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Strategies & Market Trends : MDA - Market Direction Analysis -- Ignore unavailable to you. Want to Upgrade?

To: Shtirlitz who wrote (37176)	1/11/2000 8:13:00 AM
From: Crimson Ghost	Read Replies (1) \| Respond to of 99985

Morgan Stanley chief economist Steve Roach expects bond yields to keep climbing until equity bubble breaks. Global: Probing Stephen Roach (New York) Despite a rather tumultuous start to the new millennium, the equity culture continues to have an iron grip on the global economy. America?s wealth effect has become deeply ingrained in the growth dynamic of the US economy; Dick Berner has estimated that it appears to have boosted annualized real GDP growth by 0.5 to 1.0 percentage point since 1994. While the wealth effect has typically been a good deal smaller in Europe, Eric Chaney suggests that may now be changing; by his reckoning, it may now be adding as much as 0.2 percentage point to annualized economic growth in Euroland. All this suggests that wealth creation has become an increasingly important complement to income generation in driving activity in the developed world. Therein lies the major risk to the global economy and world financial markets. The old school believes that equity risk is best assessed through valuation metrics that rely on the bond market. Needless to say, that view failed miserably in 1999 -- especially in the United States, the engine of the global stock market boom of the 1990s. At the start of last year, when yields on long US Treasuries were around 5.1%, there was widespread conviction that the stock market would cave if long rates hit 5.75%. Over the course of the year, that threshold was raised repeatedly -- first to 6% and then to 6.5%. Now there?s talk that it will take 7% to bring down world stock markets. The linkage to Fed policy is cast in a similar light: At first, there was conviction that two tightenings would bring down the Dow; then it was three. Now, there is general belief that another two rate hikes are in the cards during the first half of 2000. And yet the US stock market continues to power ahead. Can this state of affairs continue indefinitely -- with the bond market and the Fed both continuing to probe for the equity market?s ultimate threshold of pain? The answer is, of course not. But we?ve all been saying that for all too long. Bond yields are up over 180 bps from their October 1998 lows, and the Fed has tightened 75 bps. However intense these interest rate pressure appear to be, they have been more than offset by support from a host of other fundamentals -- namely, volume growth, profit margins, and a uniquely powerful dynamic driving the technology sector. All this is another way of underscoring the great uncertainty and confusion over the stock market?s interest rate bogey: We simply don?t know what it is. But that won?t keep the bond market from probing further, in my view. Indeed, it may well be that the bond market has taken on a new role in the past several years as the principal means by which tensions are vented in world financial markets. That role used to be played by foreign exchange markets. But with G-3 officials having embraced a "quiet" target zone arrangement over the past 15 months, currency volatility has been confined to a relatively narrow range. And so world bond markets have borne the brunt of shifting economic and policy fundamentals. Particularly interesting in this regard is that the latest leg in the now 15-month old bond market correction has been driven more by a back-up in real interest rates than by a shift in inflationary expectations. That?s especially true in the US, where a back-up in real rates accounts for about 75% of the 40 bp rise in nominal rates over the past six weeks. Indeed, yields on 10-year TIPS now stand at 4.4%, up nearly 30 bps from levels prevailing in late November 1999; over that same period, the so-called inflationary premium has risen only about 10 bps. As I see it, the sharp recent back-up in long-term US real interest rates reflects two factors -- the mounting vigor of the global economy and the massive external financing associated with America?s gaping current-account deficit. Such a real-rate-induced back-up in nominal bond yields underscores the obvious risk factor still playing on nominal bond yields -- the possibility of an inflation scare. With the 10-year inflationary premium still holding in at around 2.1% -- far short of the historical CPI-based norm of 3.3% -- it wouldn?t take much to trigger yet another leg to the bond correction. All this is strikingly reminiscent of the Old Era -- when financial markets were dominated by a ruthless group of bullies known as the bond market vigilantes. However, this gang of party wreckers drew their power from a very different macro climate -- one dominated by high and accelerating inflation. Lacking in such sustenance, today?s generation of vigilantes is operating from a relatively weak power base. But that doesn?t mean markets are immune to episodes of sharp and sustained corrections. As always, such possibilities are more dependent on expectations than on reality. To the extent that financial markets remain priced for the perfection of the New Era -- no inflation and ongoing earnings vigor -- then more tests seem in store in an always-imperfect world. In my view, the bond market will continue in its efforts to probe for that interest rate bogey that will finally challenge today?s deeply ingrained equity culture. And only then will we see what the New Era is really made of.