The Sure-Thing Syndrome

Contact John Mauldin

Volume 1 - Issue 17
January 10, 2005

by Stephen Roach

This week I put out my 2005 forecast that called for a See-Saw Economy. The theme being that the economy will not take off or crater but continue to move along at a relatively slow upward pace. There will be an end game to this cycle, but I don't see it this year.

One of my favorite economists, Stephen Roach, of Morgan Stanley gives us an insight into what one of the major components of that end game will look like. Let's take a look at his comments on the end of the carry trade and the consequences this could have on the economy in the coming year.

- John Mauldin

The Sure-Thing Syndrome
Stephen Roach - Morgan Stanley Global Economic Team
January 10, 2005

In the end, denial is usually the only thing left. In my view, that's pretty much the case today in world financial markets. Imbalances on the real side of the global economy have moved to once unfathomable extremes. And now the Federal Reserve belatedly enters the fray threatening to take away the proverbial punch bowl from a rip-roaring party. Financial markets hardly seem concerned over this impending collision. Spreads on most risky assets have fallen to razor-thin margins. Steeped in denial, investors have once again become true believers in the sure-thing syndrome.

There can be no mistaking the absence of risk aversion in most segments of world financial markets. Even in the aftermath of the Fed's early January wake-up call, so-called spread products have barely flinched. That's true of high-yield and emerging-market debt, and it's also the case for investment grade and bank swaps spreads. Even pricing of the "riskless" asset -- US Treasuries -- remains in rarefied territory, as yields on 10- year notes oscillate around the 4.25% threshold. At the same time, equity- market volatility has all but vanished into thin air.

Market chatter is laced with impeccable logic as to why it still pays to buy risk. In most cases, the arguments rest on perceptions of "improved fundamentals." Awash in cash flow and riding the wave of a new era of sustained productivity growth, Corporate America has nothing to worry about, most believe. That impression is evident across the risk spectrum, from high-yield to investment-grade companies. A similar verdict has been rendered with respect to emerging markets -- long the most crisis-prone segment of world financial markets. Improved external debt positions have the consensus convinced that emerging-market risk has also entered a new era. Hernando Cortina points out that emerging-market equities are now trading at the smallest discount to developed-market equities in a decade.

Perceptions of a Teflon-like US economy underpin this denial. A personal saving rate that has plunged to zero is widely dismissed as irrelevant. After all, goes the argument, it doesn't reflect the new asset-based saving tactics of American consumers. Related to that, record levels of household indebtedness are now viewed as just fine -- a logical outgrowth of ever- appreciating asset values and super low financing rates. The budget deficit is depicted as "normal." And why worry about a world record current-account deficit? Foreign investors know full well, goes the argument, that America is special -- offering superior rates of return and a system that the rest of the world can only envy. At the same time, Asian central banks have little choice other than to support the bid for dollar- denominated assets, lest they lose the currency competitiveness that lies at the core of their export-led growth models.

This sure-thing syndrome all hangs together under the general rubric of what has been called the "carry-trade." In its most basic sense, the carry trade depicts an unusually tantalizing financing climate -- in this case, underwritten by the extraordinary monetary accommodation of America's Federal Reserve. The real federal funds rate was lowered into negative territory in 2002 and has only very recently moved back to the "zero" threshold. This marks the most protracted period of negative real short- term US interest rates since the late 1970s -- hardly a comforting comparison. Carry trades have become no-brainers for yield-starved investors, who can borrow for nothing at the short end of the curve and pocket the spread virtually anywhere else in the risk spectrum. Carry trades also become no-brainers for income-short American consumers, who can draw down income-based saving and use a very facile refinancing technology to extract newfound purchasing power from asset markets. America is hardly alone in reaping the spoils of the carry trade. In a US-centric global economy, the Fed has become the world's central bank, and America's carry trade has morphed into the global carry trade.

This phenomenon underscores what I believe is the biggest risk today in world financial markets and the global economy. Courtesy of its post-equity bubble containment strategy, the Fed has taken the carry trade to an unprecedented extreme, with one bubble begetting another. There were always "good" reasons along the way that the Fed used to justify its successive moves of accommodation -- the bursting of the equity bubble in 2000, the post-bubble recession of 2000–01, and the deflation scare of early 2003. But whatever the reasons, the bonanza of costless short-term financing was there for the asking. Yet with the growing profusion of carry trades, systemic risks in financial markets and their real economic underpinnings have only mounted. In a world of mean reversion, those risks are personified in the form of the inevitable unwinding of the carry trade. In my view, the December FOMC minutes suggest that the Fed is now testing the waters for just such an exit strategy.

America's monetary authorities face a most daunting challenge. The theory of policy strategy is very clear on one key point: The longer the central bank waits to deal with a serious imbalance, the greater the imbalance becomes -- and the larger the policy adjustment that eventually is required to deal with the problem. That's precisely the problem the Fed now faces. The US central bank has waited too long. It can no longer address imbalances by simply taking the real federal funds rate out of negative territory. Nor will it be enough to return the real funds rate to its so- called "neutral" setting -- that level that is neither easy nor tight insofar as its impacts on the real economy or financial markets are concerned. Given its publicly avowed concerns about the confluence of inflation and speculative risks, the Fed now has no choice other than to push the real federal funds rate into the restrictive zone. In my view, that means at least 100 bps beyond neutrality -- consistent with a nominal federal funds rate somewhere in the 4% to 5% zone.

Were it to occur, such a policy adjustment would undoubtedly spell the end of the carry trade. The risk is that the Fed becomes unnerved over such a possibility and shies away from a sharp policy adjustment -- continuing, instead, with its campaign of a "measured" recalibration of monetary policy. With spreads on risky assets remaining extremely tight, this is the outcome that the broad consensus of investors continues to be discounting. And as long as the Fed perpetuates this mindset, the more deeply entrenched the carry trade becomes -- and the more pervasive the concomitant perils of systemic risk. The Fed, in my view, sent a very clear signal in the December minutes of its policy meeting. A regime change in US monetary policy could well be at hand. These are the defining moments in history that are made for tough-minded, independent central banks. As was the case in 1994, I believe this Fed is up to the task.

In a post-carry-trade climate, I worry most about two key areas of vulnerability -- the American consumer and emerging markets. Short of saving and income, asset-dependent and overly indebted consumers have been indulging in the biggest carry trade of them all. But now the asset base that supports this arrangement is in bubble territory; nationwide US home price inflation hit 13% in the year ending 3Q04, with double-digit increases in 25 states. In the absence of property inflation -- to say nothing of the possibility of a full-blown deflation scare in housing markets -- income-short consumers will have to reevaluate their wealth cushion. That raises real questions about any forecast of persistent consumption vigor.

That same conclusion is equally evident for the US-centric global economy - - especially emerging markets, which, in my view, remain very much a levered play on the American consumer. Yes, the developing world -- especially Asia -- learned important lessons after the crisis of 1997–98. It has taken great strides in repairing its financial vulnerabilities -- especially by reducing dependence on external debt, building up foreign exchange reserves, and transforming current account deficits into surpluses. But this is a classic pattern for emerging markets -- coping with the future by fixing those problems that have arisen in the recent past. Unfortunately, the financial repair in the developing world has not been accompanied by better balance in the sources of support to the real economy. In large part, the developing world is still far too dependent on export-led growth models, which hinge largely on the excesses of the American consumer. The greater the sensitivity of US consumption to the unwinding of the carry trade, the greater the risk of collateral damage to emerging markets, in my view.

Nor would I be too sanguine about prospects for the dollar in a more aggressive Fed tightening scenario. The recent trading rally in the greenback has given some investors hope that the currency-adjustment cycle has run its course -- offering the tantalizing prospect of reinvigorated foreign capital inflows triggering the ultimate virtuous circle for US financial assets. My advice: Don't count on it. Back in 1994, when the Fed was last faced with a similar normalization challenge, the dollar fell like a stone even as the US authorities pushed the federal funds rate up by 300 bps. In today's climate, with a US current account deficit that is nearly three times what it was back then, the downside for the dollar can hardly be minimized. There's far more to currency adjustments than swings in relative interest rates.

In retrospect, 2004 was a relatively easy year for financial markets. Returns moderated, but downside risks were tempered by a profusion of carry trades. There is a strong temptation to believe that this relatively benign climate can persist indefinitely. But what the Fed giveth it can now taketh. As I see it, the carry trade is about to meet its demise. Investors banking on the sure-thing syndrome are in for a rude awakening.

The volatility and spreads in the market have been moving lower the last several years while at the same time liquidity was pumped in by the Fed. Let's hope that a slow easy adjustment is in our future rather than the scenario that Stephen Roach has laid out. You can find Stephen Roach's current and archived commentary at www.morganstanley.com/GEFdata/digests/latest-digest.html

Your hoping for an orderly unwinding of the carry trade analyst,

John F. Mauldin
johnmauldin@investorsinsight.com

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