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It is the beginning, not the end

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Neither financial market conditions nor the strength in the real US economy gives any room to conclude that the Federal Reserve would pause in its tightening campaign and allow the bond market to recover. V. Anantha Nageswaran concludes that the climb-down from euphoria has just begun and for the 10-year Treasury Note Yield, and the climb-up is perhaps, at best, half-way through.

V. Anantha Nageswaran

FOR QUITE some time, this column has focused on investor and global financial market complacency. In other words, appetite for risk was high. Emerging market stocks and bonds were sought-after and credit spreads were tighter than ever before. Much of this was due primarily to low interest rates in the US and elsewhere in the industrialised world. Among other things, this led to the steady depreciation of the US dollar. This, in turn, resulted in low or lower interest rates even in the developing world. As a result, we have had a world awash with liquidity (easy money).

With the carry-over of the investment glut from the 1990s pretty much everywhere in the world, much of this liquidity boosted asset prices bonds, stocks and houses. Snared by low interest rates, it has also meant that households have taken on more debt into their balance-sheet. This is evident in America, Australia and in Asia.

Now, with the Federal Reserve raising the funds rate for the seventh time to 2.75 per cent and backing it up with a relatively heightened alert on inflation, financial markets have become nervous.

In the wake of this steady climb in the Federal funds rate, the American 10-year Treasury yield has also moved up from just under 4 per cent in early February to around 4.6 per cent now. Some commentators are, therefore, wondering if the increase in the Treasury yield is over and if it is time for yields to linger at around current levels before climbing down.

This column would argue, in many ways, that such hopes might be premature. Indeed, global risk appetite was at its highest in five years, in mid-February. It is not only unrealistic but also naïve to think that risky assets are already safe to wade back into.

Financial conditions are easier

For the long-term yield to climb down, it must be the case that financial conditions in the US have tightened considerably since the Federal Reserve began to raise interest rates last June. That is not the case. In fact, the opposite is true. We know that the dollar is weaker since the rate hikes began. Further, both the real short rate and the real long rate are lower than they were in June 2004. Therefore, the Federal Reserve is facing easier financial conditions than when the Federal funds rate was at 1.0 per cent. Its work is yet to begin!

Economic growth rate is above potential growth rate

This is also evident in the re-acceleration in growth in the US after the soft patch in the third quarter of last year. When the final estimate of the fourth quarter GDP growth is released this week, it is likely to show an annualised growth rate of 4 per cent or slightly above that.

Housing starts are still running at a good clip, pushing more people into believing that the US housing market is a bubble. Commercial and industrial loans are rising as well as real estate loans. Orders for non-defence durable goods (excluding aircraft orders) are rising too, indicating good investment spending in the coming months. Indeed, imports of capital goods were strong in the February.

With easier financial conditions and solid economic growth, American current account deficit would continue to rise and hence bolsters the case for continued dollar weakness, notwithstanding brief episodes of firmness for the currency. They could be rightly treated as comic interludes in an otherwise heavy drama.

Hence, neither financial market conditions nor the strength in the real economy gives any room to conclude that the Federal Reserve would pause in its tightening campaign and allow the bond market to recover. Of course, experienced commentators would point out that the Federal Reserve does not have to stop raising rates for the bond market to rally. What matters is how much of it has been discounted by the financial markets already.

Investors yet to discount worst case for rates

Federal funds futures contracts show that market participants now expect the funds rate to be between 4.0 per cent and 4.25 per cent by the end of the year. There are six meetings between now and the end of the year. Hence, the market has discounted a rate hike of 25 basis points in every meeting for the next six meetings. On the face of it, it might appear that the market had discounted a lot of tightening from the Federal Reserve already. However, let us try to put this in perspective.

A very relaxed attitude from the Federal Reserve could put the Federal funds rate at 3.5 per cent by the end of the year. An aggressive approach from now on could see the Federal funds rate at 5.0 per cent. The market expectation of around 4.25 per cent is smack in the middle of this range and hence, is not aggressive.

Again, a counter-argument is that whether the Federal funds rate of 4.25 per cent is already restrictive. It is always tricky to determine, beforehand, the level of interest rate that is restrictive. It is discernible after the fact, based on the reaction of the economy. Second, to judge the restrictiveness of the policy rate, one has to know the neutral level of the Federal Funds rate. That is equally difficult. Nonetheless, it is possible to guess the neutral level.

`Neutral' territory is some distance away

One is to take the historical average of the real federal funds rate and add one's forecast of the inflation rate to arrive at the neutral rate. The historical real federal funds rate is around 2.0 per cent. The inflation forecast is around 2.5 per cent to 3.0 per cent. One source for this is the University of Michigan survey on inflation expectations. Hence, based on this metric, the neutral rate could lie in the 4.5 per cent to 5.0 per cent interval. There is another metric of the neutral rate.

It is to equate the real Federal funds rate with the economy's potential growth rate and then add on inflation expectation. The American economy's potential growth rate is variously estimated from 2.5 per cent to 3.5 per cent. Therefore, with inflation expectations at 2.5-3 per cent, the neutral Federal funds rate could be placed at 5.0 per cent to 6.5 per cent.

Hence, the market expectation of 4.0-4.25 per cent is not overly cautious. Indeed, it could still be lagging. After all, with the economy growing at 4 per cent and inflation expectations rising, the Federal funds rate should already be in `neutral' territory. Therefore, the market is not exactly pricing in a hurried `catch-up' by the Federal Reserve. That would have been understandable.

Hence, the conclusion here is that the market expectation is not pessimistic enough to suggest that the American Treasury Note yield is close to its peak.

Real 10-year Treasury yield is still too low

One last argument is to examine the real yield on the US 10-year Treasury. The Chart measures the real yield on the 10-year Treasury during the Alan Greenspan era at the Federal Reserve. The average for this period is around 3.4 per cent and one standard deviation is about 0.8 per cent. The real 10-year Treasury yield has just come off from two standard deviations below its average of the last eighteen years. Clearly, from a structural perspective too, it is not possible to argue that the 10-year Treasury yield is cheap.

Therefore, after having presented the arguments from four perspectives current financial conditions, the state of the real economy, the neutral Federal funds rate and the long-run equilibrium real yield this column concludes that the climb-down from euphoria has just begun and for the 10-year Treasury Note Yield, the climb-up is perhaps, at best, half-way through.

It might be a good occasion to consider one last counter-argument. Some might rightly point that not only the US economy but also financial markets are so geared (in debt) that the Federal Reserve might not be able to push the Federal funds rate beyond 4.0 per cent and that anything above that level might trigger a global financial crisis. That is a possibility.

If that is the case, then the question is whether that risk is priced into American and global stock market valuations. I leave it to the readers to ponder over this question until the next column.

(The author is founder-director of Libran Asset Management (Pte) Ltd., Singapore. The views are personal. Address feedback to van@libranfund.com)

(This article was published in the Business Line print edition dated March 28, 2005)
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