conduct interventions.  

Third, one way we judge to see if a policy is ‘good’ is to ask what the economic impact would be if other countries were to adopt the same policy.  We believe that this particular bill is sensible enough that if Euroland and Asia were also to adopt this bill, the net impact on the global economy would not necessarily be negative. 

Fourth, in practice, however, there would be operational issues, particularly regarding emerging market currencies such as the CNY.  If the US Treasury were to decide to intervene to sell dollars and buy CNY, it would be difficult for it to implement this trade without the consent of Beijing

Fifth, this bill presumes that the JPY misalignment is considered ‘benign’, while the CNY misalignment is considered ‘malign’.  Under this bill, no action can be taken regarding the JPY. 

·    Thought 3.  Measures of misalignments are subjective.  Currency misalignments are essentially the differences between the spot exchange rates and what one may consider is the ‘correct’ price for the currency, based on some economic fundamental variables or other considerations.  While this may sound straightforward in theory, in practice, there is no one ‘correct’ equilibrium price because different practitioners consider different variables in coming to that view.  For example, for USD/CNY, there are estimates of misalignments ranging from 5% to 50%.  In fact, in a recent paper issued by the US Treasury, the subjective nature of currency valuation was highlighted as a source of major policy complication. 

The subjective nature of currency valuation will make it difficult for the US and other countries to agree on whether and by how much a certain exchange rate is misaligned. 

·   Thought 4.  Currency interventions in the G10 space may not be effective.  On Monday, June 11, 2007, the RBNZ conducted its first intervention since the float of the NZD in 1985.  We are not convinced that its intervention will be effective in capping NZD/USD, though it could be an effective way for the RBNZ to accumulate some foreign reserves.  Like many other countries, the RBNZ faces the ‘impossible trinity’ or the policy ‘trilemma’ of trying to target both interest rates and the exchange rate with an open capital account.  If we are right that global capital flows have fundamentally distorted exchange rates and pushed them away from their FVs, the RBNZ would be ‘taking on’ these private sector flows.  In the end, 8.00% of ‘risk-free’ government bond will likely remain attractive to many investors in the world. 

Bottom line

We have become introspective about the concept of fair valuation of exchange rates, and have come to the view that FV calculations may be fundamentally ‘biased’ in that they are usually based on real economic fundamentals.  But with financial globalisation and the sharp surge in cross-border asset holdings, persistent exchange rate misalignments could simply reflect differences between capital markets and the real economies.  This hypothesis of ours suggests that exchange rates will likely stay mis-aligned, as long as financial globalisation continues, and that policy makers should exercise care when contemplating intervening in the currency markets.

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USD to Reassert; Non-G4 Currencies to Shine
June 15, 2007

By Stephen Jen | London

Summary and conclusions

We are refreshing our currency forecasts.  While keeping our view on EUR/USD and USD/JPY essentially unchanged (EUR/USD to trade below 1.30 and USD/JPY to eventually break lower in 2008, conditional on several assumptions), we are revising up our forecasts for the commodity currencies (AUD, NZD and CAD).  We believe that the global economy will continue to benefit from trade and financial globalisation.  While there may be sporadic inflation scares, we foresee an essentially ‘Goldilocks-like’ global environment.  As a result, we expect risk-taking to resume after the bond markets stabilise, and continue to believe that emerging markets (EM) should, in general, be well placed to outperform.  

Our forecast update

Our last forecast update was on March 22, 2007.  Back then, we called for another bout of generalised USD weakness in 2Q, as the US drifted deeper into a soft patch.  We warned, however, that this was a cyclical trade, and that when the US economy began to recover, so would the dollar.  We rejected the counter-argument about a US recession and the rest of the world being dragged down with a slowing US.  

The main changes to our forecasts are limited to the commodity currencies: the CAD, AUD and NZD.  I make the following points: 

  • Point 1.  Very positive global outlook, both cyclical and structural.  I believe that we are re-entering a ‘Goldilocks’ environment, courtesy of trade and financial globalisation.  While there may be inflation scares, I expect disinflationary pressures from globalisation to persist, preventing these scares from turning into actual spikes in inflation.  Indeed, fast-growing economies such as Australia, Japan, Switzerland, Sweden and Norway continue to experience surprisingly low inflation rates, partly as a result of tame import prices, rapid productivity growth and immigration — all of which are related to different aspects of globalisation.   Elsewhere, in large EM economies, inflation remains well-contained.  We calculated that the 19 largest EM economies saw their weighted average inflation rate decline from 3.4% in 2006 to 2.8% in 1Q.  Circling back to the US, our US economists, Dick Berner and David Greenlaw, see the core PCE declining from 2.2% in 2006 to 2.1% in 2007 and 1.9% in 2008. 

As the global economy accelerates, it is likely that inflationary pressures will also mount.  But I believe that central banks will manage to stay ahead of the curve.  

The strength (beyond 5.00% on the US 10Y) of the sell-off in bonds has been surprising. (I wonder if we would have had such a sharp bond sell-off if US growth were 2.3% for both 1Q and 2Q, instead of 0.6% and 4.1% in these two quarters.)  While mortgage convexity hedging may have helped accelerate the move, we don’t believe that it was as powerful a factor as before.  The re-rating of the US economy, without an inflation scare, should not have had such a drastic impact on the bond markets, unless the factors that underpinned global excess savings were also beginning to change.  In any case, the weighted average G3 bond-equity yield spread remains quite supportive of equities, even if interest rates were to rise further.  In other words, I believe that there is still ample scope for the return on equities and that on bonds to converge, with both the P/E ratios and interest rates rising.  In sum, I believe that risky assets should remain supported in this ‘Goldilocks’ environment. 

  • Point 2.  The dollar should gradually reassert itself against most G10 currencies.  As the US economy reasserts itself, so should the dollar.  The sell-off in the dollar in late 1Q/early 2Q was a cyclical move, not a structural one.  Further, as the dollar gains momentum, it is quite likely that some investors will pay more attention to the improving trend in the US current account deficit, and use this as another justification to buy dollars.  Both our US economists and we have argued that the prospective trend improvement in the US external imbalance is genuine, and will persist even when the US economy re-accelerates, because domestic demand in the rest of the world has accelerated in earnest, providing powerful support for US exports.  In addition, I believe that cable will be interesting, as the expected decline in inflation in the UK will likely push cable back down below 1.90.  EUR/USD should be dragged lower as a result.  We continue to see 1.28 as a likely parity for EUR/USD by year-end. 
  • Point 3.  Our JPY-story remains ‘schizophrenic’.  Last summer, I abandoned the view that valuation would push down USD/JPY.  Instead, I acknowledged the importance of the ‘portfolio shift’ story, which has dominated as Japanese retail investors may indeed be going through a historical phase where they raise their exposure to riskier assets.  Since the Nikkei has underperformed other markets, it made sense for Japanese investors to continue to expatriate capital.  The breaching of the 122 mark this week is potentially important, as the market had failed on several occasions since 2005 to break this threshold.  My own view on USD/JPY is that investors should not challenge the trend, as it continues to suggests that the ‘portfolio shift’ theme is more powerful than the ‘economic fundamentals’ theme.  Specifically, as the world starts to tighten again, the JPY could be ‘left behind’.  USD/JPY, therefore, could linger in the low-120s in the coming months. 

The reason why we still have a downward trajectory for USD/JPY over the medium term is to reflect our view that, first, the Japanese economy is doing just fine (1Q GDP growth of 3.3% ranks it number two among the G10 economies, after Canada).  If the global economy is indeed re-accelerating, then the chances of Japan being the next major country to be re-rated by investors are quite high.  Second, the Nikkei’s relative performance is key.  For the past year, and especially during and after the risk-reduction in February and March, the Nikkei underperformed the other major markets.  But with Japan being the only country in the world not susceptible to outright inflation or an inflation scare, it is likely to remain in a ‘Goldilocks’ state for longer than other countries.  As a result, the Nikkei should have a good chance of outperforming from this point forward.  Japanese retail investors so far have taken more risk through overseas assets.  If and when the Nikkei starts to outperform, the JPY can rally, supported by local flows.  This is our central case.  But if the Nikkei continues to lag, we would not recommend that investors put on long-JPY positions.    

  • Point 4.  China and the ‘CNY-bloc’ currencies.  The biggest change in our view is that we now recognise, belatedly, how powerfully the emergence of China has affected the three commodity currencies, the CAD, AUD and NZD.  Although these were previously known as ‘dollar-bloc’ currencies, we would consider calling them, from now on, ‘CNY-bloc’ currencies.  Not only have the positive terms of trade shock and the positive export effects China have had on these economies been significant, but going forward, they are also likely to be the targets of M&A flows and private capital flows.  These three currencies have been performing well since 2002, and I expect them to continue to reflect strength from China and the global economy.  Among the three, however, I believe that the AUD should outperform.  

Bottom line 
We believe that the dollar should reassert itself as the US economy accelerates.  EUR/USD and cable should fall.  We are patient on the JPY call, and anticipate that an outperforming Nikkei will support the JPY by this autumn.  We now believe that the AUD, NZD and CAD can continue to do well, as a derivative of a buoyant Chinese and global economy. 

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June 15, 2007

By Stephen Roach | New York

Two years – 1982 and 2007 – frame the window of my experience as an economist at Morgan Stanley.  When I walked in the door a quarter century ago, my focus was on a $3 trillion high-inflation US economy that was mired in the depths of its worst recession of the post-World War II era.  Today, all eyes are on a low-inflation, increasingly integrated $52 trillion world economy.  There couldn’t be a greater difference between then and now. 

As I look back on the journey, I am struck by three macro milestones: At the top of my list is the extraordinary disinflation of the past 25 years.  When I began working at Morgan Stanley, the ravages of America’s double-digit inflation were just starting to recede.  Following nearly a 12% average annual increase in the CPI in 1980-81, the 6% increase that was unfolding in 1982 came as welcome relief.  Interestingly enough, no one at the time really believed it would stick.  The shock was that it did.  US inflation settled down to a 3.5% trajectory over the balance of the 1980s and memories of the Great Inflation finally started to fade.  This was the defining development for the greatest bull run in modern financial-market history.  On the back of sharply receding inflation, yields on 30-year US Treasuries (the bond market benchmark at the time) were literally cut in half – falling from 11% in early 1983 to around 5% at present – and the S&P 500 went up about fifteen-fold over the same 25-year period. 

During the second half of the 1970s and the early 1980s, we agonized endlessly on how to arrest the Great Inflation.  In retrospect, the cure was painfully simple – a wrenching monetary tightening.  It took the vision and courage of Paul Volcker to pull it off – at one point in 1981 pushing the federal funds rate up to 19%.  Ironically, central banks may be better equipped to fight high inflation than they are to preserve the gains of low inflation.  While the new religion of monetary discipline succeeded in keeping inflation and inflationary expectations in check, the confluence of two powerful structural forces – the IT revolution and globalization – took a secular disinflation to the brink of an unwelcome deflation.  Japan fell into that trap in the 1990s and the US came dangerously close a decade later – occurrences that in both cases were unmistakable outgrowths of the bursting of major asset bubbles.  As the multiple-bubble syndrome of the past several years suggests, the authorities still have a lot to learn in managing low-inflation economies – and in avoiding the liquidity-driven pitfalls that come from exceedingly low nominal interest rates.

America’s productivity revival stands out as a second milestone of the past 25 years.  When I started at Morgan Stanley, trend US productivity growth was around 1%.  Today the underlying trend is closer to 2 1/2%.  .  The explanation of the difference between now and then is still a subject of hot debate.  The productivity bulls wax eloquently on America’s innate attributes of flexibility, innovation, de-regulation, and risk taking.  The skeptics focus on “capital deepening” and cost-cutting – in effect, the substitution of capital for labor and the concomitant transformation from one technology platform to another that drove the IT revolution in the 1990s.  I’ve been on both sides of this debate – as one of the first productivity bulls of the early 1990s and then, unfortunately, as one of the first to abandon this view in the mid-1990s.  In retrospect, this was one of the biggest mistakes of my forecasting career.  My concern was that Corporate America had taken its penchant for cost-cutting too far – running the risk of a hollowing out that could compromise its ability to maintain market share in a rapidly expanding US and global economy.  I failed to appreciate the breadth, depth, and duration of the IT-enabled transformation of the US economy – as well as the broader leverage that ultimately would flow from the new technologies of the Information Age.

The US productivity revival of the 1990s turned the global competitive sweepstakes inside out.  At the end of the 1980s, conventional wisdom had it that America was “over” – in effect, beaten into submission by the world’s new competitive behemoths, Japan and Germany.  In retrospect, of course, nothing could have been further from the truth.  At the dawn of the 1990s, Japan and Germany were peaking out and, courtesy of a wrenching restructuring, the United States was about to emerge from its long slumber.  Fast forward to mid-2007, and the debate has come full circle.  America’s productivity growth has slowed to 1%, and the jury is out on whether this is a cyclical or structural development.  While the recent downshift in US economic growth underscores the apparent cyclicality of this development, the culmination of capital deepening – an IT share of total equipment spending that peaked at around 51% in 2000-03 – raises the distinct possibility that the IT-enabled productivity acceleration may have finally run its course.  Meanwhile, there are encouraging signs of a long overdue revival in German and Japanese productivity growth.  Recent history tells us that the pendulum of competitive prowess can change much more quickly than we might think.  That’s something to keep in mind in the years immediately ahead. 

Globalization is certainly on a par with the other two milestones of the past 25 years.  In this case, the comparison between 1982 and 2007 is like day and night.  I walked into this job when global trade stood at just 18% of world GDP; this year, that ratio is likely to hit a record 32%.  The problem with globalization is that we have done a lousy job in understanding and explaining it.  And by “we” I mean my fellow economists, policy makers, politicians, business leaders, and other pundits.  Far from the nirvana promised by the imagery of a “flat world” and the ecstasy of the “win-win” mantra, the road to globalization has led to saving and current-account imbalances, income disparities, and trade tensions – all having the potential to spark a very destabilizing backlash.  The threat of just such a backlash remains a clear risk in today’s environment.

Notwithstanding those concerns, globalization has been a huge success – at least on one level.  Despite persistent and devastating poverty in many poor countries, there has been a doubling of per capita GDP growth in the developing world over the past decade.  What is still missing in this newfound prosperity is a key element of sustainability – the emergence of consumer-driven growth models in these still largely export- and investment-led economies.  At the same time, in the rich countries of the developed world, the benefits of globalization have accrued far more to the owners of capital than to the providers of labor; labor shares of national income in the major developed economies are at record lows, whereas the shares going to capital are at record highs.  Moreover, the distribution of gains within the labor share of the developed economies has become increasingly skewed toward the very few at the upper end of the income distribution – at the expense of those in the middle and at the lower end.  Therein lie the seeds for a potentially powerful backlash:  As the pendulum of economic power has swung from labor to capital, the pendulum of political power is now in the process of swinging back from a pro-capital stance to that which provides support for labor.  The case for trade protectionism – especially in the United States – is alarmingly high as a result.  Sadly, this is antithetical to the global stewardship that is so desperately needed in today’s world. 

In one sense, these past 25 years have been an era of powerful transitions – transitions from high to low inflation, from stagnant to rapid productivity growth, and from closed to open economies.  Transitions, by definition, have a finite duration.  A key challenge for the global economy and world financial markets is what happens after these transitions have run their course – when disinflation comes to an end, when the productivity revival has crested, and when globalization hits its structural limits in terms of import penetration in the developed world and investment-led growth in the developing world.  Don’t get me wrong – a post-transition climate need not be characterized as a return to rapid inflation, stagnant productivity growth, or trade protectionism.  The endgame could be considerably more benign – modest inflation, “adequate” productivity growth, and a leveling out of the global trade share of world GDP.  While these outcomes offer less dynamism to the global economy than we have seen in recent years, they do not represent relapses to more problematic macro climates.  At the same time, such post-transition scenarios may well deny world financial markets the high-octane fuel that has produced such spectacular results over the past 25 years.

The jury is obviously out on these important questions – as well as on the inevitable transitions to come.  My favorite candidates in that regard: productivity catch-ups in the developed world, consumer-led growth in the developing world, a world coming to grips with climate change, and financial solutions to the demographics of aging.  There can be no mistaking the world’s increasingly robust coping mechanisms in dealing with recent and prospective challenges.  In fact, as I look back on the past quarter century, what astonishes me the most is speed – how quickly the world has come to grips with structural issues like productivity and globalization and how equally quickly the Great Inflation was brought to an end.  All this underscores the one lesson from economic history that rings truer than ever – the axiom of an ever-accelerating pace of change.  Just like Moore’s Law, it’s always hard to envision the next wave of time compression – even though it never fails to occur.

The world today is obviously a very different place than it was 25 years ago.  But let me assure you that back in 1982 there was no inkling of what was to come.  I have been privileged to bear witness to an utterly astonishing period in the transformation of the global economy.  I have relished the financial-market debate that has arisen out of this transformation.  I wouldn’t trade that experience for anything.  And now it’s off to Asia – the epicenter of the Next Wave.  My role will change, but I can assure you the lens won’t.  Stay tuned.

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Conundrum Solved?
June 15, 2007

By Takehiro Sato | Tokyo

US long-term yields: Our official view and my own

Following upward revisions of growth expectations and a 180 degree turnaround in expectations for the Fed’s policy, the 10-year US Treasury yield has topped 5% by a clear margin, led by technical selling related to heavy mortgage convexity hedging. The underlying trend was exacerbated by a flow of news suggesting that China’s diversification of its foreign-currency reserves could lead to a potential deterioration in supply-demand conditions in the US bond market. Japan’s bond market also has been buffeted by a mini panic, with the expected timing of the BoJ’s next rate hike moving up and the 10-year yield rising along with the 10-year Treasury’s and approaching 2%. This was because of a flow of data indicating further tightening in the labor market, e.g., an unemployment rate of less than 4%, and strong capital investment, based on the MoF’s Corporate Statistics. However, based on the fundamentals, we doubt that long-term yields will continue rising in Japan and other major countries, in a manner resembling a kite whose string has been cut.

The latest correction in the US bond market was sparked by 2Q growth that was much stronger than the initially cautious consensus forecast. Based on the latest economic data, our US colleagues’ updated forecast for 2Q growth is 4.1% annualized, versus 0.7% in 1Q. In this scenario, rate cut expectations naturally fade. However, both our colleagues and I have some doubts about whether growth will continue at this strong 4% pace.

For a potential growth rate of less than 3%, the fed funds rate of 5.25% is restrictive and makes a forceful acceleration in the economy unlikely. Although the labor market remains strong, it has been roughly one year since housing starts started to clearly decline, meaning that construction employment should start to be affected anytime soon. We accordingly think that 2Q growth of 4% is unsustainable and that the economy’s underlying growth trend, smoothed with the 1Q figure, is closer to 2.5%. Our US colleagues expect economic growth to slow to around 2.5%, below the potential growth rate, in 3Q onward because of the tightening of financial conditions, including the rise in long-term yields. Not only the bond market but also the stock market is likely to be under pressure because inflation concerns may rise easily, in light of the prospects for core inflation to rise to 2.5% or so in 3Q, in a reflection of the summer rise in gasoline prices. We see this case, which would exacerbate the recent technical moves in the market and possibly push up the 10-year Treasury yield to mid-5%, as a risk scenario. However, in our base scenario of a deceleration in growth to less than the potential growth rate after the summer, we expect core inflation to gradually peak at less than 2.5% in 4Q and expectations for a Fed rate hike to retreat as a result. In line with our firm’s view, we would accordingly look to buy at a yield above 5.25%, as suggested, albeit not decisively, by the relationship between the real fed funds rate and the 10-year/2-year segment of the curve.

The 10-year/2-year spread corresponding to a real fed funds rate of 3% is -0.3% for 2004-07, when long-term yields stayed very low for some puzzling reasons, and +0.3% for 1990-2003, before this conundrum developed. If the conundrum is gone, then the 10-year Treasury yield would have room to rise further, to almost 5.4%, based on the recent 2-year yield of nearly 5.1%. We are not entirely convinced that the conundrum is gone, however, in light of productivity improvements from globalization. We think it is a good time to slowly take profits on stocks, which look vulnerable to a rise in inflation expectations on concerns about the Fed falling behind the curve. In our risk scenario, we see a growing recognition that the equilibrium level for long-term yields is not that high if the correction in stocks worldwide gains momentum, as we explain later.

Japan’s long-term yields: Long moratorium of a definite end to deflation

Japan’s bond markets are likely to basically be led by US trends, with the 10-year JGB yield possibly clearing 2% if the 10-year Treasury yield rises to around mid-5%. However, the recent slowdown in bank lending is one indicator suggesting that domestic demand for funds has weakened further, and there could be opportunities again for arbitrage with loan rates, as there were prior to 2005. For most of the time since the 1990s, the 10-year JGB yield has been capped by rates on new loans. Loan growth makes the aforementioned arbitrage difficult, so even if the yield looks likely to top rates on new loans, the average loan rate on outstanding loans serves as a general upper limit.

This type of arbitrage was not possible in 1994, 1996 and 2006. The catalyst in 1994 was a concern about a deterioration in bond market supply-demand conditions owing to the Trust Fund Bureau’s outright selling operations; in 1996 it was a concern about the BoJ tightening owing to expectations for economic growth; and in 2006 it was a series of tightening moves by the BoJ, in conjunction with a resumption of growth in bank lending. In the current case, the rise in long-term yields has gained momentum because of growing expectations for a prompt BoJ rate hike, but we think that yields have already overshot. In other words, based on historical trends, the 10-year JGB yield would likely stay above the average loan rate on outstanding loans for only three to four months at most, on par with the duration in 2006. As long as bank loan rates do not rise noticeably because of discounting competition, we would recommend aggressively buying on weakness at a 10-year yield above 2%.

The upside for Japanese stocks, as well as US stocks, is likely to be limited if inflation concerns dominate in overseas economies. With almost no signs of inflation budding in Japan, inflation worries overseas could temper, rather than exacerbate, domestic inflation expectations through a correction in asset markets. Given the buying in the US stock market in the two months following the late-February China shock, on expectations for the Fed’s easing owing to an economic slowdown, a reversal could last for two to three months. In this case, we think it would be premature to believe that Japanese stocks would be immune to external conditions just because they have lagged other major markets. Our Japan equity strategy colleagues estimate a fair value for TOPIX of 1,800-1,850 at most, even based on our fairly optimistic corporate earnings forecasts. In January and May-June 2006, the market approached fair value but then corrected quite a bit on trivial news. Based on this cautious stock market outlook, we doubt that the equilibrium level for the 10-year JGB yield will rise substantially.

As in the US case, if we try to get a rough idea of where the 10-year JGB yield should be based on the real unsecured call rate and the 10-year/2-year spread, we find that the shape of the curve was much different in 1990-96, before the economy went into a serious deflationary phase, than it was thereafter. The shape of the curve since 1997 has also differed depending on the phase of the BoJ’s monetary policy. As a result, the correlation is not as clear as it is in the US case.

Even so, if we use the average shape of the curve since 1997, the recent real unsecured call rate of 0.6% (0.85% if the BoJ raises rates in the summer) would mean a 10-year/2-year spread of 85bp (0.75% after a rate hike). And assuming no major shift in expectations for the pace of tightening and not much change in the 2-year yield from its current level of around 1.1%, we estimate that the 10-year yield’s fair value is just 1.95% (1.85% after a rate hike), or not even 2%.

We accordingly think that the 10-year Treasury yield has room to overshoot, depending on the outlook for inflation, but a 10-year JGB yield that is solidly remains above 2% is difficult to justify. However, this is the model case since 1997, when the economy went into a deflationary period. If deflation definitively ends, then the shape of the curve could go back to what it was like in 1996 and earlier. In this case, we would be prepared for a large correction in the level. As part of our economic forecast, we expect core inflation to turn slightly positive in early 2008 and the GDP deflator to do so in mid-2008, which would mark an end to deflation from a statistical perspective, but we think that the momentum in these indicators is likely to be extremely feeble.

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Bond Yields and Pension Fund Portfolios — Stabilizing or Destabilizing Demand?
June 15, 2007

By David Miles | London

Since the start of the year, bond yields are up (a lot) and so are stock prices (a bit). Across all maturities, sterling bond yields are sharply higher. Most of the adjustment at the longer end has come in the past few weeks. Much of the rise has been in real yields — the increase in implied (or breakeven) inflation has been much smaller. Since January, yields are up by close to 60bp pretty much across the nominal yield curve; real yields (on indexed gilts) are up almost as much — except at the very long end where the sell-off in index-linked bonds has been somewhat less marked. Implied (or break-even) inflation has moved up hardly at all at the short end; it is only noticeably up at the very long end. Even at the 20-year horizon, implied (breakeven) inflation has moved up by only about 20bp, while real yields are up by almost 40bp.

So, holders of real and nominal bonds have taken quite a hit. Meanwhile, stock prices are still up by a healthy margin over the start-of-year values. The FT Allshare and FTSE 100 indices are up by around 5%.

This combination of sharply higher yields and higher stock prices has reduced the current value of pension deficits of large UK companies. Estimates of deficits based on the relative size of the current value of assets and the liabilities — calculated using current bond yields to discount anticipated future pensions — will have improved for companies who are not duration-matched. So, those who hold fewer bonds (or bond-like instruments) than would be needed to match the sensitivity of asset values to yield curve shifts to that of the liabilities will have improved their funding. The great majority of UK pension funds are in this position. Watson Wyatt estimates that at the start of the year the aggregate pension fund deficit (on an FRS17 basis) of the 350 largest quoted companies in the UK was around £60 billion. It currently (start of June) estimates that the aggregate deficit is only around £2 billion.

This significant decline is an indication of the limited extent to which pension funds duration-match — UK pension funds still hold around 60% of their assets in equities.

How might we expect the demand for bonds with long durations (that help match the duration of the liabilities) to evolve as deficits have fallen?

One can tell two very different stories about pension fund demand for bonds as deficits fall — I have heard both versions.

Version 1

As deficits fall, companies and the trustees of their pension funds worry less about funding problems and feel more comfortable taking the risk that yields fall and/or equities underperform. On this view, recent gains leave pension funds more willing to leave chips on table; they make implementation of LDI strategies that seek to match short-term fluctuations in assets to that of (measured) liabilities less attractive (or at least less pressing). So, the perceived need to hold bonds is lessened.

Version 2

As deficits fall, pension funds are more willing to lock in their current funding positions to a greater extent. So, they will be more keen to follow LDI strategies that typically involve selling equities and getting more exposure to fixed income. In this version, recent good fortune leaves pension funds happy to take some of the chips off the table; they will seek to get more exposure to bonds.

Which of these stories is more plausible as a description of what pension funds will do? The answer matters. If it is the first story, then the sell-off in the bond market will not generate natural pension fund buyers coming in as yields rise and deficits fall. If it is the second story, there is more chance of buyers looking to add to bond holdings as yields move up.

One way to answer the question is to ask pension fund trustees how they see the optimal portfolio allocation of the fund changing as funding improves. A different strategy —   which might give the same answer — is to assume that what trustees do is trade off risk against return in a similar way to other investors and model how the optimal portfolio evolves as funding gets better, This requires us to make some assumptions about risk aversion and the payoffs to trustees.

In earlier reports, Melanie Baker and I followed the strategy of trying to figure out optimal portfolios for defined benefit pension funds in an environment with many types of risk — and using the assumption that trustees care about the balance between assets and the costs of pension liabilities at the point in the future when pension funds are mature and the risks have crystallised. What we found there was that for risk-averse pension fund trustees, the optimal amount of duration-matching — matching the yield sensitivity of the assets to that of the liabilities — rises as funding improves. In more recent work with David McCarthy of Imperial College, where we have made the pension fund model more realistic by allowing for the existence of forms of insurance and have also calculated the optimal dynamic strategy for portfolio allocation, we find the results even stronger: the right amount of duration-matching seems to increase even more sharply as pension funds see their funding positions improve.

I conclude that there are grounds for believing that the second of the two stories outlined above is the more persuasive. Those currently nursing significant losses on their bond portfolios might take some comfort from that thought.

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