The Message from Jackson Hole
August 29, 2008
By Richard Berner | New York
The Grand Tetons’ timeless beauty provided a relaxed backdrop in which to debate and reflect on the state of the global economy and financial markets at the Kansas City Federal Reserve’s annual Monetary Policy Symposium this weekend in Jackson Hole, Wyoming. Gone was the extreme stress permeating the atmosphere a year ago, shortly after the current financial crisis began. In its place was a gloomy acceptance by policymakers and market participants that while the gale force of the storm may have peaked, the crisis is far from over, implying continued downside risks for the global economy and financial markets. Discussions focused on the origins of the crisis, what comes next, and what to do about it — both to repair the damage and to reform the structure.
Diagnosing the sources of the crisis is clearly essential to assessing the outlook and evaluating remedies. Not surprisingly, most agreed that the crisis originated in excessive leverage and mispriced risk, classic ingredients for a credit boom and bust. Discussions assigned blame broadly to market participants, to regulators, and to monetary policy. But two observations underscore the limits of this collective diagnosis. First is the severity, persistence, and breadth of the financial storm. This suggests that leverage and mispricing was more pervasive, and that the crisis will last longer, than many have imagined. Second, and in contrast, so far the economic fallout has been mild, even at its US epicenter. All welcome the disinflationary promise of the slowdown, but it remains a promise. As a result, the near-term policy implications still vary: Inflation-wary central banks, like those in Latin America, are still inclined to tighten or, like the ECB, to stay firmly on hold. Fed officials are also on hold after their series of rate cuts, but remain concerned about downside risks to growth as well as potential upside to inflation. Longer-term, the crisis has spawned unanimous resolve to build a stronger regulatory architecture and infrastructure for the financial system. Just what that means and how to achieve it dominated the debates. The evolution of this crisis is now broadly familiar: The combination of unwarranted leverage — both explicit in debt ratios and embedded in opaque, structured securities — lax underwriting, and a broad mispricing of risk fueled a housing and credit bubble. Losses from the bursting of those bubbles, starting with subprime mortgages, triggered a drying up of liquidity, ongoing dislocations in securitization markets, a delevering and re-intermediation of lenders’ balance sheets, and a scramble to raise capital. Despite aggressive policy action, the uncertain magnitude of the losses and the reduced risk capacity of leveraged lenders have decimated their shareholders and reduced the availability of credit. Critical nuances distinguish this crisis from past credit busts. Much of this has a familiar ring. Indeed, the presenters at the conference, like Charles Calomiris, agree that a long period of benign credit conditions and a long housing boom fostered time-honored complacency about cyclical economic and credit quality risks. But he, Gary Gorton, Tobias Adrian, Hyun Song Shin and Peter Fisher point out some critical nuances that differ from the past. In Calomiris’ view, the newness of subprime lending contributed to unrealistic assumptions about mortgage losses. Gorton demonstrates how those assumptions and a lack of timely information about home and asset prices induced lenders to make and securitize loans that were highly levered to home price appreciation even after the fundamentals turned down. As important, Adrian and Shin remind us that, ironically, the balance sheets of securities firms now matter as much or more than those of depository institutions in this “first post-securitization” crisis. That’s because securitizers finance a pipeline of assets to be sold with money-market borrowing, and in credit booms they tend to finance a growing volume of credit to be securitized with higher leverage. Moving such assets off balance sheet into SIVs and conduits further amplifies this pro-cyclical leveraging. When funding dries up, the resulting deleveraging and re-intermediation of the banking system promotes a significant contraction in the availability of credit and an increase in its cost. Likewise, Peter Fisher points out that our system of secured funding (for example in repo markets), which is based on the value of assets rather than on the borrower’s ability to pay, can, in times of stress, add to this pro-cyclicality. Three implications for monetary policy. This analysis carries three important implications that shed new light on the way monetary policy affects the economy. First, unlike the past, when depository institutions could backstop troubled markets or vice versa, this time both are partially impaired. Second, this leveraging is highly sensitive to short-term funding rates, so changes in monetary policy and in liquidity will have a significant effect on lenders and credit supply — in addition to their influence on expectations and longer-term rates. And third, monetary policy can offset the pro-cyclical expansion and contraction of market-based intermediaries’ balance sheets and thus contribute to financial stability — or instability. What’s unclear, of course, is just how to calibrate all these changes in the channels of policy transmission. Policy dichotomy between restraint and accommodation. One year into the credit crisis, it’s clearer that the financial storm is morphing into an economic slowdown, but uncertainties like those just described mean it is far from clear how it will play out. Deleveraging and risk aversion are reducing the availability and increasing the cost of credit. Worries about the adverse feedback loop from credit restraint to the economy and back have reinforced the logic of policy accommodation for some. Such worries support our view that the Fed is on hold until mid-2009. Although there was surprisingly little explicit discussion of inflation at Jackson Hole, inflation concerns remain widespread and throw policy conflicts into sharp relief. For his part, Fed Chairman Bernanke reasserted his belief that growing economic slack would slowly tame inflation. Others, more worried about inflation or the risk of rekindling yet another boom/bust cycle, were committed to restraint. Proposals to increase financial stability are emerging. Policymakers and market participants agree that greater financial stability is desirable, and they agree in principle on how to improve it: Develop incentives to disclose and manage risks and liquidity, strengthen the financial infrastructure to make it more resilient to shocks, and recast the regulatory framework to dampen the pro-cyclicality of risk-taking and leverage, primarily by raising minimum capital requirements. The good news: New approaches to capital regulation and infrastructure are emerging to turn principles into practice. The proposal of Kashyap, Rajan and Stein to allow or require leveraged lenders to buy capital insurance that varies across the cycle and that pays off in a crisis — essentially, to go long ‘macro’ options that hedge the options they are inherently short in their lending — may be a helpful way to reduce the cost of such buffers. For investors, these crosscurrents carry critical implications. The benefits of policies to counter credit and economic concerns and the hope for inflation relief seem increasingly to be in the price of risky assets, as both credit and equities have remained range-bound despite signs of a global slowdown. But a prolonged economic and credit downturn probably is not in the price. Recognizing the near-term risks, my colleague Abhijit Chakrabortti just cut his outlook for S&P 500 earnings to a well-below-consensus decline of 7% for 2008, and a modest rebound for 2009. His $84 EPS estimate for 2009 is 20% below the consensus. Nor are the full implications of coming regulatory changes aimed at ensuring financial stability in the price; they will impose constraints on leverage, risk taking, and returns for both financial institutions and their clients. The ever-changeable weather in the Tetons is often the proverbial pathetic fallacy, a metaphor for the conference. Not so last year or this: Last year’s weather was ideal, but the tone of the conference was grim. Worries about a ‘tail’ scenario involving sinking housing wealth and activity and consumer retrenchment proved too dire. In the event, strong global growth kept the US economy out of recession. That was then. This year, the contrast between the spectacular weather and the cloudy litany of economic, financial, and policy concerns was more diffuse but still stark. With global growth slowing, there is reason to worry that the adverse feedback from the economy to credit quality will trigger more financial dislocations that will require tough choices — choices that involve tradeoffs between moral hazard and real economic hazards, potentially setting lasting and uncomfortable precedents for the future.
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Moving Up the Left Side of the Dollar Smile
August 29, 2008
By Stephen Jen & Spyros Andreopoulos | London
Summary and Conclusions We are updating our currency forecasts (the last round of forecast revisions was published on July 3, 2008 in Dollar Smiling Against EM, Still Frowning Against EUR). We continue to look for a tentative and asynchronous dollar recovery. As the global economy downshifts in earnest, the world will be pushed further up on the left side of the ‘Dollar Smile’, i.e., the sharper the global slowdown, the more the dollar should be supported. We convey this notion in our new forecasts, as we have done in the previous forecasts, while marking to market the sharper-than-expected move in the dollar in the past month. As Asia slows, the AXJ currencies should continue to depreciate against the dollar. If the global slowdown is severe enough, commodity prices should also come under downward pressure, however temporary, with logical implications for commodity currencies. We are revising down our forecasts for EUR/USD to 1.40 and 1.32 by end-2008 and end-2009, and our new year-end targets are now 107 and 112 for USD/JPY. We are looking for weaker GBP, AUD, NZD and CAD. The ‘Dollar Smile’ Coming Out of Hibernation Data out of Euroland and Asia in the past month have turned definitely negative; the year-old financial crisis has finally led to visible weakness in the global economy. What is remarkable is that the rest of the world (RoW) seems to have slowed before the US has – the US was the fastest-growing G7 economy in 2Q. The relative timings of the economic contraction in Euroland, Asia and the US suggest that the key sources of shocks are energy/inflation and the credit crunch, rather than the weaker import demand of the US. This slowing in the global economy, however belated, will have important implications for the dollar. We assume that most readers are familiar with our ‘Dollar Smile’ framework, which has been central to our call on the dollar all year (the 2009 outlook piece centred on the Dollar Smile was published on December 10, 2007, The Dollar Smiles in a Recession). However, for the first five months of the year, not only did the Dollar Smile not work, but the dollar collapsed against virtually all currencies. The main reasons why we were wrong for the first part of the year on the dollar were that (i) the US economy did not weaken that much and (ii) the Fed’s hyper-proactive rate cuts early in the year. For the dollar to smile, there will need to be a broad-based slowdown in the US and global economy and the Fed will need to halt its rate cuts. When these two conditions began to be satisfied in early May, the dollar started to smile, first against the AXJ currencies, and more recently against all the major currencies. For the coming two or three quarters, the world is likely to move higher on the left side of the Dollar Smile (i.e., towards point A). Rather perversely, the primary mechanism for the dollar to strengthen despite the economic slowdown and financial dislocations we are likely to see in the US is portfolio flows. In the past five years, there have been massive flows from USD-based investors out of the US. As of end-2007, the US had total foreign asset holdings of around US$17.0 trillion, up from US$6.7 trillion in 2002. If we superimpose this rise in the US international investment position (or total foreign asset holdings) on top of the data we have on assets under management by the US real money community, we see that foreign exposure of these institutional funds might have risen by 53% since 2002. (The data on assets under management by US mutual funds, life insurance companies, private pension funds and public pension funds come from the Fed’s flow of funds data. This foreign exposure index measures the proportion of the real money assets that is held in non-USD investments.) Just as most investors accept that JPY and CHF tend to rally on bad news, though this ‘safe haven’ characteristic did not exist until Japan and Switzerland became large foreign asset holders, investors should consider that the USD could now exhibit the same safe haven characteristic. We believe that this is the process through which the dollar will perform well in a global slowdown (i.e., on the left side of the Dollar Smile). Beyond the next two to three quarters, we expect (hope) that the US economy will start to recover, and the RoW should follow, with a delay. This means that we should move to the right side of the Dollar Smile. Whether the dollar will rally will depend on the sharpness of the US economic recovery. For the right side of the Dollar Smile to work, we need to have a recovery brisk enough to stoke sufficient ‘greed’ that equity flows into the US can power the dollar higher. However, given the nature of the problem in the US (i.e., a recession centred on a credit cycle), it seems more likely that the US and global recovery will be rather tepid. This means that the right side of the Dollar Smile is likely to be ‘flattish’ and the dollar may not rally as hard in that phase. In any case, there are several implications for currencies for the remainder of the year. 1. The AXJ currencies should continue to weaken against the dollar. AXJ are ‘high-beta’ economies, and have been recipients of large portfolio and fixed investment flows in recent years. The dollar will appreciate against most, if not all, of these currencies as the world slows and capital is pulled from Asia (see Post-Olympic China and the AXJ Currencies, August 21, 2008). To us, continued downward pressure on the AXJ currencies is the more reliable indicator that the world is on the left side of the Dollar Smile. 2. NZD, AUD and CAD should weaken further. If the world slows in synchronism in the quarters ahead, notwithstanding industry-specific supply factors, commodity prices should be soft, and so should the commodity currencies. We do think, however, that the NZD will be the underperformer in this bunch, while the CAD will likely be the outperformer. 3. EUR and GBP to weaken further against the dollar. This negative call on the GBP is more obvious. But the EUR is still over-valued on an index basis and against the dollar. Global central banks may still be long the US dollar, but we believe that the private sector is net long the EUR. Cross-border risk-reduction will be negative for EUR/USD, in our view. 4. JPY to remain on the weak side, though spikes of risk-aversion could provide temporary support for the JPY. While there might be modest safe haven flows into the JPY, we believe that the magnitude of the potential JPY rally will likely to be limited. After the Bear Sterns crisis in mid-March, USD/JPY did sell down to 97. However, after the GSE crisis in mid-June, USD/JPY only managed to correct to 105, disappointing many hedge fund investors. We believe that Japanese investors have learned to keep capital outside Japan, by diverting their investments from Australia and New Zealand to the likes of Brazil and Turkey. We expect this pattern of investment to persist, and therefore USD/JPY should stay higher than the fair value. The key risk is that, if the global economy slows dramatically, even BRL and TRY could be jeopardised, and this could trigger a more powerful repatriation back to Japan. Bottom Line We believe that the world is moving up on the left side of the Dollar Smile, which should be USD-supportive. The most reliable leading indicator of whether this thesis will remain correct is that the AXJ currencies continue to depreciate against the USD. Bad news all over the world should be USD-supportive mainly because the current distribution of global assets is USD-negative, and an unwind of these cross-border positions will be positive for the USD. Going forward, we expect to see a more hesitant and asynchronous USD recovery than that witnessed in the past month.
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