Global Financial Markets

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Volume 1 - Issue 22
February 14, 2005

by ECR Research

In a past Thoughts From the Frontline letter, I quoted some economic forecasts from a group in The Netherlands called ECR Research. ECR is an independent financial research group with a team of analysts and economists specializing in medium-term developments in interest rate and currency markets. ECR supplies their research to some of the top financial financial insitutions in the world.

ECR's Global Fiancial Markets report from February 3rd takes a look at the current situation in the U.S. They see short term rates going up more than the market currently predicts and at the same time the dollar will get stronger, then in 2006 the tides will turn and we could see deflation and a weakening dollar. This letter is a little longer than most, but well worth the time because ECR has a few other Outside the Box predictions for the coming year, so let's take a look at what they see in the future.

- John Mauldin

Global Financial Markets
ECR Research
February 3, 2005

For now, the fight against deflation is over

In the financial markets and among economists there is widespread consensus that in the course of the coming years the dollar will collapse under the weight of the enormous US current account deficit. We agree that this is the most likely development. However, there are various scenarios that could be drawn up concerning the way in which this will happen, and even some whereby the dollar would become a strong currency again. In other words, we believe that prolonged dollar weakness over the coming years is likely, but that it is not a fait accompli.

Increasingly the US administration and the Fed seem to be of the opinion that the US economy has been steered onto a self-sustaining course in terms of growth, and that the spectre of deflation has therefore disappeared. Therefore they have announced that measures will be taken to normalize the very loose monetary and fiscal policies in the United States. The Bush administration promises to halve the budget deficit over the next five years. The Fed indicates that it wants to gradually raise short-term interest rates, to at least neutral level.

A proper medicine?

In other words, essentially this is exactly the policy switch required by the dollar. For, after all:

Higher interest rates mean that the return on US investments will increase; therefore there is a higher chance that the capital flow from abroad toward the United States will remain sufficient to finance the current account deficit.
The 'carry trade' will decrease if US short-term interest rates are higher. That is to say, it will become less profitable to borrow US money against short- term rates and invest the capital elsewhere against higher returns.
On principle, higher US short rates will lead to higher savings. This is just the medicine for the US economy, in its struggle with a very low level of savings. If savings increase in the United States, this will be favourable to the current account deficit, as the latter could also be regarded as the gap between savings and investments in a certain country. That is to say, investments have to be financed through national savings. If the level of savings is low - as has been the case for years in the United States - the lack of saved capital will have to be supplemented by money from abroad. As mentioned above, in this way by now foreign capitalists finance around 6% of the US economy. If, because of higher short-term interest rates, savings in the United States were to increase, the current account deficit as well as the dependence on foreign capital would decrease.
A narrowing of the fiscal deficit has the same effect, as in actual fact this means that the government starts to save more (or, if you prefer, starts to dissave less).

However: if it now seems likely that the ailing dollar is going to get the proper medicine, why do most long-term predictions remain negative as far as the US currency is concerned? The answer is simple. The markets are very sceptical about the policy intentions of the administration and the Fed:

It seems likely that government spending will increasingly be curbed in various respects, but during his State of the Union address, president Bush has again upheld his intention to tackle the US social security system. Although there are various options, calculations show that the plan preferred by the administration will cost the state one to two trillion dollars. Moreover, the US government does not yet want to commit itself to a deadline in terms of the withdrawal of US troops from Iraq. Meanwhile, an additional military budget has been applied for, to the tune of no less than $80 billion. The outcome for the restructuring of the social security system is still uncertain (within US society and among politicians there is a lot of resistance against the plan), but in any case, these developments do generate doubts about the promise to halve the fiscal deficit.
It could be argued that if government spending remains high, this will stimulate the economy, and as a result the Fed will be able to implement more extensive rate hikes without overly impeding economic growth. As a result, the net effect on the dollar might become positive after all. However, the markets do not seem to take this view at all. To start with, they think that consistently wide budget deficits will not have a very stimulating impact. The fiscal deficit would have to be widened further in order to enable another impulse to the economy in 2005 on a rate-of-change basis.

In addition, the reason why the budget deficits remain huge is important. Social security reforms and military spending are not regarded as categories that could be expected to stimulate the economy to any great extent. (At the most, the privatization of the social security system could be said to mean that savings are shifted from the governmental sector to households. For according to the plans made by Mr Bush, a portion of income tax will be diverted into personal investment accounts of private individuals. The money will then have to be invested in shares and bonds, and this will perhaps have a positive impact on economic growth through lower bond yields and a wealth effect. However, it is offset by the fact that the government will have to start borrowing more, which may put upward pressure on bond yields).

In other words, the markets do not anticipate that a potential negative impact on economic growth, resulting from the normalization of short-term interest rates by the Fed, will be compensated by a positive fiscal impulse. And there seems to be a fairly broad consensus that rising interest rates will quickly start to affect growth in a negative way.

Many economic analyses point out that due to the low interest rate levels over the past years, households have incurred very high debts. Even now, while short- term interest rates are still low, interest payments as a percentage of consumer income have reached historic heights. Therefore, commentators and analysts greatly worry about what will happen if the rates start to rise. Moreover, they agree that to a large extent the high increase in consumer spending over the past years has resulted from the increase in value of consumer wealth, especially of property. However, property prices have soared much more steeply than wages. As a result, the general expectation is that the property market will also fairly quickly feel the pain if further rate hikes are implemented. In the financial markets, this perceived vulnerability of the US economy to rising short-term interest rates is reflected in persistently low bond yields and Fed funds futures which only allow for very moderate expectations in terms of rate hikes by the Fed.

In other words, investors assume that the Fed will not be in a position to raise short-term interest rates to any great extent during its current tightening cycle, and that the central bank will find it difficult to push interest rates up to neutral. ('Neutral' is the level whereby the economy is neither curbed, nor stimulated; for the Fed funds rate it is on average estimated to be around 3.5%). Also, in all likelihood the markets are of the opinion that the Fed will not be forced to do this, as inflation expectations are very mild. The latter can also be concluded from the growth expectations for this year.

The consensus expectation is around 3.5%. If we offset this against the most commonly used estimation of 'potential growth' - equally around 3.5% - it seems likely that low inflationary pressure is to be expected. After all, the often used 'output gap model' indicates that there will only be rising inflationary pressure if real growth is clearly above 'potential growth', while at the same time spare capacity is low or non-existent.

In short, economists and markets generally expect that the Fed will be able to - or forced to - keep short-term interest rates relatively low. By means of the 'curve trade', which allows for the relatively cheap acquisition of short money in order to obtain a higher return at the long end of the curve, downward pressure on bond yields will continue, especially as within this scenario the risk of inflation is low.

Conclusion:

In actual fact, economists and markets are saying that because of the extremely loose monetary and fiscal policies over the past years in the United States, various bubbles (among consumers, in the housing market, the bond market, etc) have developed, which will hamper the attempts to normalize interest rates and budget deficits. That is to say, the authorities are, as it were, forced to pursue a loose policy because there will be an unacceptable high risk of a slump towards deflation should these bubbles burst. Therefore, the consensus expectation is that the persistent combination of enormous twin deficits and low US short-term interest rates will keep the dollar on its gradual downward slope. And the possibility of a real dollar crash is not being ruled out.

Over the past years, Asian central banks have prevented such a crash. They did this by buying massive amounts of dollars, in order to avoid excessive appreciation of their currencies against the falling dollar, led by China, which keeps its currency pegged very strictly to the dollar. As they did not want to loose a lot of their competitive edge to their strongly emerging neighbour China, many other Asian countries that are dependent on exports - including Japan - had no choice but to follow suit to a higher or lesser degree.

However, recently there has been strong speculation among commentators that the Chinese authorities will shortly revalue the yuan, or even allow it to float freely against the dollar, to slow down inflation and their fast-growing economy. If, under circumstances that are negative to the dollar - i.e., persistently wide US deficits and persistently low US interest rates - the Asian central banks would also remove the last support propping up the dollar, there is a very high chance that a crash will take place. (We do not expect a dollar depreciation against the Asian currencies to deflect trade flows to any great extent, but in our view in that case capital flows towards the United States will certainly start to decrease.

Long-term scenario's for the dollar

Essentially, we also share in the expectation of a weaker dollar as far as the longer term is concerned. Nevertheless, we do not want to create the impression that no other outcomes are possible for the dollar:

Although we agree that considerable bubbles have been created in the United States, we do not expect that in the short run further US rate hikes will hit growth very painfully. Indeed, over the coming quarters we foresee fairly high growth. In our view it should not be forgotten that even though the Fed's tightening cycle started more than six months ago, during this period monetary conditions in the United States have actually become looser. In this respect, much more relevant are the movements of share prices, bond yields, and the dollar.

If we look at the situation from this angle, falling bond yields, rising share prices and a falling dollar have amply counterbalanced higher short-term interest rates. In any case, in all likelihood short-term interest rates are currently still well below their equilibrium level, therefore they don't put the brakes on the economy yet.

A second important development that in our opinion will support economic growth over the coming quarters is lower increase in productivity. Prolonged cuts in terms of labours costs, plus the massive implementation of modern technology have greatly boosted productivity growth over the past years. This has put downward pressure on the demand for labour. However, it seems as if these processes are gradually petering out. It is not realistic to expect a much more extensive reduction of labour costs, as otherwise it will be impossible to meet the consistently high level of domestic demand - which is in itself a consequence of the loose monetary conditions.

In addition, most US companies have already switched to increasingly cheap modern technology and are now ICT enabled. Only if a trail-blazing new technology would present itself could the increase in productivity be expected to receive another strong impulse. However, there are not many signs that another technological revolution is imminent. In other words, it seems likely that the reverse of the situation of the past years is about to take place, namely a lower increase in productivity, which will put upward pressure on job creation and income growth. Equally, this would mean that unit labour costs rise and that some wage inflation will again start to occur.

We could also view this differently. A shrinking increase in productivity also leads to lower 'potential growth', which could therefore drop from 3.5% in the direction of 3%. Simultaneously, we believe that looser monetary conditions and a gradual increase in job creation could boost actual growth until it reaches the 4% mark, or even higher.

Numerous surveys increasingly indicate that bottlenecks are developing, the degree of capacity utilization is rising and companies are more inclined to raise their prices. Therefore we think that over the coming quarters inflation is likely to become higher. If we are right in this, we think that the Fed will not hesitate at all to slam the monetary brakes on more aggressively (statements by the Fed fairly clearly imply this). However, we do not believe that this will immediately cause large problems for asset prices or for consumers. For in our view higher interest rates will be compensated by job creation and income growth also becoming higher. For example, if we examine the ratio between interest payments on the one hand, and household income on the other, not only will the interest rate component increase, but the wage component will be higher as well. Therefore on balance the drop in living standards does not need to be substantial.

The same story is true for the property market. In our opinion, this will also benefit from improvements in the labour market. In addition, many mortgages are subject to a fixed rate, for which the pain of rising interest rates will not be felt for the time being. In other words, we expect that all of the above will enable (and force) the Fed to raise the Fed funds rate to a greater extent, over the coming quarters, than the markets are calculating right now. This is the main reason that we expect the dollar to become a surprisingly strong currency in 2005. All the more so, as we think that there is a high chance that China - and therefore the rest of Asia - will at any rate over the coming quarters keep its currency from appreciating against the dollar.

A number of important domestic developments can be listed as reasons why it is unlikely that China will start to revalue the yuan soon (its political leadership has also clearly pointed this out at the World Economic Forum in Davos and the G7 in London recently). To start with, in this context often the fragile financial system in China is mentioned; in all likelihood as yet this will not be able to cope well with free and volatile capital flows. Moreover, there is constant migration of many tens of millions of farmers from the Chinese interior towards coastal provinces where economic developments are advancing faster. In that sense, China has a large labour surplus. In order to prevent social unrest, job creation has to be maintained at such levels that it remains possible to absorb this surplus of workers. In order to achieve this, economic growth has to remain very high. As domestic demand in China is not at all adequate to carry this growth rate, the export machinery will have to keep performing at full tilt.

This is a strong argument in favour of the dollar-yuan linkage. However, there is another important factor that explains why a revaluation of the yuan is not likely. It should not be forgotten that the overheating of the Chinese economy is mainly related to investments. Production capacity is created superfast and on a massive scale. This means, however, that if demand starts to slump even slightly, deflation instead of inflation will become a problem to China. This would create large new problems for the banking system as well, in the shape of bad debts. In other words, viewed from this angle revaluation as a means to cool down the economy would be very hazardous.
However, it is interesting to look at the longer-term prospects. Two issues are extremely relevant in this context. First, if we are right and the US economy continues to grow fast for the time being, how will the United States subsequently deal with the rewards that it then reaps?

The deflationary forces that the United States has had to fight over the past years were mainly the result of the accelerating emergence of the low-wage countries in Asia and also of the massive introduction of labour-saving machines and technology. This led to a labour surplus in the United States and therefore to downward pressure on wages and prices. This labour surplus can only be absorbed again if the United States succeeds in quickly creating many new companies in new modern sectors. In this respect the situation will improve if growth remains high, but over the longer term it is essential that the United States again creates an attractive and very innovative investment climate.

Compared to other old industrial nations, the United States possesses the most flexible economy and labour market, which facilitates the re-allocation of capital and labour away from old sectors to more modern fields. However, in recent years there has been a dearth of new ideas, risk-taking, risk capital, etc. A reason for this could be that education (anything below the top layer of the top universities) has clearly deteriorated in the United States. Since the terrorist attacks on September 11, 2001, there has also clearly been a lower influx of excellent foreign students and researchers into the United States, probably because of more extensive security measures (in other words, there is lower mobility of human capital). Therefore much more investment is needed in this respect, as well as in areas such as Research & Development, collaborations between businesses and universities, etc.

Government has an important part to play in all of this. However, if the first term of office of the Bush administration is something to go by, the omens are not very good. As mentioned before, during that period the administration put all its eggs in one basket and went all out in stimulating consumption. Now that the US economy seems to be more or less engaged in a self-sustaining growth process, the government is in a position to shift its focus from consumption towards investment (for example by means of a sales tax). In addition, from this point of view it would be desirable to leave Iraq as quickly as possible and to pump this war capital into the private sector. If the United States manages to change its course in this direction, over the long term this could lead to a very positive scenario for the dollar.

In all likelihood, this will not affect economic growth to any great extent, for in this case a possible downturn in the growth of consumption will be compensated by higher investment. It would be positive however to the US current account deficit if the United States itself would produce more new, internationally competitive products (increased export), while domestic consumption takes a slight downswing (decreased import). The US current account deficit would improve even more if the United States would start to increase its exports to Asia. The bilateral trade deficit with China by itself already amounts to almost a quarter of the total US current account deficit.

This brings us to the second important factor that will in our opinion determine the longer-term course of the dollar. A common assumption is that an improved balance of the trade flows between Asia and the United States requires a revaluation or the appreciation of the Asian currencies against the dollar. Recently, however, various economists have put forward a number of interesting recommendations. Asia specialist Andy Xie of Morgan Stanley proposes, among others, to substantially increase minimum wages in China. Because of the labour surplus, for many years Chinese wages have hardly increased at all. Moreover, in China consumption is structurally impeded by a very high level of savings, in view of the fact that social safety nets have completely collapsed (in other words, citizens have to save a lot for their old age, illness cover, unemployment, etc.).

Just like a revaluation of the yuan, an increase of the minimum wage will slow down growth in the overheating export sector (as Chinese products become more expensive), but in contrast to a revaluation, higher minimum wages will boost domestic demand. In other words, theoretically the increase will cause the economy to shift away from exports and investment, and towards consumption. We want to add that, should the United States manage to manufacture new products that cannot be made in China as yet, there will be a higher chance that the United States will be able to export much more to China. The US current account deficit would narrow as a result.

Summarizing, a downtrend for the dollar over the coming years is no 'sure bet'.

However, if global policymakers want to stop this from happening, they need to make the right choices. The same goes for policymakers in Japan and in the euro zone. These countries are hampered by the same deflationary developments as the United States. Their fight against deflation is equally focused on maximum stimulation of demand through the application of the monetary and fiscal reserves. However, the problem is that the Japanese and euro zone economies are far less flexible than the US economy.

This means that a stimulating policy has a much less positive effect on economic growth than in the United States. Therefore much more work needs to be done to reorganize these economies in a structural sense and make them more flexible, in order to boost domestic demand and to enable the United States to export more to Japan and to the euro zone. However, structural reform is a slow process and depresses growth at first. Moreover, it is hard to predict whether the Chinese authorities will (want to) consider raising the minimum wage, for that will increase the labour costs for companies and this is at odds with the wish of the political leadership to create as many jobs as possible.

The US administration has tentatively started to indicate that it increasingly wants to gear its fiscal policy towards boosting investment, but so far there have been very few concrete proposals. It is therefore too early to determine in what direction the US administration will chose to go. In our opinion, there is still a high chance that the narrowing of the US deficits will be a difficult process. In all likelihood the war on terrorism will continue to cost a lot of money. Furthermore, the social security reforms (if implemented) will in the first instance be very expensive.

In short, from the fiscal angle there is still a high chance that any choices that are made will be negative to the dollar. But in our view, the following is more important. As mentioned earlier, we also think that over the past years new bubbles have emerged in the United States because of the loose monetary policy. Nevertheless, we expect that for the time being these will not burst when interest rates rise, because we foresee that job creation and income are also due to grow. However, this equally implies that for the foreseeable future the Fed will be able to continue its series of rate hikes (even more aggressively, in our view, than the markets are currently discounting).

As we have explained extensively in our previous reports, we foresee that this will eventually hit asset prices and economic growth after all, late this year or at the start of 2006. Quickly, the danger of deflation will then re-emerge. If that happens, we think that the Fed will be forced to retrace its footsteps and take up its position 'behind the curve' again.

In other words, by that time it will in our opinion become clear that the Fed is not able to combat higher inflation without affecting asset prices and economic growth too forcefully. Subsequently, we foresee that the dollar will then resume its downtrend, because the Fed will be 'behind the curve', the current account deficit will still be wide, and inflation increases.

I always find it interesting to get a perspective on the economic situation in the U.S. from a group outside the country. You can find out more about ECR Research at www.ecrresearch.com.

Your enjoying a non-U.S. perspective analyst,

John F. Mauldin
johnmauldin@investorsinsight.com

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