Rethinking Bonds and Another Conundrum
John Mauldin's Outside the Box

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Introduction

This week's letter is again by one of my favorites, Stephen Roach of Morgan Stanley. We will look at two pieces, one from May 31st and another from June 3rd. The first article lays out why Roach is moving from a bond bear to a bull or at least neutral stance. Low inflation, slowing china, and low relative rates in other parts of the world will help keep our long end rates down.

The second article examines the movement of the dollar. If the current account deficit is to narrow, the dollar must fall and interest rates must rise. The first part looked at why Roach does not expect rates to rise on the long end of the curve, which means the dollar rally must end and Asian currencies should rise. This type of insight is why Roach is one of the smartest economists around and picked for this week's Outside the Box.

- John Mauldin

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Rethinking Bonds

May 31, 2005
By Stephen Roach

When I first wrote of an interest rate conundrum in January, little did I know how deeply this concept was about to become ingrained in the heart and soul of central banks and financial markets (see my 18 January dispatch, "The Real Interest Rate Conundrum"). But conundrum it is, as real rates remain at unbelievably low levels at the short and long end alike -- in the US, Europe, Japan, and even emerging markets. Given my concerns over the US current account deficit, I have long been in the bearish camp with respect to the US bond market outlook. A rethinking is now in order. The likelihood of a China-led slowing of Asia has prompted me to change my view. I now suspect bond yields will stay low for the foreseeable future, and I wouldn't rule out the possibility that they might even drift lower.

Recent trading action in fixed income markets has revealed a lot about the character of the interest rate conundrum. During the credit scare of early May, the so-called riskless asset -- namely, US Treasuries -- have benefited from a classic safe-haven bid. Yields on 10-year Treasury notes fell from close to 4.3% to nearly 4.0%. Yet something strange has occurred as the angst of the credit event faded -- long-term yields haven't returned to their earlier levels. As always, there are a multitude of factors bearing down on financial markets that make it difficult to dis-entangle the impacts of any one development. The mid-May release of a surprisingly benign CPI report -- a core rate of inflation that was unchanged for April on a month- to-month basis and decelerating on a year-over-year basis for the second month in a row -- certainly stands out as a new and constructive piece of information for the bond market. But I don't think that was enough to neutralize the typical reflex effect that almost always occurs as the urgency of a flight-to-quality bid fades. Something else is going on in the bond market.

The asset-allocation flows of a low-return world are obviously an important part of this equation. The demographic imperatives of funding ever-mounting asset-liability mismatches have put a natural bid under long duration assets. With the days of heady, late 1990s-style returns on equities long thought to be over, fixed income instruments have become the new asset class of choice for fund managers. Central banks have encouraged this tilt by holding policy rates near the zero threshold in real terms for the past several years. The result has been a succession of carry trades that became the icing on the cake for ever-frothy fixed income markets -- also bringing hedge funds and speculators into the game. The migration of bets along the risk curve has had a stunning logic. Investors have been vulture-like in squeezing excess returns out of one type of instrument and then moving on to the next. It started with sovereign bonds and has then spread in rapid succession to investment-grade corporates, high-yield corporates, emerging- market debt, and, more recently, the exotic structured credit products.

I have been highly suspicious of the staying power of this flow-driven bull run in bonds. Such momentum-driven buying almost always goes to excess and there is good reason to believe that this will be the case this time as well. What worries me the most in this regard is the coming US current account adjustment. History is devoid of examples where external adjustments are not accompanied by falling currencies and rising real interest rates -- the latter being necessary to compensate the creditors of deficit countries for taking undue currency risks. With the funding of America's current account deficit now requiring close to $3 billion of capital inflows each business day and the dollar on a three-year descent -- at least until early this year --- the pressures for some type of interest rate adjustment were mounting. Timing, of course, is the trickiest part of this call -- especially since the bulk of the recent flows appears to have been driven by the "policy buying" of dollar-denominated assets by foreign central banks. But with the buyers at the margin -- namely, Asian monetary authorities -- seriously overweight dollars, the logic of portfolio diversification suggested the day of reckoning was likely to come sooner rather than later. That one consideration has kept me in the bearish camp on the bond market for most of the past few years.

As strongly as I have felt -- and continue to feel -- about this conclusion, I must also confess to being torn by the other side of the trade. What concerns me the most in this regard are two major risks for an unbalanced global economy -- a possible growth shortfall and another downdraft on the inflation front. Nor do I view these concerns as purely cyclical. The ever- powerful IT-enabled forces of globalization -- now spreading from tradables to once-sacrosanct nontradables -- seem to be imposing new limits on pricing leverage that our traditional inflation models are simply not equipped to handle. Against this secular backdrop of the globalization of price compression, the impacts on inflation and inflationary expectations could be magnified by any major cyclical shortfalls in global activity.

That is precisely what I now suspect could be in the offing -- a China-led slowing of the pan-Asian economy that could have a very important bearing on both global growth and inflation. As I noted last week, there is now a compelling case for a China slowdown later this year that could last well into 2006 (see my 23 May dispatch, "What If China Slows?"). Two sets of forces appear to be at work -- domestic policies that bear down on China's property bubble and external policies that squeeze Chinese exports. Collectively, fixed asset investment and exports make up 80% of China's GDP. There is now good reason to stress the downside risks to this huge piece of the Chinese economy that is currently expanding at nearly a 30% y-o-y rate. For the past six years, China's GDP growth has fluctuated in the 6-9% range. Currently, it is growing at the upper end of this range. By the time the China slowdown plays out, I suspect that its GDP growth could be near the lower end of this range.

If such a slowdown comes to pass, two broader macro impacts are likely to unfold -- the first being a slowing of activity in China's pan-Asian supply chain. That would take an especially large toll on Taiwan, Korea, and Japan, but few economies elsewhere in Asia would be spared. Collectively, Asia accounts for fully 35% of world GDP (as measured by the IMF's purchasing- power-parity metrics). That means the direct effects of a two-percentage point slowing of growth in China-centric Asia -- a distinct possibility, in my view -- would knock 0.7 percentage point off world GDP growth. The second macro impact comes on the inflation front -- namely, in the form of a sharp reduction of Chinese commodity demand. With China now accounting for only 4% of world GDP (at market exchange rates) but 8% of crude oil consumption, 20% of world aluminum consumption, and 30-35% of steel, iron, coal, and a broad array of other industrial materials, a slowdown in the pace of Chinese industrial activity is hardly without consequence for commodity inflation. The Journal of Commerce spot index of industrial materials has already done a round trip -- moving from a peak rate of inflation of nearly 35% in early 2004 to an outright decline of -3% y-o-y in late May of this year. In the event of a China-led Asian slowdown, recent downward pressures on commodity prices could intensify. That could have an important impact on tempering the inflationary expectations embedded in bond markets.

But what about the interest rate implications of America's coming current account adjustment? This has been my own personal stumbling block on the bullish call for bonds. I have thought long and hard about this and have now concluded that I may be guilty of having overlooked a critical aspect of the interest rate piece of an external adjustment. In the end, what foreign creditors seek in a current-account adjustment is a relative premium for taking currency risk. The key aspect of this premium is the word "relative." As long as spreads widen between the US and other international interest rates, that may be sufficient compensation for America's foreign lenders. In other words, US interest rates need not rise sharply in the absolute sense in a current-account adjustment. All that is needed is that they remain attractive in comparison to rates elsewhere around the world. Interestingly enough, Joachim Fels feels about the same way with respect to European bonds, especially in the aftermath of the French "non" on the EU constitution (see his 30 May dispatch, "Vote No on Eurozone Bonds"). While I understand the near-term appeal of that call, over time, I suspect that the risks associated with a likely US current account adjustment will be far more important in shaping relative returns in the global bond market than will be the more remote possibility of an EMU breakup.

I must confess to being stuck on one key piece of this macro riddle: In my view, real interest rates -- both short and long -- are still far too low for sustainable growth in the global economy and for stable conditions in world financial markets. Yet central banks -- especially America's -- have been reluctant to lead the charge in normalizing the rate structure. The best we have gotten from the Fed is a policy rate that has gone from negative to zero in real terms over the past year. I continue to believe this is ultimately a recipe for disaster. America's bubble-prone, saving- short, overly-indebted, asset-dependent economy is very much an outgrowth of excessively low real interest rates. But in the context of what could now be an impending shortfall in global growth, real rates may stay low. In fact, financial markets may well be correct in pricing a Fed that could go on hold sooner rather than later. Consequently, given the likelihood of a China-led compression of inflationary expectations, another leg to the secular rally in bonds can hardly be ruled out. At some point over the next year, I wouldn't be shocked to see yields on 10-year governments test 3.50% in the US, 2.50% in Europe, and 1% in Japan.

So call me a bond bull for now. In today's era of low-inflation globalization, a China-led growth shortfall would be a big deal in shaping the cyclical forces that drive the inflationary premium embedded at the long end of yield curves around the world. America, with its gaping current account adjustment, should benefit less than surplus countries in riding the next wave of any bull move in bonds. But in this climate, the bear case makes less sense -- unless, of course, you want to bet on the dark side of global rebalancing and a potential protectionist backlash. While I remain quite sympathetic to those concerns, the markets do not -- at least for the time being. Should that sentiment change and protectionism intensify -- an endgame I continue to fear -- the bond market could then do a quick about- face and come under severe selling pressure.

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Another Conundrum

June 3, 2005
By Stephen Roach

The interest rate conundrum is challenging enough. But now the dollar is springing back to life in the face of America's record current account deficit. In my view, this defies both the history and the analytics of the classic current account adjustment. Is this just another example of a world turned inside out, or is it a head-fake likely to be reversed?

Despite rebounding nearly 3% from its low this January, the broad dollar index is still down about 13% from peak levels hit in early 2002. The dollar's descent is a logical outgrowth of America's massive current account deficit. The only problem is that it hasn't fallen nearly enough to make a dent in the US external imbalance. A comparison with trends in the late 1980s underscores this conclusion: During that earlier period, America's current account deficit peaked out at 3.4% of GDP and the broad dollar index fell nearly 30% over the three-year period, 1985-88. With our estimates placing the US current account deficit at about 6.5% in 1Q05, it is hardly a stretch of the imagination to see the external shortfall rise into the 7- 7.5% range over the next year. In other words, today's current account problem is easily twice as bad as it was back in the 1980s but the US currency has fallen by less than half as much as it did back then. On that simple basis, alone, the dollar has plenty more to go on the downside.

I have long maintained that the dollar can't do the job alone in correcting America's current account imbalance. Two reasons come to mind -- the first being that the impact of currency fluctuations on real trade flows and inflation seems to have diminished over the past decade. Trends over the past three years underscore this observation: The US trade deficit has continued to widen fully three years into what had been a 15% dollar depreciation, whereas inflation has remained generally subdued over this same period. By this time in the dollar's downtrend of the late 1980s, both trade and inflationary impacts were evident. I suspect that the diminished impact of currency swings in the current climate stems importantly from the increasingly powerful forces of globalization, as low-cost offshore price setters (i.e., China) constrain domestic pricing leverage -- even in the face of currency swings and concomitant fluctuations in import prices. That suggests, of course, the impacts of currency fluctuations could show up more in corporate profit margins than in generalized inflation.

But the second and far more important reason that the dollar can't solve America's trade and current account problem is that it doesn't get directly at the most critical ingredient of the imbalance -- excess imports, which are, in turn, an outgrowth of excess US domestic demand. One number says it all: In March 2005, US imports were fully 54% larger than exports. In my view, there is no conceivable dollar adjustment -- or should I say no politically acceptable dollar adjustment -- that would eliminate America's excess import problem. The only effective way to temper an import overhang of this magnitude lies in a real interest rate adjustment that would squeeze excess consumption -- and its import content -- out of the system. At a minimum, this would entail a normalization of real US interest rates -- both short and long. Specifically, I believe that would require the term structure of real rates to move upward by about two percentage points from present rock-bottom levels. Not only would that hit the interest-sensitive components of domestic demand -- consumer durables, capital spending, and residential construction -- but it would also cool off frothy asset markets and the wealth-dependent consumption (and imports) such market excesses are fostering.

In this context, America's current account adjustment requires a combination of currency and real interest rate adjustments -- both a weaker dollar and a normalization of real interest rates. This underscores an important tradeoff: To the extent that one of the ingredients in this external adjustment equation doesn't deliver its fair share, the burden of rebalancing should then be transferred to the other part of the equation. Therein lies the case for a significant further weakening in the US dollar. In my recently revised view of US interest rate prospects, America's long overdue normalization of real rates is likely to be aborted (see my 30 May dispatch, "Rethinking Bonds"). In the face of the coming China-led slowdown in global growth and its collateral impacts on reduced inflationary expectations, a decidedly pro-growth and market-friendly Fed is unlikely to have much of an appetite for additional monetary tightening. Moreover, the combined impacts of a global growth shortfall and further declines in commodity prices point to a likely compression in the inflationary premium embedded at the long end of the yield curve. As I now see it, given the urgency of a US current account adjustment, further dollar depreciation is a logical outgrowth of such a benign climate in the bond market.

Of course, precisely the opposite is now happening. After an orderly three- year descent of about 5% per year, the broad dollar index has been edging higher over the past four months. This momentum has accelerated in the days immediately after the French and Dutch rejection of the EU constitution. Market participants have taken this political verdict as negative feedback on the future of European integration and the reforms and efficiency enhancement such convergence was long thought to deliver. I agree with Stephen Li Jen, head of our currency team, that the frenzy of euro selling has probably been overdone in the aftermath of this political setback. I also share his views that this political shock is unlikely to have a critical bearing on the region's commitment to structural reforms -- a conclusion somewhat at odds with the views of our Euro-zone team. However, given my concerns over the US current account deficit and my reassessment of the US interest rate prognosis, I do not agree with Stephen that the dollar's structural decline is over. By my count, this is the fourth trading rally in the dollar's recent 39-month downtrend. Like the first three, I believe this one will also fade as the power of the US current account adjustment regains its prominence as the dominant macro theme shaping foreign exchange markets. In the absence of an upward adjustment to US real interest rates, I believe this possibility is even more compelling than might have otherwise been the case.

The next downleg of the dollar should be very different from the first one. The euro has borne the brunt of the dollar's decline over the three years ending January 2005. Most Asian currencies -- especially the yen and renminbi -- were completely unscathed. If the dollar resumes its downward descent, as I suspect, that will have to change. Not only do I look for a politically driven change in Chinese currency policy that would allow for an RMB revaluation, but I also suspect that the yen-dollar cross-rate could move into the mid-90s. The Japanese currency has been virtually unchanged on a broad trade-weighted basis over the entire span of the dollar's adjustment. If the Japanese recovery is finally for real, as official Japan seems to be signaling, then yen appreciation should be a natural outgrowth of that healing. If the Chinese and Japanese currencies strengthen, most other Asian currencies should follow suit -- with the possible exception of the Korean won, which has already moved a lot. I've said it from the start: Global rebalancing is a shared responsibility. It is high time that Asia participate in the adjustment process.

The currency call has long been one of the trickiest in the macro trade. In large part, that's because foreign exchange rates are relative prices that reflect shifts in a broad array of comparative metrics between nations -- namely, productivity growth, inflation, interest rates, perceived returns on assets, capital flows, and the like. At the same time, monetary authorities often attempt to target their currencies through intervention and/or policy- directed reserve-management practices. And the toughest aspect of the currency call is that the markets do not assign constant weights to the factors above -- the main drivers of fluctuations in foreign exchange markets are seemingly never the same from year to year.

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Of course, currency markets are also highly sensitive to swings in investor sentiment. And with the benefit of hindsight, we should have known that the dollar was about to surprise on the upside. At our annual global investment conference at Lyford Cay last November, the consensus was tightest on the belief of a further decline in the dollar. The "curse of Lyford Cay" has worked its magic once again. Nevertheless, I think this counter-trend rally will be short-lived. The imperatives of global rebalancing -- underscored by America's massive current account deficit in conjunction with an aborted adjustment in US real interest rates -- points to nothing less. If I'm wrong and the dollar continues to defy gravity in a low interest rate climate, you can forget about global rebalancing. In that case, global imbalances will continue to mount and asset markets could become all the frothier. Sadly, the endgame would then be ever more treacherous.

Conclusion

I hope you enjoyed this week's letter. You can find Stephen Roach's current and archived commentary plus commentary by others mentioned in the global economics team at http://www.morganstanley.com/GEFdata/digests/latest-digest.html

Your still long-term bearish dollar analyst,


John F. Mauldin
johnmauldin@investorsinsight.com


Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Posted 06-06-2005 2:48 AM by John Mauldin
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