Together, these forces have contributed to an era of abundant liquidity, asset inflation, yield compression and elevated risk appetite (some would say complacency), amongst investors. These forces are now waning however, which will be likely to lead to both higher inflation and higher yields on longer-dated Treasuries, although neither is likely to be too dramatic.
The disinflationary effect of cheap imports of manufactured goods is dissipating as labour, property and raw material costs rise in China and other emerging markets, augment the inflationary pressure arising from high energy costs and high global employment and capacity utilisation levels.
Central banks around the world are responding by raising rates. However, whilst the stock of debt is very large and may result in greater sensitivity to higher rates, it is important to emphasise that recent moves reflect more a normalisation of rates in the face of a normalisation of inflation, rather than a restrictive tightening in response to run-away inflation.
Furthermore, the yield on the benchmark US 10-year Treasury is finally adjusting. While the Fed raised rates 17 consecutive times from 2004 to 2006, the 10-year yield barely budged, leading Greenspan and others to muse frequently on this apparent “conundrum”. In recent months however, it has moved suddenly and dramatically, climbing over 60 basis points to 5.3% in the four weeks from 10 May. While it has been off somewhat since then, this development heralds the unravelling of the mystery.
Given the sheer size of the exporting countries’ foreign exchange holdings, it no longer makes sense on any level for these countries to continue accumulating them at the same pace or simply to channel them all into US government debt – not without its own risks. While large-scale sales of US Treasuries by central banks is highly unlikely, some diminution of the phenomenon is almost inevitable. While a couple of data points does not indicate a trend, China was a net seller of Treasuries in April, for example, and overall net purchases were $376 million compared to $31 billion in March.
Rising long-term rates are currently of particular significance, since a trillion dollars of US mortgages are scheduled to reset over the next 12 months. Moreover, even moderate adjustments in yields could reveal excesses in the system causing credit spreads to widen or liquidity to dry up suddenly at a time when risk taking by market participants across the spectrum is likely to have been excessive. The system is vulnerable and the catalyst for dislocations is upon us.
Still, in spite of somewhat persistent inflationary pressure, rising long term yields will finally give effect to the Fed’s recent rate-hiking campaign, making it much less likely that further rate rises in the US will be necessary. Ironically, just as many mainstream financial institutions are backing sharply away from calls for up to 75 basis points of rate cuts this year – of which we were always sceptical – rate cuts may be becoming increasingly likely, as consumers bear the strain of higher mortgage, energy and other costs. The Fed after all will want to avoid a Japanese type scenario at almost all costs. This is perhaps a risk that ought not to be underestimated. Irrespective, the Fed will probably continue to struggle to wrest control over US monetary policy away from the bond market and re-exert its authority. Monetary policy has indeed become an international affair.
However, while there are likely to be negative consequences arising from the developments discussed above, there are also likely to be benefits. Many developing countries are establishing Sovereign Wealth Funds to which they are allocating a portion of their foreign exchange reserves. Already, these funds are capitalised with more assets than the entire global hedge fund industry has at its disposal and they arelooking for investment opportunities – acquiring public and private equities and properties amongst other assets. Further, as the foreign exchange reserves of many of these countries clearly exceeds any realistic need, it is conceivable that they will diminish their purchases of western currencies, allowing their own currencies to strengthen. (Already some Asian exporters and Middle Eastern oil exporters have de-linked their currencies from the USD$ to regain control over their domestic monetary policy).
At last we may be on the verge of an adjustment where the enormous imbalances that have characterised the global macroeconomic environment for the past several years begin to correct themselves.
Although ultimately these are likely to prove positive for the stability of the international financial system, perhaps the most predictable shorter-term outcome is markedly higher volatility.