Pain now, party later or party now, pain later ?
thehindubusinessline.com
Prolong the party
Greenspan's choice: Party or pain
V. Anantha Nageswaran
The options before the Fed chief, Mr Alan Greenspan, are clear. Prolong the party and risk a bigger and longer hangover in America and, by extension, the rest of the world, or take pre-emptive action to bring about or force a much needed re-alignment of global demand by cooling America's economy and by ending the complacency in the financial markets. His decision in February will dictate how history would remember him, says V. Anantha Nageswaran.
THE first month of the year has just one trading day left. Most major stock markets are in the red. In America, there is a saying that as goes January so goes the year. It might be an imperfect adoption of the usual belief that a job well begun is half done. But statistics seem to bear this out.
A scrutiny of the American stock market performance from the 1940s indicates that a negative January invariably has been followed by negative returns over the next 11 months.
If the American stock indices go on to end the year in negative territory, it would once again be a vindication of the well-known truth that markets inflict maximum losses on the maximum number of people.
Complacency of the consensus...
Consensus forecasts for the year expected a 10 per cent appreciation of the S&P 500 stock index, economic growth at around 3.5 per cent, Federal funds rate at around 3.5-4 per cent, the 10-year Treasury Note Yield at around 5 per cent and a current account deficit that is larger than ever. All the above forecasts are strung together with the fond hope that the US dollar correction that has gone on for three years would continue in an orderly and gradual manner, notwithstanding a higher external deficit.
In making the prediction of such an orderly transition from the last two years of economic recovery into a gentle slowdown, consensus opinion is perhaps guilty of substituting hope for a scenario constructed on economic logic.
These forecasts appear to ignore the starting point. It is not as though American current account deficit is coming off a very low level of say around 1-2 per cent of GDP, for one to ignore its consequences. The weak dollar has begun to hurt economies and have caused growth forecasts to be ratcheted down in small, open economies such as Canada and Switzerland.
Not a day goes by without the Swiss National Bank expressing concern about the impact of the strong franc on the export-dependent land-locked economy. In the rest of the world, it has caused housing bubbles and, surprisingly, that includes even the Eurozone.
Hence, from the forecasters' point of view, the prediction of rising American current account deficits and the consequent weaker dollar should have taken into account rising pain everywhere and their feedback effect on geo-politics and economics.
If they had done so, the forecast of an uneventful and mildly profitable year for stocks would not have rolled off their keyboards so easily. The important question, however, is whether the Federal Reserve subscribes to this complacency.
... is tempting for Fed to accept
To be sure, the pains of a depreciating dollar are not washing up on the shores of America. It is, in fact, writing down the value of its IOUs to the rest of the world. Further, the economic costs of financing the American current account deficit, has not risen appreciably enough for most countries, particularly in Asia, for them to balk at doing so. Indeed, benefits accruing from reliance on relatively stable to weak currencies to export to America are still outweighing the costs of sterilising dollar inflows.
Therefore, it may be tempting for the US Federal Reserve chairman, Mr Alan Greenspan, not to take any pre-emptive action to rein in the current account deficit.
After all, it is fuelling growth in the rest of the world and the weaker dollar has not really hurt too many countries significantly to become politically unsustainable for America. The cost, however, in terms of financial market exuberance, might be rising.
Exuberance in low volatility, not in high valuation
Exuberance is evident not in stock valuation measures, which are more reasonable now than they were in 2000 with the exception of technology sector, but in volatility measures. Volatility in all financial asset prices has dropped to historical lows signalling investor complacency.
In a recent presentation to investors, the Chief Economist of UBS Limited made the compelling argument that the drop in implied volatility of the S&P 500 stock index is largely due to the drop in leverage (debt) in the American corporate sector and hence fundamentally justified.
The bigger the de-leveraging (or, reduction of debt), the lesser is the corporate risk and hence, all things equal, it should result in a drop in volatility and not an increase.
Fed is common global factor
This argument would not only be compelling but also complete if there was no reduction in volatility in all other assets and that too, all over the world. Volatility in currency markets, in bond markets - in America and outside, has dropped. The common theme behind all of these is not the de-leveraging in the American corporate sector.
There is a global factor. That global factor is the accommodative Federal Reserve. While, in nominal terms, the Federal funds rate went up by 125 basis points in 2004 to 2.25 per cent, in real terms, it has gone up only by 37 basis points as the rise in inflation had kept pace with the rate increase (see chart).
By keeping the real cost of funding so low, it has taken the risk out of funding riskier and longer-term investments and hence the low volatility everywhere.
In the same presentation, the UBS Chief Economist made another observation that while the yield on American government bonds might be too low in relation to the nominal GDP growth in the economy (the former is around 4 per cent while the latter is around 5 per cent or more), the behaviour of the bond yield is consistent with the expectation in the money market on American short-term interest rates.
That is, the yield on the 10-year government note has waxed and waned in accordance with the market expectation of American short-term interest rate. Yours truly agrees with that.
Low bond yields reflect low short rates
Indeed, if one compares the yield on American inflation-indexed 10-year Treasury note and the yield on the nominal 10-year Treasury Note, the gap between the two has remained at a constant 2.5 per cent over the last six months. In other words, bond investors have not become over-optimistic on inflation.
Their expectation of the annual inflation rate in America over the next ten years has remained constant at 2.5 per cent. The relatively low level of nominal yield compared to the nominal GDP growth is, therefore, due to the expectation in the money market for short-term interest rates which is, in turn, dictated by the actions of the Federal Reserve on the funds rate.
The Federal Reserve has proceeded to hike interest rates at a very gradual pace and has flagged its intentions very clearly. To its credit, this has, barring the occasional volatility (in April-May 2004) been digested by financial markets. But the Federal Reserve might have been too successful with its transparency.
Its actions have neither resulted in a restrained demand in America (as evidenced by the rising current account deficit) nor have they led to a better pricing of risk in financial markets (please refer to the discussion on implied volatility above).
Options for Fed chief
If it continues in this fashion, there is every possibility that the Federal Reserve will leave most asset markets in the world in a bubble-like state at the end of 2005 not to mention an even larger current account deficit, a weaker dollar and a higher price for oil. Consequently, in my personal view, it would be leaving the financial world at an inherently more unstable state.
The Federal Reserve has given some hints of grasping the nettle. In its December monetary policy meeting, it flagged its concern over excessive risk-taking in financial markets and in the housing market.
Also, it acknowledged that medium-term risks to price stability would surely rise if the policy accommodation were not removed. Bluntly stated, it was an acknowledgement that interest rates were too low and needed to rise.
Unfortunately, economic data in recent weeks have not provided any justification to the Federal Reserve to justify pushing interest rates up more aggressively. But, Chairman Greenspan has enough political capital to risk such a seemingly unpopular course of action. It would also be an opportunity for him to dispel the impression that he is quick to dampen excessive pessimism and slow to curb irrational exuberance.
In that sense, February is going to be a crucial month. The Federal Reserve Open Market Committee meets on February 1 and 2. Then, on February 16, Mr Greenspan delivers his semi-annual testimony to Congress. Markets should be clearer then as to how he intends to guide monetary policy in his last year in office.
Pain now, party later or party now, pain later
If it is business as usual, the equity market would like it. On Friday, it was disappointed by the slower than expected growth in the fourth quarter. The bubble-like mentality in the American stock market is still intact. But the foreign exchange market was relieved to push the dollar slightly higher at the data.
Therefore, if he does not signal any intent on the part of the Federal Reserve to restrain demand, expect the stock market to celebrate and the dollar to resume its weakness. Sooner than later, that would send bond yields higher and end the irrational exuberance in the stock market.
The choice before Mr Greenspan is clear. Prolong the party and risk a bigger and longer hangover in America and, by extension, in the rest of the world or take pre-emptive action to bring about or force a much needed re-alignment of global demand by cooling America's and by ending the complacency in the financial markets. His decision in February would dictate how history would remember him.
(The author is founder-director of Libran Asset Management (Pte) Ltd., Singapore. The views are personal. Address feedback to van@libranfund.com)
Article E-Mail :: Comment :: Syndication :: Printer Friendly Page |
