What Will be the Trough in Rates?
January 25, 2008
By Richard Berner and David Greenlaw | New York
The Fed’s aggressive ease this week seems to signal a desire to front-load monetary stimulus. Or does it? To assess the Fed’s next move and to decide how low rates will go, we need to understand what triggered the policy shift. In our view, there are four possibilities. 1) If officials were behind the curve and were merely playing catch-up, then our recent call for a 3% trough in the Federal funds rate might be right. 2) Likewise, even if officials were on pace but simply want to front-load stimulus rather than add more, the 3% call could be right. 3) The Fed may be responding to market developments in knee jerk fashion. 4) In contrast, if the downside risks to growth from new financial restraint require additional offsetting moves, including a possible overshoot, then a lower trough is likely.
We’re in the last camp; we now think that the trough will be 2½%, or 50 bp lower than previously. The reason: The Fed’s actions have been on pace, but both financial restraint and their own communications gaffes now require them to be more aggressive. Whether or not such a trough will represent an overshoot is unclear. To be sure, market-based inflation measures bounced higher following the Fed move. But it’s important to recast the debate in risk-management terms: The key message in an uncertain world is that the FOMC is willing to err on the side of more ease. And as long as officials are willing to take any overshoot back quickly, it need not be a policy mistake. That logic does not apply to the outcome of next week’s FOMC meeting, however; we expect that officials will opt for a 25 bp move. Here’s why. Our colleague Eric Chaney correctly points out that the Fed took out insurance against the chance that a market meltdown would menace the financial system. That danger of systemic risk seemed very real over the weekend. The key threat: That the monoline insurers would lose their AAA ratings and thus would be unable to make good on their financial guarantees. That triggered fears of a cascade of global counterparty defaults and related worries that the global economy would recouple to a US downturn. Providing liquidity would clearly not be enough; the Fed had to send a strong signal that they would be the backstop of last resort. Disclosures that unwinding of rogue trades also contributed to the weekend meltdown have nurtured perceptions that a new ‘Bernanke put’ has appeared. In that view, the Fed is simply reacting to and bailing out markets and got ‘snookered’ into action. In fairness to Chairman Bernanke and the FOMC, however, he and they made the decision before the meltdown to move; they clearly laid out the prescription for action the week before. In Bernanke’s own words: “Financial and economic conditions can change quickly. Consequently, the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability.” The only question was the timing. Timing is often everything. In our view, however, the more important issue for understanding the Fed’s actions is the disconnect between the Fed’s actions and rhetoric and market perceptions over the past few months that set the stage for this week’s events. Beginning in October, the Fed’s view of the balance of risks fell out of step with the market’s, and despite 100 bp of ease, the Fed never caught up. Market participants thus became convinced that the Fed had fallen behind the curve. Worse, investors came to think that the market’s view of the outlook, rather than the Fed’s, would dictate monetary policy. The Fed’s words and deeds reinforced that perception. They eased incrementally, and as important, gave little sense of impending downside risks. The FOMC twice was unable to state the direction of risks in post-FOMC statements, so the market gave little heed to the Committee’s longer-term views unveiled in November. Poor execution of aggressive, coordinated and completely appropriate actions to provide liquidity through the creative use of a new Term Action Facility diluted their symbolic benefits. Twice the Chairman or the Vice Chairman was forced to acknowledge that tighter financial conditions threatened the economy by more than they thought. Weakness in incoming data reinforced recession fears while the Fed expressed concerns about inflation. So when Chairman Bernanke clearly and forcefully hinted at aggressive policy action last week, and none came quickly, investors assumed that Fed would wait for the FOMC meeting. But once again, the market would call the tune for policy. More than before, the Fed’s action this week thus appeared to be tied explicitly to market developments. This creates two major problems for monetary policy. First, market downdrafts may again create expectations for immediate ease regardless of the level of rates. Second, it creates uncertainty about the Fed’s reaction function. Nonetheless, the Fed won’t address them by being too restrictive. Indeed, in the short run, they probably require more ease. We assume that the Fed wants quickly to get to the level of the funds rate that will offset the tightening in financial conditions over the past six months. Just as Vice Chairman Kohn noted last October that “we [held] the federal funds rate at 5¼ percent…in part to compensate for what had been very narrow yield spreads and readily available credit,” so the Fed must recalibrate policy to offset the widening in credit spreads, reduced credit availability, and falling stock prices. Only two weeks ago, we thought the appropriate level was 3%. It may still be 3%; as noted above, an intermeeting move doesn’t signal a change in our thinking or the Fed’s about the appropriate trough in rates. But given the uncertain outlook, and the Fed’s abrupt shift away from gradualism, it’s reasonable to assume that the Fed will err on the side of ease. A working assumption consistent with such overshooting is that the Fed will lower the funds rate to 2½%, or about zero when adjusted for underlying inflation. What about next week? Many assume that the Fed will lower the funds rate by 50 bp to 3%, using the same logic: Front loading is still appropriate; if 2½% is needed, why wait? We disagree, thinking that officials will jump on the chance afforded by more stable markets to slow the pace and ease by another 25 bp. A little risk management perspective suggests that 100 bp of ease in the space of a week — especially given the low level of real interest rates — still constitutes a very aggressive move. The FOMC probably will emphasize that in the post-meeting statement. For investors, an aggressive Fed means a steeper yield curve, and for now, that will be bullish for bonds. But the more aggressive the Fed is now, the more likely is a healthy economic recovery. As market participants begin to anticipate that outcome, interest rate strategist Jim Caron thinks it will promote a bearish steepening of the yield curve as long yields back up. We agree. Such a bear steepening may not last long, however. When the economy begins to recover, the Fed will need quickly and forcefully to reverse course, flattening the curve. Likewise, the fundamental forces that will contribute to a bear steepening of the yield curve will also drive inflation breakevens as measured in the TIPS market wider. Inflation rate strategist George Goncalves believes that backend (10-year maturity and greater) TIPS are poised to outperform nominal bonds as breakevens should stay wide to discount the coming reflation phase in the second half of this year (see his “Looking Under the L/T TIPS Hood," January 24, 2008). For their part, Fed officials likely will also work to improve their communication strategy. Indeed, they have started by simplifying and using less boilerplate in post-FOMC meeting statements. The balance of risks framework is gone, replaced with clear emphasis on growth risks. The Chairman and Vice-Chairman are now de facto the only policy voices. Officials probably will offer more discussion of the factors affecting financial conditions and how they affect the outlook. Those changes will eventually put the Fed’s view of the outlook, rather than the one priced in to financial markets, back in charge of monetary policy. Correspondingly, genuine policy transparency will once again provide a compass for investors looking to understand where policy will go after the trough in rates.
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A 70:15:15 Currency Basket Numeraire for the GCC
January 25, 2008
By Stephen Jen | from Hong Kong
Summary and conclusions The GCC countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE) face the same macroeconomic difficulty that China faces in dealing with their massive balance of payments surpluses. Eventually, in our view, they will need to follow the exchange rate and monetary transformation undertaken by Beijing, and one day adopt a flexible exchange rate regime that will permit the GCC to absorb large swings in the oil prices and allow the GCC countries to devise their own monetary policy – independent from that of the Fed. Since the GCC countries are committed to establishing a monetary union by 2010, it makes sense for such a comprehensive structural transformation to be undertaken after this monetary union is established. However, this does not mean that there will be no changes whatsoever to any part of the exchange rate regimes before 2010. In fact, under certain conditions, small step revaluations – with the dollar pegs retails – remain a risk, particularly for the smaller open economies within the GCC. Here, we propose a basket reference numeraire for the GCC countries to consider until the GCC central bank can be fully independent of the Fed. We should stress that this numeraire need not be a hard peg, and could be used as a reference index relative to which the new GCC ‘dinar’ could crawl. China’s experience as a template for the GCC
It is by now familiar that China’s large current account (C/A) surpluses over the years have helped accelerate China’s adoption of a flexible currency regime. (China’s C/A surpluses registered US$69 billion in 2004, US$161 billion in 2005 and US$250 billion in 2006. It is likely to have reached US$340 billion in 2007.) Persistently large balance of payments (BoP) surpluses have implications for base money growth and monetary control in general. In fact, they are at the root of the inflationary pressures China is experiencing now. China is moving gradually from Point A (dollar peg) to Point B (a managed float regime with independent monetary policy). But the need for China to get to Point B is clear. The GCC countries confront a similar challenge. Instead of merchandise exports, the GCC countries run massive energy (oil and gas) trade surpluses. (The collective C/A surpluses of the GCC reached US$481 billion in 2004, US$608 billion in 2005, US$718 billion in 2006 and US$750 billion in 2007.) Similar to China, we believe that they will eventually need to adopt a more flexible exchange rate regime and a more independent monetary policy. However, for the time being, the GCC countries have elected to maintain an exchange rate regime similar to that of Hong Kong, rather than that of China: the main reason being that such a major transformation would be best executed under a common monetary regime, which is scheduled to be established in 2010. (Until a few weeks ago, there had been an intense debate on whether the GCC countries should adopt EUR pegs or basket pegs with heavy weights on the EUR. In retrospect, with the dollar now appreciating, doing so would have been a major tactical mistake.) Why look at a currency basket?
First, a currency basket, with proper weights, minimises the volatility of the nominal effective exchange rate of the ‘Gulf dinar’. By ‘borrowing’ the credibility of the Fed, ECB and BoJ, the newly established GCC monetary authority would likely minimise the ‘ex ante’ risks of large fluctuation in the currency. Of course, this theoretical benefit would come at the cost of losing the transparency of a dollar peg. Second, such a basket currency index need not be used as a hard currency peg. Rather, it could be used as a reference index (i.e., a basket numeraire) against which the ‘Gulf dinar’ could crawl, i.e., the central bank could guide the Gulf dinar at a faster or slower rate relative to this numeraire, depending on macroeconomic needs. Singapore has a similar regime. Monetary policy could thus be centred on the rate of crawl of the ‘Gulf dinar.’ Further, instead of using such a basket numeraire as a reference index after the establishment of the Gulf monetary union, the GCC member countries could, in theory, adopt such basket pegs before 2010, similar to the use of the parallel currency – the ECU (the European Currency Unit, introduced in 1979) – in Europe prior to the introduction of the EUR. What would such a basket look like?
We examined the direction of trade, including oil trade, of the GCC member countries . Intra-regional trade is about 10% of total trade or 20% of non-oil trade by the GCC countries. It makes sense to look at total trade (exports and imports, including oil and gas), because oil exports are such an important component (25%) of the GCC’s overall trade (or 67% of overall exports in 2006). Further, we should look for a common currency basket for the six GCC countries, collectively, rather than different baskets for different countries. (As pointed out by Prof. John Williamson of the Institute for International Finance (2005) in A Currency Basket for East Asia, Not Just China in August, “adopting a common basket … would guarantee no change in the third country exchange rates would disturb the trading relationships among the (relevant countries) themselves”. Prof. Williamson also argued, “the arguments favoured using total trade weights rather than giving different treatments to exports and imports; using elasticity weights if these are available (which they usually won’t be, but trade weights should be a reasonable proxy); using the directions of trade rather than the currency of denomination; and relying on the choice of peg just to stabilise the nominal exchange rate”.) We believe that the common basket numeraire for the GCC should be 70% in USD, 15% in EUR and 15% in JPY. Our thoughts
We highlight these thoughts: Thought 1. This basket numeraire could be used in a wide array of exchange rate regimes. As discussed above, this basket numeraire could be used by the GCC countries as a hard peg after the formation of the monetary union, if the needed policy instruments for monetary control are not fully developed in time. This would be yet another transitional regime before an independent monetary framework could be put into practice. Second, similar to Singapore, this numeraire could be used as a reference point for the Gulf dinar after 2010. Third, if pressured, some GCC countries could contemplate adopting such a basket peg before 2010. This would be analogous to an EMU member pegging to the ECU. Thought 2. Which weights to use: total trade, non-oil exports or imports? The GCC countries have a rather special pattern of trade. Roughly half of all exports are oil exports. If the objective of having a basket numeraire is to preserve the price competitiveness of merchandise exports, then non-oil exports should be used in the calculation of the weights. If, however, the goal of the numeraire is to preserve the purchasing power of imports, then import weights should be used. Lastly, if the goal is to have a general anchor to facilitate monetary operations in the new monetary union, then perhaps total trade is best. While the economic structure and trade pattern is (currently) similar, the economic paths of the GCC countries may differ going forward, and their trade pattern may diverge a bit. This would also result from the wide difference in the oil reserves that these countries have. This makes both export and import patterns important for a future common currency basket. Thought 3. Directions of trade or the invoice currency? Only 4.0% of Bahrain’s trade is with the US, and another 10.5% with the EMU and Japan. This means that 85% of Bahrain’s trade is with the non-G3 countries. There is, thus, the choice between using the directions of trade as weights, or the invoice currencies as weights. We believe that it does not make a difference if Qatar is exporting gas to Korea or Mexico, as both are likely to be invoiced and settled in dollars. We have thus assumed that all of the trade with the rest of the world is invoiced in dollars. Thought 4. The dollar still dominates this basket numeraire. Our rough calculations show that the dollar – accounting for 70% of the overall basket – still dominates the basket numeraire. Interventions will continue to be conducted in dollars. However, we acknowledge that weights will likely be time-varying as trade patterns evolve in the GCC countries. Bottom line
We have conducted very rough calculations of the likely currency weights (70% in USD, 15% in EUR and 15% in JPY) in a prospective basket numeraire that the GCC could use to guide its exchange rate policy. Most likely the use of such a numeraire will only be relevant after the formation of the monetary union – scheduled for 2010. However, there is a non-negligible risk that it might be adopted before 2010.
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