From Morgan Stanley This Morning.
They see yield curve inversion as primarily technical and NOT signalling a slowdown in the economy or a significant bond rally.
Global: Tick Tock
Stephen Roach (New York)
Turn off the snooze button. The unmistakable sound of the cyclical clock is growing louder. Central
banks around the world are awakening from their long slumber. That?s especially the case in a fully
employed US economy, which is about to enter a record 107th month of uninterrupted expansion.
But it?s also the case elsewhere around the world. The challenge for world financial markets is to find
value in an era of monetary tightening. I continue to believe that will prove to be a much tougher task
for investors in 2000 than it was in the preceding four years.
The crux of financial market tension is in the United States, heretofore the leader in the global
economy. New economy or not, the debate in America is boiling down to the time-honored tradeoff
between growth and inflation. And for the first time since 1994, there is now a legitimate case for an
inflation scare. Upside surprises to 4Q99 reports on the Employment Cost Index (+1.1%) and the
broadly based GDP price index (+2.0%) cannot be taken lightly in this regard. Nor can the flagrant
overshoot of US economic growth -- average annualized gains of 5.75% in the final half of 1999, the
strongest six-month increase in 15 years. On the heels of such momentum, Dick Berner has raised
his US growth forecast for 2000 to 4.3% (from 4.0%), his third such upward revision in four
months. This is precisely the cyclical outcome that leaves the Federal Reserve with little choice. There
is no traction whatsoever between its sole policy instrument -- the real federal funds rate -- and the
real economy. A multi-stage Fed tightening is the only appropriate response.
A similar verdict is evident in Euroland, albeit in a very different context. Compared with classic
late-cycle pressures now evident in the US, inflation risks are far more muted in an early-cycle
Euroland economy. Even so, Joachim Fels argues that there is now good reason to believe that
Euroland price stability is in jeopardy. That?s certainly the message that comes through on several
different fronts -- accelerating money-supply growth; the euro?s breach of the
psychologically-important parity barrier; signs that headline inflation are about to pierce the 2%
threshold; and risks that aggressive wage demands in Germany?s IG Metall union could set in
motion a classic wage-price spiral. In the end, credibility is a central bank?s most potent weapon. For
the newly constituted ECB, the time to establish credibility is now at hand. This will also take a
multi-stage monetary tightening, in our view.
Elsewhere in the world, our economists have reached similar conclusions with respect to central banks
in the United Kingdom, Canada, Australia, and Sweden. With inflation risks in these countries tipping
to the upside, short-term real interest rates seem likely to follow. The questions increasingly boil
down to timing and the cumulative magnitude of such actions. Japan remains the notable outlier in all
this. Despite a global economy that continues to play to the upside of our own above-consensus
growth prognosis, the data flow coming out of Japan still conforms nicely with Robert Feldman?s
below-consensus growth prognosis. December?s household surveys were particularly disconcerting
in this regard, underscoring the distinct possibility of renewed weakening in Japanese consumer
demand in 4Q99. This will make it all the more difficult for the Bank of Japan to move away from its
zero-interest-rate policy -- leaving the BOJ increasingly isolated vis a vis the world?s other major
central banks. Japan continues to run against the grain of an otherwise synchronous global business
cycle.
Many are now arguing that our scenario is now "old news" -- or essentially in the market. Yield
curves do appear to have discounted multi-stage monetary tightenings by most central banks, and
long-term interest rates have even started to rally in anticipation of the coming slowdown that such a
policy response implies. This is all too cute for me. For starters, it is important to remember the
outcome of the slowdown bet over the past several years: It has failed miserably, especially in the
United States. Second, I concur with David Greenlaw and see no economic or policy significance to
the recent inversion at the long end of the US Treasury yield curve; instead, it reflects more of a
supply-demand imbalance at the 30-year end of the maturity spectrum rather than a US economy that
is about to falter. Indeed, long-term real interest rates (for a 10-year TIPS) have held relatively steady
at 4.3% during this inversion, suggesting that the bulk of the rally is coming more from a reduction in
inflationary expectations than from a rethinking of economic growth prospects. This is very much at
odds with evidence increasingly in support of an inflation scare -- underscoring our view that the
yield curve inversion is more technical than fundamental. In my view, barring a spontaneous collapse
in equity markets, a sustained rally in global bond markets is unlikely; after all, it?s early in the
monetary tightening cycle and global growth is still surging to the upside.
In the end, world stock markets probably hold the trump card for an increasingly wealth-dependent
global economy. Just when most timeworn valuation models have been discarded, global equity
investors are starting to tremble at the possibility of fighting the Gang of Five -- the Fed, the ECB, the
Bank of England, the Bank of Canada, and the Reserve Bank of Australia. In recent years,
accommodative central banks have largely abdicated control over their real economies and financial
markets. The task now at hand is for them is to regain that control. And equity investors are just
starting to figure out what that means: Not only are they faced with the macro tradeoff between
volume growth and margin pressures, but they are also staring at much tougher comparisons from
elevated bond yields. The hope, of course, is that a spontaneous rally in global bond markets will save
the day -- resetting the valuation clock and bringing dip buyers back in with a vengeance. While
that?s the way it?s worked out for several years, I fear that another timepiece will shape the ultimate
outcome. The cyclical clock is ticking. Don?t roll over and go back to sleep. |
