Jubuk's Journal:
Rising interest rates go global
The European Central Bank will likely hike interest rates repeatedly in 2006, and even the Bank of Japan will actually raise them a bit. Here's what that means for the global economy and your wallet.
By Jim Jubak
I think 2006 is likely to be a year when the direction of the global economies and financial markets are set, not by a single bank (as they were in 2005 by the U.S. Federal Reserve), but by the interaction of policy at the U.S. Fed, the Bank of Japan and the European Central Bank.
The more moving parts in any machine -- even a virtual financial machine -- the greater the chance of a breakdown, of course. And the greater the chance that a slight malfunction in one part will cause unexpected and erratic performance by the machine as a whole. In other words, whether you liked departed Federal Reserve chairman Alan Greenspan or not, a 2005 dominated by the U.S. Federal Reserve was more predictable than 2006 is likely to be.
The U.S. Federal Reserve succeeded in hogging the interest-rate headlines in 2005. Raising interest rates 14 times for the world's largest economy does tend to send the spotlight in your direction. Add in the excitement of Alan Greenspan's departure as Federal Reserve chairman and speculation about whether or not incoming chairman Ben Bernanke is up to the job, and you've got media coverage that even Mariah Carey might envy.
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In 2005, the Federal Reserve's activity held center stage so easily because the world's other major central banks -- especially the Bank of Japan and the European Central Bank -- did so little.
What were the world's two other big-name central banks doing while the U.S. Federal Reserve was raising short-term interest rates to 4.5% at its Jan. 31 meeting?
The Bank of Japan, of course, was doing nothing -- as it has done, year in and year out, since it set short-term interest rates in Japan at 0%. On Monday, the official discount rate (the rate the Bank of Japan charges member banks for loans) stood at 0.1%, exactly where it has been since Sept. 19, 2001.
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The European Central Bank was a comparative dynamo in 2005. After keeping short-term interest rates at 2% for five years, the central bank for the European Union raised rates to 2.25% in December 2005.
So for 2005, the story in the financial markets was the growing gap between interest rates set by the Federal Reserve and interest rates in Japan and Europe. At the beginning of 2005, the difference between the Fed's short-term rate for the United States at 2.25% and short-term rates in Japan at 0% was 2.25 percentage points. By the end of last month, the gap had widened to 4.5 percentage points. In the case of the European Union, the gap in rates grew from a mere 0.25 percentage points at the beginning of 2005 to a relatively major gap of 2.25 percentage points.
The conundrum, explained
No wonder that in 2005, the United States had no trouble getting overseas investors to cover a record trade deficit of more than $700 billion, more than $80 billion larger than 2004's record. Energy prices, government budget deficits, consumer indebtedness -- none of that mattered in the final analysis. Overseas investors saw that huge edge in yield that they'd get by "Buying American," and they bought. As a consequence, the U.S. dollar stayed strong, surprising just about everyone (myself included). And because the dollar was steady -- or better -- for much of the year, overseas investors flocked to buy long-term U.S. notes and bonds, in order to lock in comparatively high U.S. interest rates for the long haul.
So, much to the surprise of Alan Greenspan, U.S. long-term interest rates actually declined as short-term rates climbed.
So far, at least, 2006 looks like it will be much different. The European Central Bank seems determined to hike rates repeatedly in 2006, with the next increase projected for March. And, amazingly enough, it's likely that the Bank of Japan will actually raise interest rates this year -- although not by very much.
We're not talking about a quick closing of the yield gap in 2006, however. European economies are just not that strong. Economists polled by The Economist magazine indeed do expect the economies of the euro-zone to grow at a faster rate in 2006 than in 2005. But the pickup is exceedingly modest: to 1.9% growth in 2006 from 1.4% growth in 2005. The Germany economy is projected to show the biggest improvement, with growth swinging to 1.7% in 2006 from 1.1% in 2005. But France (at a projected 1.9% growth rate in 2006) and Italy (at 2.1% in 2006) have major budget and unemployment problems that would lead to loud and probably violent protests against multiple interest-rate increases.
The combination of 2% economic growth (and especially the big improvement in the Germany economy) with 5% to 10% appreciation in the euro against the dollar could lead the European equity markets to outperform U.S. equity markets again in 2006. In 2005, the German DAX index ($US:DAX) returned 16.2% to the 3% return of the U.S. Standard & Poor's 500 ($INX) stock index. That followed similar outperformance in 2004 when the DAX returned 15.4% to the S&P 500's 9%.
Rate increases in Japan are likely to have strikingly different effects because 1) they start from such a low interest-rate base, and 2) the Japanese financial system is so close to a crisis brought on by the country's rapidly aging population.
Only in a country battered so badly and for so long would the 0.3% growth in GDP projected for 2006 be greeted with such joy. But because the country has been traumatized by its long-running economic slump, the Bank of Japan faces a huge uphill political battle to raise rates even a token 0.25 percentage points. No politician in Japan wants to run the risk of prematurely shutting down the current economic recovery and restarting the deflationary spiral that has kept Japan down for so long. Each time the Bank of Japan has even breathed the possibility of a rate increase, the government has lashed back hard, pointing out that growth is still extremely fragile.
Too little, too soon
The consensus among analysts who follow the Japanese markets is that any rate increase is extremely unlikely before the end of the country's fiscal year on March 31. It's too close to the year-end financial reports to rock the boat so radically. My opinion is that the timing of the move will depend on how fast inflation shows up in Japan. But no matter what the timing, I don't think we're looking at more than one or two 0.25 percentage point moves in 2006.
That's not enough to significantly close the gap with yields in the U.S., so I don't think the U.S. financial markets need to worry about any shortage of Japanese buyers for Treasury bonds and other dollar-denominated instruments.
In fact, a small rise in Japanese interest rates will quite likely increase Japanese purchases of investments priced in anything but yen. That's because the potential new yields on Japanese bonds don't even begin to outweigh the dangers to bond principal.
Remember that the value of an existing bond goes down when interest rates go up. (An old Japanese bond paying a yield of 1.6% falls in price if new bonds pay 2%. The old bond declines in price until its current yield -- the yen paid out on the lower yen price -- equals 2%.) So if the prospect is for higher interest rates in the future, the logical move would be to put your yen into something else where you're principal doesn't face this danger.
My best guess on that something else? Bonds denominated in euros and dollars and gold. Yes, perversely, the first result of Japan's economic recovery and its tentative steps toward rejoining the world of positive real interest rates may be a move by Japanese investors away from investments denominated in yen.
How big and fast that move will be in 2006 -- and, consequently, how much of a boost Japanese investors will give to the price of gold, euros and dollars -- depends on how the government handles the pension crisis that any increase in interest rates will set in motion.
Japanese pensions, you see, are stocked full of low-yielding government bonds. Any rise in interest rates will lead to declines in the market value of the bonds hold in those retirement funds. If Japanese pension funds are forced to mark their bonds to market, rising interest rates will result in losses and funds will start to show up as under-funded. (Private retirement funds invested in government bonds will similarly show losses if interest rates rise.)
One proposal is to let pension funds carry the bonds in their portfolio at purchase value rather than having fund managers mark them to current market prices. Over time, obviously, that produces an increasingly large divergence between the book and market value of the pension funds. And it's exactly the kind of fantasy accounting that undermined faith in Japan's capital markets and that sent the country into its lost decade.
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But forcing pension funds and individuals saving for their retirement to recognize losses has its own dangers, too. It risks setting off a kind of reverse wealth effect. In the United States, the Federal Reserve helped inflate the value of homes because the perception of rising personal wealth from real estate would offset perceptions of stock market losses from the crash of 2000. And the wealth effect would keep consumers spending and the economy rocking along. In Japan, falling bond values, in a country of investors overweighted to bonds, could undermine confidence just when the economy is finally starting to grow. Add in the government's need to raise taxes to shrink its huge budget deficit and keeping the Japanese economic recovery going will require either a great deal of skill by the country's leaders or a big dollop of luck.
In short, investors who are expecting Japan to join the economic engines pulling the global economy in 2006 are likely to be disappointed. But Japan's cash flows are likely, exactly because of the extent of the country's problems at home, to support the value of gold, the euro, and the U.S. dollar.
Japan faces the kind of conundrum in 2006 that only an Alan Greenspan could love. Hey, maybe he'd like a challenge now that he's out of a job at the Federal Reserve. Got to beat giving speeches at $40,000 a shot.
New developments on past columns
"8 stocks to watch in a wandering market": Things go better with, well, Frito Lay. On Feb. 8, PepsiCo (PEP, news, msgs) reported fourth-quarter profits of 65 cents a share, up 12% from the fourth quarter of 2004. The company was able to meet Wall Street projections despite higher costs for raw materials and fuel. Revenue actually grew faster than analysts had expected, by almost 15%, to $10.1 billion, well above the $9.5 billion projected. Sales growth was strong across the company, with Frito-Lay North America reporting a 13% increase in revenue and the North American beverage business growing revenue 13% on gains in noncarbonated brands such as Gatorade and Aquafina. The best growth came internationally --16% revenue growth -- with snacks volume up 13%. For 2006, PepsiCo projected earnings of at least $2.93 a share. At the Feb. 8 closing price of $57.28, the shares trade at 19.5 times projected 2006 earnings. The Standard & Poor's 500 stock index ($INX) traded that day at 20.1 times trailing 12-month earnings per share. As of Feb. 10, I'm raising my target price on PepsiCo to $68 a share by June from my previous target of $66 a share. (Full disclosure: I own shares of PepsiCo.)
Editor's Note: A new Jubak’s Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For suggestions to help navigate the treacherous interest-rate environment see Jim's new portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: PepsiCo. He does not own short positions in any stock mentioned in this column. |
