Thoughts on Interest Rate Tightening - April 4th, 2011

The London Brief

Thoughts on Interest Rate Tightening

April 4th, 2011

A new book called "Expected Returns: An Investor's Guide to Harvesting Market Rewards" cites a case study proving that the returns relative to risk of bonds improves up to two years and then levels off. If pricing were dictated by maturity alone, there should be a more linear pattern. The behaviour provides evidence that investors will pay a high premium for liquidity. The book's hypothesis on the behaviour is that investors want to maintain an adequate buffer of near cash securities when times are rough.

But the high liquidity premium was less evident prior to 2008. My hypothesis is that investors are highly uncertain about the macro-economic environment and so are willing to pay a premium for short duration investments knowing that someday the music may stop. This can best be seen by the current debate over whether the Federal Reserve's intention to stop quantitative easing will cause a sharp market correction, or even a market crash.

The Tightening Cycle?

The European Central Bank has signalled that rates are going up next week. Hawks within the Federal Reserve are expressing concerns over inflation. The probability of further quantitative easing looks low. Oil prices are skyrocketing risking an increase in wage inflation demands from workers.

How important is loose monetary policy for markets? Will markets precipitously decline as the Federal Reserve stops buying bonds? The answer is that it's hard to know. On one hand loose monetary policy has fuelled high, bubble-like growth in emerging markets and created a marked increase in asset prices. On the other hand, velocity collapsed in 2008 and is now recovering. The current money supply times historic velocity could very well mean that we are at the start of a new inflationary cycle. There are also few places to invest the mountain of cash that has accumulated during the loose money period. The Fed bought so much paper, there is a shortage of government bonds to buy.

Yet I lean more towards the bearish view. Wages have not been rising with inflation as the labour market is still weak. Increases in interest should slow growth and dim employment prospects. It could create weaknesses in the U.S. housing market, a key ingredient to any long-term recovery in America. It will greatly impact the European periphery, many of whose population are on variable rate mortgages. Similar to what we saw in post-bubble Japan, velocity should decline. Bernanke's view appears to be to hold out until there is evidence that price increases are feeding into wage inflation. This is intelligent if you believe the best path to get out of the high levels of debt is through inflation. Wage increases raise the general price levels of all goods, including housing, and reduce the real value of debt.

More worrisome could be the impact of interest rate increases on emerging markets, particularly China. Here is an interesting documentary on some of the over-capacity issues the country faces (http://www.realecontv.com/videos/china/real-estate-madness-in-china.html).  This week's comments by Xiang Junbo, Chairman of Agriculture Bank of China, further illustrate the effects of the Fed's policies: "Around three years ago, 70 to 80 per cent of our branches at the county level and below were loss-making but now 96 per cent of these branches are making money. This has been a life-changing, fundamental transformation. This is why our competitors, such is ICBC and CCB, are planning to return to the rural areas and open at least 3,000 branches at the county level or below". Optimists attribute this to Chinese command-style economic management. But there is also a high correlation with Ben Bernanke's monetary policy.

The over-capacity issues will probably work themselves out if China continues to exhibit wage inflation. This could take some years. However, a rise in U.S. interest rates would reduce hot money flows into the country. In my opinion, this is akin to Japan raising interest rates in 1989, which subsequently caused their property bubble to collapse. A slow-down in Chinese growth would hurt the global economy. It would also make the developed world's debt burdens much more burdensome. Of course, that change could make the Federal Reserve loosen monetary policy again.

My base case is still that the Federal Reserve does not look to increase rates until 2011, but I'd be cautious if the Fed raises rates sooner than expected.

The Role of the SDR

Joe Stiglitz talked about enhancing the role of SDRs in the monetary system. He criticizes the role of the dollar as the reserve currency. It creates a recessionary bias post financial crisis as the nations that run deficits have to adjust to payments imbalances; it creates tensions when the U.S. runs current account deficits and it creates global imbalance problems from nations that develop large reserves as "self insurance" against a future balance of payments crisis. If surplus saving nations store in the form of SDRs, it's better because it reduces the role of the dollar.

However, SDRs are fundamentally used by the IMF for a lending program, whereas dollars are used in private sector transactions. This would essentially mean China and excess savers using their savings to finance IMF lending to needy nations that may be competing with them and who are more likely to default on their loans. Funding the private sector, even in dollar form, allows the savings to be re-circulated for real growth.

End Note

In light of the fears around Tokyo, here are some interesting facts about Hong Kong post crisis from a recent Bloomberg article:

"Typical amounts of radiation in Hong Kong exceed those in Tokyo even as workers struggle to contain a crippled nuclear plant in northern Japan, indicating concerns about spreading contamination may be overblown.

The radiation level in central Tokyo reached a high of 0.109 microsieverts per hour in Shinjuku Ward yesterday, data from the Tokyo Metropolitan Institute of Public Health show. That compares with 0.14 microsieverts in the Kowloon district of Hong Kong, the Hong Kong Observatory said on its website. A person is exposed to 50 microsieverts from a typical x-ray."

Omar Sayed

London, April 4th, 2011