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Morgan Stanley Report - Razor-edge For Risk-assets

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Global: Razor-Edge for Risk-Assets

Joachim Fels (London)

Conundrum solved

With global bond markets in bearish mood and 10-year benchmark yields approaching the 5%, 4%, and 2% thresholds in the United States, the euro area and Japan, respectively, Alan Greenspan’s interest rate conundrum is in the process of being solved.

Central bankers, analysts and journalists almost fell over each other trying to explain the supposed conundrum last year — why had US long-term bond yields remained so low or even fallen further after the Fed started its successive interest rate normalisation campaign in mid-2004? Some claimed it was due to strong demand for long-term bonds from Asian central banks, pension funds and life-insurers. Others thought it reflected the death of macro-economic volatility and surprises due to much more credible and skilful central bank policies. And others yet, including Alan Greenspan’s successor Ben Bernanke, attributed the conundrum to a global savings glut, especially in Asia and the Middle East, which supposedly depressed real interest rates.

Back then, I was sceptical of these explanations, as they didn’t really fit the stylized facts, and the recent significant rise in bond yields makes these explanations look even less convincing now, in my view. If excess savings or central bank credibility were the reason for low bond yields, have they evaporated all of a sudden? If Asian central banks and pension funds had such a strong appetite for long-term bonds, why did yields rise in the first place? And where are these buyers now?

Global excess liquidity was the answer

I remain convinced that the main explanation for the conundrum was global excess liquidity, which was pushed into the financial markets by the G-3 central banks. True, the Fed had started to normalise interest rates. But throughout last year, the Fed funds rate still remained below neutral and, more importantly, the ECB and the Bank of Japan where at the pump, keeping short rates extremely low. As I argued in a piece published before Alan Greenspan coined the ‘conundrum’ phrase, even if the Fed kept tightening, the ECB and other central banks would take over as providers of excess liquidity (Liquidity Springs Eternal, 17 January 2005).

As I see it, global excess liquidity was the only explanation that was consistent with the synchronised global rally in virtually all asset classes, not only bonds. And the fact that bonds are now selling off as the Fed has moved beyond neutral since the start of the year, the ECB has started to normalise rates, and the Bank of Japan is preparing its exit from ZIRP, lends further credibility to the excess liquidity explanation for what happened last year. Liquidity is now becoming less plentiful as global short term interest are rising and hence bonds are selling off.

A new puzzle: risky asset are still flying high

However, just as the conundrum dissipates, a new puzzle has emerged. Despite the rise in short-term interest rates and the sell-off in global bond markets, risky assets are still shining. Equities have rallied further, the yields of low-rated corporate bonds (formerly known as ‘junk’ or ‘high yield’) have fallen further with their spread to safer paper shrinking closer towards historical lows, emerging market debt and equity markets are doing well generally despite some jitters here and there, and commodities — especially metals — are rallying, too. Normally, higher interest rates should make it more difficult for risky assets to rally as the discount factor for expected dividends is rising and as higher long-term bond yields and money market interest rates make investments in these safer assets more attractive. But the opposite appears to be happening right now, with investors eager to take on more risk in a rising interest rate environment. A new puzzle?

It must be growth: goldilocks is back

This puzzle is easier to solve than the conundrum: the only logical explanation for the apparent dichotomy between bearish bond markets and bullish markets for risk-assets is that investors are making a big bet on the continuation of strong global economic growth. Incoming economic data from many countries suggest that the global economy had an excellent start into 2006, following a slightly disappointing last quarter of 2005. With many institutions revising up their growth estimates for the global economy recently, more and more investors are becoming convinced that growth is here to stay. Central bankers appear to be in the same camp: both the Fed and the ECB are on record with fairly upbeat assessments of the growth outlook. Against this backdrop, the rally in risk assets and the simultaneous global rise in real bond yields are not that puzzling at all — they fit the growth explanation. Note that while real bond yields have risen, inflation expectations in the bonds market have remained broadly unchanged. Hence, investors are betting not only on strong growth but also on a continuation of the low inflation environment. It’s goldilocks all over again!

The razor’s edge for risky assets

In my view, risk-assets will have a tough time rallying much further this year. I hasten to emphasize that the reason for my bearishness is not the supposed end of the so-called yen carry trade, which has been much-discussed in recent weeks, for two reasons. First, the empirical evidence for a sizeable yen carry-trade is extremely thin. Cross border bank lending statistics published by the Bank of International Settlements (BIS) do not support the notion that there has been much cross-border borrowing going on in yen in recent years. The share of cross-border bank lending denominated in yen has fallen steadily from about 12% of total cross-border lending to only just above 4% recently. Second, with expected double-digit returns in emerging markets and equities, it is simply not very convincing to claim that a rise in Japanese short-term interest rates from 0% to, say, 0.5% should make the carry-trade much less attractive.

My worry is thus not the end of the carry trade, but it is growth. More precisely, growth would have to follow a razor’s-edge like path -- neither too hot nor too cold -- in order for risk-assets to continue to do well. If growth were to accelerate from its current strong path, central banks would worry more about rising resource utilisation and inflationary pressures and would push short rate significantly higher. This would eventually undo the rally in risky assets because global liquidity conditions would move from less abundant to tight. Conversely, if growth slows significantly in the course of this year, risk-assets would sell off, too, as the buoyant growth expectations embedded in current prices would be disappointed. To sustain the current ‘nirvana’, growth would have to slow at best slightly and chuck along at around its trend path, inflation would have to remain low, and the Fed would have to stop tightening before long. This scenario cannot be excluded, but I find it too good to be true.

My most likely scenario: growth falters, bonds rally, risk-assets sell off

My own scenario for global asset markets this year remains unchanged from my 2006 outlook piece last December (see The Passing of the Batons, 8 December 2005). Following a climb higher in global bond yields and a good period for risky assets in the first half of the year, I see global growth slowing, led by a US slowdown, and the Fed ending its tightening campaign and switching towards an easing bias. This would spark a rally in bonds and mark the end of the outperformance for risky assets. The US yield curve would steepen in a bullish move, and US bonds would outperform European and Japanese bonds.

The main risk to this view is that global growth remains strong, which would lead to a further tightening by central banks and a continued sell-off in bonds. But even in this scenario, risk-assets should suffer as liquidity would successively be drained and money market funds and bonds would become more attractive as interest rates rise. Thus, unless they are confident that the global economy can continues to move along the razor’s edge of neither too hot nor too cold growth and low inflation, investors should be cautious on risk-assets and stay closer to shore.

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The article sums up where we are and where we are going. A HPC is certain and its becoming more certain that it is going to be this year.

The worldwide surge in IR is like a long lance with a sharply pointed tip just beginning to indent the wall of the housing bubble.

When house prices have been inflated by 250% according to the propaganda that blitzed the public over the last few days we can expect quite a loud bang to ensue.

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