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Global
More Action, Some Traction December 05, 2008 By Joachim Fels | London Faced with a downdraft in virtually all economic indicators and helped by falling inflation rates, what we have called ‘the great monetary easing’ continues to be in full swing. Interest rates in most countries are continuing their downward path, and the Fed last week adopted ‘targeted’ quantitative easing (QE), aimed at lowering mortgage rates and supporting the extension of consumer credit. Encouragingly, money supply M1 growth in the G5 is now accelerating and our measure of excess liquidity, which had been shrinking for more than two years, has started to expand. Zeroing in on lower rates. Following large rate cuts in China (108bp) last week and Australia (100bp) and Thailand (100bp) this week, further rate reductions are likely in New Zealand, Sweden, the euro area and the UK over the next 24 hours. Our economists’ central expectations are for a 75bp cut by the RBNZ and 50bp reductions by the ECB, the BoE and the Riksbank, with a significant chance of larger moves in all four cases (see The Global Monetary Analyst, December 3, 2008, for more colour). Moreover, within the G10, we expect the Bank of Canada to lower rates by 50bp on December 9, the Fed to do the same a week later on December 16 and Norges Bank to cut by 25bp on December 17. More rate cuts in virtually all G10 countries are likely to follow in the first half of next year. Notably, Takehiro Sato expects the Bank of Japan to return to ZIRP during 1H09 and Elga Bartsch now sees the ECB cutting the refi rate to a new low of 1.5% by the end of 1Q09 (see Euroland Economics: Testing Times, December 3, 2008). Global and G10 policy rate towards new lows. Thus, on our forecasts, the weighted G10 official policy rate will soon drop below its previous low of early 2004 to just above 1% by mid-2009. Likewise, with rate cuts also expected in many emerging economies, our measure of the global policy rate (weighing together official rates in our entire coverage universe) should also make a new low, dropping towards 3% during next year, from 3.8% currently. Fed adopts ‘targeted’ QE. Arguably, cutting official rates is not enough in an environment where banks are deleveraging and the transmission mechanism from monetary policy to the real economy may thus be blocked. This is why, as we have documented before, several central banks including the Fed, the ECB and the Bank of England have already adopted QE by creating high-powered money via expanding their balance sheets (see “Neither the Great Depression Nor Japan”, The Global Monetary Analyst, November 19, 2008). However, as David Greenlaw explains in more detail below, last week the Fed took yet another important step by adopting ‘targeted’ QE aimed at driving mortgage rates lower and supporting the extension of consumer credit. Since the announcement, mortgage rates have already dropped by around 50bp and Treasury yields have also been dragged lower. ECB, BoE to follow? Will the ECB and/or the Bank of England follow the Fed in adopting some form of ‘targeted’ quantitative easing? While nothing can be ruled out, we think that this is unlikely, for the following reasons: • First, the Fed’s announcement already sparked a rally in US bonds across the curve that has also pulled bond yields in Europe lower. This positive spill-over allows Europe to free-ride on the Fed’s move to ‘targeted’ quantitative easing. • Second, and more importantly, most mortgages in the UK, Spain and Italy are adjustable-rate mortgages that are linked to short-term interest rates rather than long-term interest rates as in the US. Moreover, in those countries where mortgage rates are predominantly fixed for longer maturities – Germany, France and the Netherlands, to name just a few – refinancing fees are often prohibitive so that lower long-term rates don’t lead to major refinancing activity as in the US. Thus, targeting longer-term interest rates by buying long-dated private or public sector bonds would be less effective for the ECB and the Bank of England. Thus, the onus in Europe is more likely to be on a combination of lowering short-term interest rates further, continuing to flood banks with excess reserves and using ‘moral suasion’ (both from governments and central banks) to induce banks to lend. Traction watch. With the great monetary easing in full swing, the key uncertainty is no longer about the policy reaction by central banks, but whether the massive stimulus will find its way into the real economy. Despite the Fed’s latest step to adopt ‘targeted’ QE, which bypasses the banking sector, banks still play the key role in the transmission mechanism. In this respect, we are encouraged by the recent pick-up in the growth rate of money supply M1 (cash and non-banks’ sight deposits held with banks) both in the US and the euro area, which has also pushed the growth rate of M1 in the G5 economies higher. A rising deposit base will make banks more willing and able to lend and is thus good news, in our view. Also, we note that the acceleration of M1 growth, along with the deceleration of nominal GDP growth, has returned the growth rate of our favourite indicator of excess liquidity (M1 growth minus nominal GDP growth) into positive territory, after more than two years of shrinking excess liquidity. By definition, excess liquidity is the part of money supply growth that is not needed to finance the economy and is thus available to churn asset prices. We believe that a further expansion of excess liquidity in the coming months, which appears likely to us, given central banks’ aggressive action on rates and QE, would bode well for the recovery of risky assets that our strategists foresee in 2H09. US: Introducing ‘Targeted’ QE David Greenlaw (1 212) 761 7157 The Fed takes it up another notch: The two new programs announced by the Fed last week represent important action aimed at (1) supporting the extension of consumer credit and (2) driving mortgage rates lower. Here are the announcements: http://www.federalreserve.gov/newsevents/press/monetary/20081125a.htm http://www.federalreserve.gov/newsevents/press/monetary/20081125b.htm The new Term Asset-Backed Securities Loan Facility (TALF) is modeled along the lines of other facilities introduced in recent months. In particular, it includes equity participation by the Treasury as is done in the Commercial Paper Funding Facility (CPFF). Moreover, the TALF appears to be similar to the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) from the standpoint of providing non-recourse loans for certain types of assets – in this case, for securities backed by auto loans, credit cards and student loans. The non-mortgage ABS market is nearly US$2 trillion in size, but net issuance has actually been negative over the course of the past year. The Fed will lend up to US$200 billion to holders of newly originated ABS through the new facility. See TALF: Turning Flat Markets Around? November 26, 2008, by Vishwanath Tirupattur and other members of the US credit strategy team for details on the likely market impact. Meanwhile, the new Agency/MBS purchase program is having a significant impact on the mortgage market: The Fed will buy up to US$100 billion of agency debt and US$500 billion of MBS. That is quite a bit of firepower considering that net issuance of MBS over the past year was less than US$700 billion. Mortgage rates have already declined about 50bp since the Fed’s announcement, and the refi pipeline appears to be growing. Recall that every 50bp move in mortgage rates equates to a 5% swing in home prices from the standpoint of maintaining unchanged housing affordability. Since affordability has already corrected to a reasonable level, the dip in mortgage rates should help to put a floor under prices. Of course, home prices could continue to move lower for a while longer, but this does suggest that any further deterioration would reflect an overshoot that is likely to be corrected when excess inventory is cleared and homebuyer psychology improves. Different than TARP: The TALF and the Agency/MBS purchase program are different from the asset purchases originally planned for the TARP. The TARP buying was going to be focused on low-quality mortgage assets, whereas the new Fed programs will focus on higher-quality debt. Moreover, the TARP requires debt financing by the Treasury while the Fed’s programs will be financed via an expansion of their balance sheet – or ‘printing’ money. Indeed, the new programs represent a form of what I would call ‘targeted’ quantitative easing. By definition, QE is simply the creation of high-powered money via central bank balance sheet expansion. The Fed has been engaging in QE for the past couple of months. For example, excess reserves exceeded US$600 billion in the latest maintenance period (versus a normal level of about US$1.5 billion). The new measures will push the size of the Fed’s balance sheet still higher in the coming months and, perhaps more importantly, will involve the acquisition of specific types of assets. Indeed, the MBS purchases are reminiscent of Operation Twist – an action taken by the Fed and the Treasury back in 1961. Operation Twist was aimed at flattening the yield curve in order to promote capital inflows and strengthen the dollar, while at the same time maintaining low long-term mortgage rates. The Treasury concentrated its debt issuance in the front end and the Fed started buying long-term Treasuries via open market operations. These actions shortened the maturity of the outstanding public debt. Although this action was marginally successful in generating a flatter yield curve, most economists believe that it ultimately failed to achieve its objective because of a lack of commitment on the part of the Federal Reserve. In contrast, the Fed certainly appears to have a strong commitment to supporting key credit markets in the current environment.
Currencies
US Fiscal Deficits and the Dollar December 05, 2008 By Stephen Jen & Spyros Andreopoulos | London Investors fear a run on Treasuries and the dollar In our view, the investment community may not yet be fully convinced by the dollar’s rally since July. The perversity of the currency at the epicentre of the global financial crisis appreciating so sharply since July is, to some, both unfair and unsustainable. Not only has the Fed begun to conduct quantitative easing (QE), but the US fiscal outlook may also seem precarious. (See The Fed’s QE Operations and the Dollar (November 26, 2008), in which we argued that it is US structural weaknesses, i.e., the reasons behind QE, rather than QE itself, that would likely weigh on the dollar.) Indeed, our colleague David Greenlaw expects total Treasury issuance to reach US$1.5 trillion in FY2009 (more than 10% of US GDP – see Budget and Treasury Financing Update: Time to Tally the Red Ink, October 31, 2008, by David Greenlaw). In an environment where reserves-rich emerging markets may have local needs for their financial resources and may still harbour doubts about the sustainability of the USD, some investors are justifiably worried about the fate of the USD as a result of the large fiscal deficits in the coming years. Unlike the JGBs, the world already has so much exposure to US Treasuries that a severe deterioration in investor sentiment on them could, in theory, lead to large sales by foreign holders of these papers, triggering a rise in US long bond yields and a fall in the dollar. Some investors are concerned about these risks. But There Are Several Stabilising Factors for the USD The fiscal deficit-dollar nexus may actually turn out to be more stable than some may think. So far, the ability of the long-term yield in the US (and elsewhere) to fall, in spite of the well-recognised risk of an impending flood of new debt issuance in coming quarters, is a tentative indication that there need not be a run on US Treasuries, and therefore the USD. Here are some stabilising factors for US Treasuries and the USD (for related analysis by my colleagues, please see Do Global Financial Assistance Plans Menace Inflation and Sovereign Debt, Berner, Greenlaw and Miles, October 21, 2008): • Factor 1. Recession is more powerful than surges in debt issuance. While it is true that, all else equal, more debt supply is negative for bond prices and positive for bond yields, all else is usually not equal. Surges in government debt issuance tend to coincide with the need to provide fiscal stimulus in recessions. (Indeed, in a study by the Federal Reserve (New Evidence on the Interest Rate Effects of Budget Deficits and Debt (April 2005) by Thomas Laubach), it was argued that, isolating the pure supply effect (by suppressing all other factors that may simultaneously determine the bond yields), “a one percentage point increase in the projected deficit-to-GDP ratio is estimated to raise long-term interest rates by about 25 to 30 basis points”.) This ‘simultaneity’ problem is more than technical. In the last four US recessions, the US 10Y bond yield has been positively linked to GDP growth. In other words, when the US economy decelerated into the trough of a recession, long-term bond yields fell. Conversely, when the US economy has climbed out of a recession, US long-term yields tend to rise. Thus, in general, variations in US bond yields have followed the business cycle. This historical regularity appears to be strong. In the case of Japan, the massive JGB issuances in the past decade were also accompanied by relatively low 10Y JGB yields. • Factor 2. The US debt sustainability is not materially altered by the recent operations. In light of the massive size of the fiscal deficit the US is likely to have in the coming two years, as well as the expected rise in public debt burden associated with the demographic trend, there are now serious concerns about US debt sustainability. Over the medium term, it is clear that the US will need to tackle the fiscal issue aggressively. But, regarding the current fiscal stimulus, it may be useful to note that much of the fiscal deficit is linked to the financing of asset swaps, which should eventually be unwound, with some losses or profits. Further, to the extent that some of the actual spending on goods and services by the government is on infrastructure, the long-term productive capacity of the US economy could actually be enhanced, and the ‘crowding out’ effect mentioned above would not apply. Only large and sustained tax cuts and government consumption would lead to a ‘sustainability’ issue, in our view. Unlike individuals, large countries like the US need not ever fully pay down their debt. Debt service is considered sustainable as long as the real growth rate of the economy (g) is above the real interest rate (r) paid on the debt, i.e., as long as g > r over time, the public debt should be considered sustainable. In the US, the long-term average growth rate since 1950 has been 3.3%, while the average real long-term interest rate has been 2.6%. (Demographic and productivity trends could of course alter g, and the risk premium could alter r.) • Factor 3. Potential demand for US Treasuries could be large. There has been much focus on the likely supply of sovereign bonds in the next year or so, but perhaps not enough analysis on the potential size of demand for these papers. The world’s real money community (pension funds, mutual funds and life insurance companies) had US$59.4 trillion in assets under management (US$22 trillion in the US, and US$20 trillion in Euroland) at the beginning of 2008. This compares with the US$5.7 trillion market for US Treasuries and €1.2 trillion (US$1.5 trillion) market for German bunds. A severe global slowdown accompanied by a sharp decline in inflation could tilt the portfolios of these funds in favour of bonds. Second, commercial banks could also become a major source of support for sovereign bonds. Japan is perhaps a useful example. Japanese banks have, as the economy has stagnated, curtailed traditional loans in favour of holding JGBs (we are grateful to our colleague Takeshi Yamaguchi for guidance with the Japanese data). Since 2000, holdings of government securities have risen from 9% to 20% of total bank assets, which are roughly ¥300 trillion (or some US$3 trillion). Banks’ holdings now account for 36% of total JGBs outstanding. Right now, US banks have about 10% of their assets (US$1.1 trillion) in government securities (down from 20% in 1993). Finally, the Fed could be the buyer of last resort, as was the case with the BoJ in its rinban operations during the QE period of 2001-06. In short, potential demand for US Treasuries could be substantial. Notice that we haven’t mentioned Asian central banks. Their participation in the Treasury market is important, but perhaps not as critical as some may think. Bottom Line Fears of a run on the US Treasuries and the dollar are understandable. However, we believe that US fiscal sustainability has not been significantly compromised by the recent operations – most of which are related to asset swaps rather than outright spending. Further, potential demand for US Treasuries could be substantial, particularly in a soft economic environment. Real money investors, banks and the Fed are three key sources of demand for US Treasuries, in addition to foreign central banks. We do not have a structurally negative view on US Treasuries or the US dollar. |