Global: New Game
Stephen Roach (New York)
The message from the recent sell-off in global bond markets should not be ignored. The great conundrum of unusually low real long-term interest rates may now be a thing of the past. If so, that could have profound implications for the liquidity cycle and an interest-rate-dependent global economy.
I remain convinced that central banks are always in control of the liquidity spigot. And the biggest news in close to a decade is that the Bank of Japan now appears to be on the cusp of abandoning its policy of über accommodation. In doing so, the BOJ would be following the lead of the other two major central banks in the world -- the Federal Reserve and the European Central Bank. Each of these institutions abandoned standard operating procedures for extraordinary reasons. For the Fed, it was the post-bubble deflation scare of the early 2000s. For the ECB, it was in response to the near stagnation of the European economy arising form fierce structural headwinds. And for the BOJ, it was the ultimate nightmare for any central bank -- confronting the corrosive perils of an outright deflation.
One by one, these special circumstances appear to have been overcome -- allowing the monetary authorities to remove policies of extraordinary accommodation. America’s Fed, in a determined effort to learn the lessons of Japan, moved quickly and aggressively to provide excess liquidity to a post-bubble US economy. Once this policy achieved traction, the Fed moved at a “measured pace” over the past 20 months to “renormalize” its policy rate. Similarly, as the European economy has improved in recent months, the ECB has embarked on a comparable journey, with last week’s 25 basis point tightening the second installment in what our Euro team believes will be a multi-step adjustment entailing at least another 75 bp of rate hikes by the end of this year.
But the biggest move of all has to be the BOJ. On the heels of three consecutive months of positive and accelerating y-o-y inflation in Japan’s core CPI, our crack BOJ watcher, Takehiro Sato, now believes the Japanese central bank may move as early as this week to begin its own normalization campaign. This represents a shift in Sato-san’s thinking -- he had previously been looking for the adjustment to begin somewhat later. Given the extremely delicate nature of this operation -- namely, the lingering post-bubble fragility of the Japanese economy -- the BOJ’s normalization campaign will undoubtedly be managed with great caution. As has been widely advertised, this will be a two-step process -- with this week’s likely action entailing the end of “quantitative easing” -- the provision of excess reserves to the Japanese banking system. The second shoe to fall -- the end of the infamous zero-interest rate policy (ZIRP) that has been in place for seven years -- is still not expected for another year.
Financial markets are impatient beasts. As soon as the broad consensus of investors gets a whiff of a major change brewing in the underlying macro fundamentals, they begin to re-price securities accordingly. As such, they have little tolerance for the analytical justification of slow, or glacial, adjustments such as the coming policy change of the BOJ. The fact that we and other macro teams are in the process of bringing forward our calls for the onset of monetary policy normalization in Japan is reason to suspect that we may end up doing the same thing with respect to ZIRP. With the Japanese economic recovery gathering momentum and with inflation now “breaking out” into positive territory, investors take the old adage very seriously: They move quickly -- and ask questions later.
That message has not been lost on global bond markets in the past couple of weeks. From their recent lows on 22 February, yields on 10-year Treasuries have moved up by 16 bp, whereas those on comparable-maturity Bunds and JGBs are up 17 bp and 12 bp, respectively. While yields in all three cases remain quite low in a broader historical context, the normalization of central bank policies provides good reason to ponder whether we have now seen the secular bottom for long rates. Equally important is the possibility that the BOJ -- long the low-cost source of funding in world financial markets -- is about to change the rules on the multitude of “carry trades” still popular for yield-hungry investors. If that’s the case, a normalization of spreads in what traditionally have been the more risky segments of world financial markets -- namely, high-yield corporate credit and emerging market debt -- may also be close at hand.
All this takes us to the burning question of the hour: What happens to the world economy if the bond market conundrum is suddenly resolved and real long-term interest rates revert toward historical norms? My guess is that this is not good news for what has been a liquidity-driven, increasingly asset-dependent global economy. I don’t think it’s been a coincidence that global growth has strengthened in recent years as real long-term interest rates have been trending to the downside. Nor have these been minor deviations from historical norms. If our global baseline forecast comes to pass and world GDP rises 4.2% in 2005, this will mark the fourth year in a row of above-trend growth (3.6%) in the world economy -- marking the strongest four-year global growth spurt since the early 1970s. At the same time, a composite gauge of real long-term interest rates for the major countries of the industrial world has moved further and further below its post-1985 average of 3.7% -- hitting a 20-year low of 1.8% in 2005. In my view, there can be little doubt that the real interest rate conundrum has paid a handsome dividend to the world economy.
The transmission of that impact has been well documented. In a world dominated by an ever-widening US current account deficit, there can be no mistaking the global impacts of the great American growth engine -- and its consumer-led dynamic. Driven by an unprecedented consumption binge by US households who suffer from a seemingly chronic shortfall of labor income, asset-driven wealth effects have played an increasingly important role in fueling aggregate demand. That’s where the bond-market conundrum comes into play -- not just by providing the high-octane valuation support to asset markets but also by serving as the functional equivalent of a subsidy for low-cost equity extraction from those assets. Yet that’s a sword that cuts both ways: The interest rate dividend ultimately gets drawn into question if and when the policy normalization driving rates at the short end of the global yield curve finally gives way to normalization at the long end of the curve.
That’s precisely the risk that’s now in play in world financial markets. While the recent upward move in bond yields is tiny when compared with the anomalous moves of recent years, it certainly bears watching insofar as the prognosis for the interest-rate-dependent global economy is concerned. Given the US-centric character of the global economy, that pretty much puts the focus of the debate on the asset-dependent American consumer.
In that vein, the Fed tightening campaign of the past 20 months has already led to important shifts in several key aspects of the macro landscape that are key to the US consumption outlook. That’s especially the case with respect to the property-driven wealth effect. Not only do home sales appear to be topping out, but there has been a dramatic downturn in home mortgage refinancing activity -- with the refi loan application index having fallen to less that one-third peak levels hit in 2003, according to the Mortgage Bankers Association. This points to a likely downturn in home equity extraction, which Alan Greenspan estimates ran in excess of $600 billion in 2005. In a climate of anemic growth in labor income -- with private sector compensation increasing only about 2% over the 12 months ending December 2005 -- surging equity extraction was critical in boosting consumption growth to 3.5% last year.
In my view, the Fed tightening cycle has already taken a toll on the housing market, with significant implications for prospective growth in personal consumption. As the monetization of the property wealth effect now slows in accordance with the downturn in refi activity, the only way to avoid a significant downshift in consumption would be through a spontaneous revival of labor income generation. That might be expected from the old closed-economy models of yesteryear -- especially with the US unemployment rate now having fallen below 5%. But in the “open economy” models of globalization, both hiring and real wages should remain under pressure -- constraining the growth in worker compensation and leaving income-short, asset-dependent American consumers with little choice other than to rein in excess consumption (see my 21 February dispatch, “Open Macro”). To the extent that upward pressures on interest rates now move from the short end of the yield curve to the long end, risks to overly-indebted US consumers could be compounded.
There’s another key piece to this puzzle that is much harder to quantify -- the potential unwinding of the global carry trade. In the current liquidity-driven climate, the search for yield has all but taken the risk out of the price of risky assets. That has shown up in the form of an extraordinary compression of spreads in emerging market debt and corporate credit -- to say nothing of sharply reduced volatility in global equity markets. The consensus has swung to the belief that this spread compression is supported by vastly improved fundamentals -- inflation control, reforms, and debt repayment in the developing world and surging cash flow and balance sheet repair in the corporate sector of the developed world. While these improvements should not be taken lightly, I continue to worry that markets may have gone too far in dismissing systemic risks in these assets -- especially for emerging market securities. A US consumption shock would be especially worrisome in that regard -- a development that would reverberate quickly into Mexico, China, Asia’s China-centric supply chain, and even a China-linked Brazilian economy. Absent the incentives of the carry trade, a normalization of the pricing of macro risk also seems likely.
The bearish bond call has been met with repeated frustrations over the past several years -- and far longer than that for the so-called “JGB short.” The problem may be traceable to focusing on the wrong issue -- inflation -- and paying too little attention to the global liquidity cycle. In that latter regard, a key shift has now occurred -- the central bank anchor of cheap money has finally been hoisted out of the waters. It was one thing for the Federal Reserve to remove its extraordinary accommodation, but it’s another matter altogether for the Bank of Japan to begin implementing its exit strategy. It’s a new game for the global liquidity cycle -- and possibly a new game as well for real long-term interest rates and an asset-dependent global economy.
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