Global liquidity is the main driver
morganstanley.com
Global: The Passing of the Batons
Joachim Fels (London)
The year of the conundrum. This year has been a particularly challenging one for many forecasters. It has been a year of unexpected and often puzzling developments in the economy and in markets. ‘Conundrum’ would most certainly win the ‘word of the year’ award in financial markets, if such a prize existed. Why have bond yields remained so low despite strong economic growth and rising short-term interest rates? Why did the global economy continue to motor ahead despite yet another major oil price shock and continued Fed tightening? Why has the dollar defied the bearish consensus, even though the US current account deficit kept widening? These are only some of the questions that have kept us on our toes throughout the year.
Global liquidity is the main driver. There is no generally accepted answer to these puzzles. Yet, my own working assumption has been and remains that the answer is global excess liquidity, which has been created by the world’s main central banks over the past several years (Liquidity Springs Eternal, 17 January 2005). True, the Fed has mopped up some of the excess liquidity through a series of rate hikes. However, by keeping rates at unnaturally low levels the ECB became the world’s marginal supplier of excess liquidity, pushing the global money to GDP ratio to a new record high. The liquidity glut ensured that global bond yields remained low, risk spreads tight, and equities on the upswing. Easy financial conditions, in turn, help to explain why the global economy kept expanding rapidly. And with dollars becoming more scarce due to the Fed’s liquidity withdrawal, but euros becoming more plentiful due to the ECB’s pumping operation, the dollar recovery should not have been all that surprising either.
Focus on central bank policies. To me, the events of 2005 confirm my long-held view that monetary policy actions — which drive liquidity — hold the key for explaining much of what’s going on in the global economy and markets. Hence, in thinking about the outlook for global fixed income markets in 2006, which is the purpose of this note, I believe it is essential to focus first and foremost on prospective central bank policies and their impact on excess liquidity. And in this respect, I expect the year 2006 to bring important changes.
Normalisation goes European. The most important trend for markets in 2006, in my view, was already kick-started this month, when the ECB raised interest rates for the first time in more than five years. I see this as only the first of several steps up in euro area short rates that are aimed at bringing monetary policy closer to neutrality. Thus, the ECB is now joining in with the Fed, which already started the normalization process 17 months ago. While markets easily shrugged off the first ECB rate hike, which was well telegraphed in advance, the real significance of the move is that the ECB, as the world’s largest supplier of excess liquidity this year, is finally starting to take its foot off the accelerator. True, ECB President Trichet carefully avoided giving the impression that the bank had already decided on a series of rate hikes. Still, I share our European economics team’s view that this was not a one-off hike, and I expect euro short rates to rise by another 75 basis points (bp) to 3% in 2006. Thus, global liquidity looks set to become less plentiful … unless somebody else takes over the baton as the marginal supplier from the ECB.
Bank of Japan deliberately lagging behind. One potential candidate to step in for the ECB as global liquidity provider is the Bank of Japan. Note that the lifting of the quantitative easing policy, which our BoJ watcher Takehiro Sato expects to occur by April 2006 or so, would not be at odds with such a role. This is because the end of quantitative easing is not expected to be accompanied by an end of the zero-interest-rate policy (ZIRP) in 2006. Sato-san expects ZIRP to remain in place until 2007. And with interest rates at zero and the money multiplier starting to work again as deflation ends, property prices rise, and the banking sector is out of the woods, the Bank of Japan could well take over the baton from the ECB as the world’s global liquidity provider. Moreover, it may even get help from another companion in the course of 2006 — the Fed.
The Fed: from tightening to easing? If the Eurodollar futures markets are right, the Fed will reverse course in 2006, with two or three more rate hikes being followed by a rate cut in the second half of the year. Note that this view is not shared by our US economists, who expect growth to remain strong throughout 2006 and the Fed to raise the funds rate to 5%. However, the Eurodollar markets appear to have a very different scenario for 2006 in mind, similar to the bond market, where the beginning inversion of parts of the Treasury yield curve raises the spectre of a US recession in about four quarters. As I have argued elsewhere (The Recession of 2007, 17 November 2005), I take the message from the yield curve seriously and assume a sharp slowing of the US economy in the second half of next year, and possibly even a recession in early 2007 (for a debate on these issues amongst Morgan Stanley economists and strategists, see Debating the Yield Curve, 27 November 2005). Thus, my scenario assumes that the Fed will return to the liquidity pump in the second half of 2006 and will, alongside the Bank of Japan, compensate for at least some of the liquidity shortfalls caused by ECB tightening.
From Greenspan to Bernanke … Another theme for fixed income markets in 2006 is likely to be the leadership transition at the helm of the Fed. There has been much speculation that Chairman-designate Bernanke would adopt a very different approach from Chairman Greenspan, mainly because the former is a proponent of ‘inflation targeting’. However, in my view, any changes would be evolutionary rather than revolutionary, for two reasons. First, the Fed is bound by its dual mandate, which requires the Bank to aim at price stability and maximum sustainable growth/employment. Ben Bernanke made it very clear in his recent testimony before the Senate’s Banking Committee that he fully endorses the dual mandate. Second, even if Bernanke as Chairman wanted to revolutionize the Fed (which again I doubt), he would have to win a majority in the Federal Open Market Committee (FOMC), which would be likely to defend the Greenspan legacy. Hence, I do not expect any major or abrupt changes at the Fed due to the arrival of the new Chairman.
...and from Issing to _____. A (so far) less discussed but very important personnel change will occur at the ECB next June, when Executive Board member and Chief Economist Otmar Issing retires. He has at least two roles at the ECB. First, as a former board member and Chief Economist at the Deutsche Bundesbank from 1990 to the start of EMU in 1999, when he joined the newly formed ECB, he personifies the personal continuity from the old Bundesbank to the new ECB, which was especially important in the early days of EMU when the ECB had no proven track record yet. Second, Professor Issing masterminded the ECB’s two-pillar monetary policy strategy, which puts a special emphasis on the analysis of money and credit aggregates as a guide to conducting monetary policy. His upcoming departure next year has led some observers to speculate that after his departure, the role of monetary analysis in the ECB’s deliberations would be downgraded significantly and that the ECB would transition to a softer monetary policy stance. Similar to the Bernanke transition, I believe that such changes, if they were to occur at all, would be evolutionary rather than revolutionary. Moreover, while it is true that Professor Issing has been the mastermind behind and the ‘public face’ of the two-pillar strategy, it is a strategy commonly agreed and, in 2003, modified by the Governing Council. Thus, whoever may succeed Professor Issing (and this is not the place to speculate about potential successors), the ECB’s policy approach is unlikely to change abruptly.
Outlook for fixed income markets. I expect global bond markets to migrate from a focus on inflation concerns in the first half of the year to growth concerns later. Thus, yields should climb higher initially as both the Fed and the ECB hike rates and the BoJ abandons quantitative easing. Yet yields should peak and start a descent, and risk spreads should widen as soon as the US economy slows and the focus in markets shifts to potential Fed rate cuts, an end of ECB tightening, and a potential recession in 2007. With the ECB tightening in H1 but the Fed ending its campaign, Treasuries should outperform euro area bonds. The US yield could re-steepen while the European curve should flatten. And global liquidity would remain plentiful, cushioning but not preventing the sell-off in risky assets. |
