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Still selling bonds(译文在这里) / 謝國忠谢国忠搜狐博客 http://xieguozhong.blog.sohu.com/
In early June, global financial markets gyrated down on central banks'
tough language on inflation. The BoE said it would even accept a drop
in living standard for containing inflation. The Fed said that the risk
of a serious economic downturn was small and it would shift its
priority to inflation fighting. At one point, ECB sounded like a raging
bull for hiking interest rate. Even the Bank of Japan mentioned the
risk of inflation. At one point, market priced in four rate hikes by
the Fed by mid-2009. As a result, dollar firmed, oil price stabilized,
and yield curve flattened around the world. If the inflation fighting
is real, it bodes well for bonds. But, I think otherwise.
While
rates will rise, maybe earlier than mid-2009 that I expected before,
they won't be aggressive. If the Fed and ECB raise rates in the summer,
it is intended to give substance to their talk but won't herald rapid
rate increase ahead. Market is probably jumping ahead of itself. The
bottom line is that rising rates would trigger a deep recession and
central banks, while desiring lower inflation, are not yet ready to
accept a deep downturn in exchange. The tough talk is mainly aimed at
pushing down oil price, which would ease inflationary pressure and
decrease the need for raising interest rates.
Indeed,
the central banks are already backing off in a confused fashion. The
ECB now says that it may raise interest rate once. The Fed continued
its language on the balance of risk between growth and inflation. It
said that the growth was at less risk and inflation at more risk, i.e.,
it could be in a position to raise rates. It is still not saying that
it would raise rates to contain inflation even if growth is at risk.
The language confusion just indicates the central banks wish that
inflation would go away without rate hikes that would bring down growth
also. They are in denial. It is a stagflationary world. Inflation
fighting is meaningful only if central banks accept and trigger a deep
downturn.
This jawboning strategy that promises a
painless way to ease inflation is failing. Market sees through the talk
and understands that central banks still put growth ahead of inflation.
They won't hike rates as fast as inflation rates are picking up, i.e.,
monetary policies around the world would remain loose and boost
inflation. Inflation in the global economy would head up, not down. On
the other hand, the bursting of the credit-***-property bubble is
weighing down economic growth. Surging oil price allocates too much
money to a few who can't spend it all and, hence, is bad for growth
too. The IMF now expects global growth to slow by one percentage point
in 2008 to 3.7% and inflation rate up by over one percentage point to
5.5%. Inflation rate is significantly above growth rate. The gap would
widen in 2009. It seems that the world consensus as well as the reality
is moving towards stagflation.
Let me do some chest
pounding here. In late 2006, I predicted stagflation for the US and the
global economy in 2008. At the time, not a single soul I met agreed
with me. I believed that the mild recession after the tech burst in
2000 was due to the rise of a global property bubble and wrote
repeatedly on the subject then. But, I struggled with the likely
ending. I played with the deflationary ending for a while. The bubble
could burst on its own when speculators suffer acrophobia. The
collapsing asset prices would depress demand, exposing overcapacity and
triggering deflation.
As the global asset bubble went
on and on, I questioned this scenario and realized that the deflation
ending wouldn't happen. The reason is the unlimited risk appetite in
the global financial system. Most speculators play with other people's
money ('OPM'). They are paid a cut on the speculative gains but don't
share the speculative losses. This incentive system permeates the
global financial system, especially with the rise of hedge funds,
private equity firms, and the proprietary trading at investment banks.
Hence, as long as central banks keep monetary policies loose, the
resulting monetary growth would flow into some asset classes. As the
credit-***-property bubble bursts, the money was likely to go into
commodities. A commodity bubble is far more inflationary and less
growth friendly than a property bubble. A property bubble boosts growth
through wealth effect. Hence, its inflationary impact is via its growth
impact. A commodity bubble boosts production cost, which depresses
growth, and boosts inflation at the same time.
The
commodity bubble will end only when central banks decrease money
supply. That will take a long time. Central banks have been playing
Santa Claus for twenty years as inflation declined on globalization and
the collapsing energy demand in Russia and Eastern Europe, which gave
them a license to print money without immediate inflationary
consequences. This is why central bankers like Greenspan were so
popular. In an inflation-prone environment, effective central bankers
should be tough taskmasters like the Fed Chairman Paul Volker (1979-97)
or the President of the Deutsche Bundesbank Hans Tietmeyer (1993-99).
Human nature doesn't change overnight. The current generation of
central bankers couldn't transform into Volkers or Tietmeyers. They
enjoy the limelight too much and love to be loved. My stagflation call
was based on two factors-the love seeking central bankers and the OPM
wielding speculators.
A prediction is meaningful only
when one sees irrational factors that block efficient markets.
Inefficient factors ultimately come from the irrational side of human
nature or some institutional flaws. I am not always right. On oil, for
example, I underestimated the interplay between supply tightness,
demand strength due to subsidies in emerging economies, and the power
of speculative capital. The bubble has lasted much longer than I
expected. When the Fed cut interest rate last summer, I understood its
significance for oil and other commodities and called for a massive
bull run for oil due to the Fed's turnabout on its policy.
Based
on my understanding of today's central bankers, I believe that the
inflation crackdown is more noise than substance. They still believe
that, through clever posturing, they can scare away oil speculators
and, hence, support their loose monetary policies to simulate growth.
Their clever posturing, however, is running into the brick wall of OMP
wielding speculators who have no downside, only upside in calling the
central bankers bluff and pushing oil price ever higher.
The
game between central bankers and speculators would end when inflation
is high enough that public opinions put inflation fighting ahead of
growth stimulating. Today's central bankers are like politicians and
swayed by public opinions. As the pain from asset deflation still
dominates public opinions in the US and other developed economies,
today's central bankers don't have the guts to go against popular
opinions and do the right thing for the future. They are like their
counterparts in the 1970s and won't act preventively. The world,
unfortunately, is likely to repeat the stagflationary cycle of the
1970s.
Stagflation should be the most important
consideration for investors in 2008 and 09. Of course, one should
carefully consider where the prices are and how much they have priced
in stagflation. The biggest mis-pricing I see is in the bond market.
Despite a gut-wrenching bear market this year, bond prices are still
grossly overvalued. This is the biggest risk to central banks with
large foreign exchange reserves (e.g., China, Japan, Russia, and Saudi
Arabia). What can they do to dodge the bullet of a collapsing bond
market?
The yield on the 10Y US treasury has risen
30bps points to 4.12% in a month. This is a massive bear market in the
bond land. The current level, however, is still far from sufficient in
reflecting future inflation. The US's inflation is likely to be between
5-5.5% in 2008 from 4.1% in 2007, considering that the inflation in the
past twelve months was 7.2%. The 10Y TIPS or inflation protected bonds
yields 1.63%. The difference, 2.49%, is the market inflation
expectation for the next ten years. The bonds are vulnerable to both
changing inflation expectation and rising real interest rate.
Some
surveys show that American consumers expect inflation to average above
3.5% over the next five years. This is actually not too far off from
the post World War II average. Is the financial market or consumer
right? Normally, financial investors should be more reliable than
consumers. The former are armed with research capacity and investment
experience. However, the investor base for the US treasuries is a
special one. Central banks around the world are the main buyers of
treasuries. They are reluctant buyers. Their funds come from trade
surpluses and capital inflow. Both are driven by the US monetary
policy. When the Fed has an expansionary monetary policy, central banks
around the world are flooded with dollar inflow and, to prevent
currency appreciation, are forced into accumulating foreign exchange
reserves. For liquidity and security they usually buy the US
treasuries. This angle suggests that the treasury pricing may not be
rational and may not reflect fundamentals.
The
long-term average real interest rate for US treasuries is about 2.5%.
The current level of 1.6% is probably too low. Maybe the flight to
quality is a factor. As other asset classes tumble, the safest asset
class-TIPS becomes overvalued. But, as the financial crisis works its
way through, probably, by the end of 2009, the TIPS's pricing could
also normalize.
The inflation priced into the
treasuries is also too low, even thought the expectation has risen from
2.2% in January to 2.5% now. The Fed is prone to stimulating. It has
the triple mandates of keeping inflation down, supporting employment,
and maintaining financial stability. The compromise that it must make
means that it will overshoot its inflation target of 2% by a
significant margin. The historical average of 3.5% is a good indication
for the future. The US economy is likely to suffer a decade of low
growth due to (1) the retirement of the baby boomers, (2) the
skyrocketing healthcare cost, and (3) rising competition for natural
resources. The Fed would be under enormous pressure to stimulate the
economy. The chances are that the US inflation over the next decade
would be above the historical average and the dollar would remain in
the bear market for the foreseeable future.
The
involuntary investor base for government bonds is the main cause for
the pricing distortion. When the market comes to its senses, the yield
on the 10Y US treasuries may need to rise by 2-2.5 percentage points.
The re-pricing of the US treasuries would have similar though smaller
impact on government bonds in other countries like Japan, Euro-zone, or
the UK. The central banks around the world are holding a dangerous
asset. As they are the market, they cannot all escape without causing
the price to crush. They are collectively trapped. Hence, the first
mover would gain.
The oil exporters like Saudi Arabia
are flooded with money. The OPEC countries make $4 billion everyday
from oil exports. They can afford to hold the US treasuries despite the
downside risk. The loss may not be so big for them. China can't afford
to behave like them. China's foreign exchange reserves come mostly from
labor-intensive export industries like electronics, garments, shoes,
furniture, etc. Every dollar is earned from the sweat of the workers
who make $100 or so per month. China's large foreign exchange reserves
reflect the number of workers in China, not good fortune or high value
added. Hence, China can't afford to waste a penny of its $1.7 trillion
foreign exchange reserves. China's central bank should decrease the
duration of its portfolio as much as possible to avoid capital losses
from potential treasury re-pricing.
When central banks
get out of treasuries, what could they buy? As their funds are vast,
the only alternative is stock market. Global stock markets have been
declining and will probably decline more. They are trading at 2.3 times
book value at present, neither expensive nor cheap. By the way, the
only reliable measure for market value in the long run is the price to
book value ratio. As the world economy is still on the way down and
interest rates on the way up, stock markets are in rough territory.
But, the current level is supportable over time. If central banks buy
over the next twelve months, they may suffer some losses in the short
term but should make money in the longer term. Further, given their
sizes, they cannot buy when markets are buoyant; their buying would
push up markets so much that they end up overpaying and losing money in
the long run.
Stocks may not perform well during
stagflation. As rising interest rates and slowing economies depress
earnings and increase the holding cost. But, the value of stocks will
not get inflated away like bonds. Companies have assets and debts. The
assets are value preserving, while debts are likely to decline in real
value with inflation. The diminished profit outlook during stagflation
depresses market valuation. But, as soon as the stagflation is
overcome, stocks will perform well to recover the lost ground during
deflation. To a large extent, the bull market in the 1980s was due to
its undervaluation during the stagflationary 1970s.
If
central banks do decide to switch into stocks from bonds, the best
approach is probably to buy indexes via index funds or proxies. Over
the long term, index funds outperform over 90% of the actively managed
funds. This is because the later incur too much transaction costs
without adding enough value in stock picking. Central banks are
government institutions and would struggle to build up stock picking
capability. However, central banks probably know macro trends better
than an average investment house. It is possible to extend this skill
to pick sector indices.
Holding bonds is probably the
worst investment position today. Private investors have fled bonds
already. Central banks are supporting bond markets. It's time for them
to leave. China should run for the exit first.
谢国忠搜狐博客 http://xieguozhong.blog.sohu.com/
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