Now that we know who’s to be running against George W Bush in November’s US elections, that’s one less political uncertainty to have to factor in. There are, however, plenty of outstanding uncertainties to worry investors across the world.
For fixed income investors, one of the key issues seems to be whether the economic recovery, which is apparently well established is actually going to create jobs. If payroll numbers do start to increase, then the market will get what it wants which is interest rate rises. If, on the other hand, there is no rise in employment, then Federal Reserve chairman, Alan Greenspan, would have a very difficult job justifying a rate increase.
“We do not believe that the Fed will move in the next three to six months because we just haven’t seen the labour market strengthen even though the economy appears to be growing quite strongly,” states Alan Cauberghs, deputy head of fixed income at Dexia Asset Management. He adds that he is sure that the Fed would move to prevent any overheating, if it thought that jobs were being created.
But Cauberghs is reasonably convinced that the recovery in the US is underway. “They (the US) have had such accommodative monetary and fiscal policies that the shot of oxygen to the system has given it a huge boost. The US consumer must be feeling wealthier, for sure. As far as we are concerned, the risks are skewed towards this recovery turning out to be significantly stronger than people currently envisage.”
Others do not share the consensus view that a more ‘conventional’ economic recovery, with its concomitant rising interest rates is in fact underway. Martin Hueppi of Swiss group Clariden comments that there seems to be a particular tension and unease in the current state of affairs.
“As far as we are concerned, the US election story is absolutely crucial to what the Fed does. They are not going to alter policy before the election because that would be construed as much too political a move. One could argue that it was Greenspan who killed off Bush Senior’s re-election hopes in the early 1990’s.”
The US might well be experiencing genuine growth, but where does it come from asks Hueppi. “The transition to a more service oriented economy will detract from job creation because it results in jobs being exported to the Far East,” he argues, adding “and as computer programming becomes more commoditised we’ll see more. It must be fair to assume that human intelligence is quite evenly spread across the world; one look at the size of the Chinese or Indian populations and we have no doubt there’s plenty more capacity to take more jobs without sending (Far Eastern) wage levels soaring.”
Hueppi suggests that perhaps one should be adjusting one’s (US economic) growth expectations down from the historical ‘norms’ of around 4%. Considering his own country, Switzerland, he argues that in order to compete, Swiss exporters have to be very efficient in order to offset price disadvantages. The result is that the growth potential is limited.
“There is clearly lots of uncertainty around at the moment. Look at what happened at the start of the year when everyone was bearish on rates, says Hueppi, “And US Treasury yields fall about 40 basis points. It was one of those classic cases of everyone expecting one thing and then the opposite occurs.”
In the ongoing ‘tussle’ between investors and central bank officialdom it is sometimes the case that investors will be nearly all on one side and the central banks will be lined up on the other, and this is what many believe is happening just now. In an interesting paper from David Folkerts-Landau and his team at Deutsche Bank Research*, they suggest that most investors, the ‘private sector’, are indeed bearish on both interest rates and currencies and are positioned accordingly and on the ‘buy’ side are the central banks.
“We argue that the rapidly increasing domination of the official sector on the ‘buy’ side of treasury markets is creating a technical factor that is separating benchmark yield curves from standard fundamental analysis. It has created both a large fundamental and a huge technical factor that is bolted on to the normal cyclical adjustment with such weight that it can muffle its normal response.”
It is the Asian central banks and finance ministries who have been the most significant buyers of Treasuries. Indeed the central banks of Japan and China now hold a combined share of almost 35% of foreign investors’ holdings, but even the Fed has been a huge buyer of its own paper. Such has been the impact on interest rates that they argue investors should be looking to the supply shortage of the 2000 Treasury buybacks for more similarities to 2004, not to the run up in interest rates in 1994.
Whilst not arguing that the private sector is unaware of these massive Treasury activities, the Deutsche Bank analysts suggest quite the opposite in fact. They suggest that where market participants are wrong in investor thinking is believing that there is a limit on reserves or credit or the amount of pain a central banks is willing to put the economy through and that eventually its currency will indeed collapse. There is one country where Deutsche Bank argue that the speculators and other investors could be quite wrong, and that is Japan.
“Investors seem to be holding up a case study of the Mexican peso against a mirror and thinking the more yen they buy, the more they ratchet up the pain in Japan. Quite the opposite is true in deflationary Japan: the more yen the Bank of Japan creates to counter this, the less the economic pain. And if the Ministry of Finance wins and the yen depreciates, it even gets a financial gain. So what limits yen creation in defence against a strengthening yen? Nothing. Who can stand the most pain from their unbalanced positions this year – the bentral banks or the private sector? Who is likely to blink first?”
*‘The cosmic risk: An essay on global imbalances and treasuries’, Deutsche Bank Global Markets Research, February 2004