Steven Roach throws the towel

Steven Roach has been a bond bear for a long time, calling for an imminent rise in interest rates since a couple of years. In the face of rates still getting lower rather than higher (The Greenspan "conundrum"), he is finally conceding that he might have missed something.

"That is precisely what I now suspect could be in the offing -- a China-led slowing of the pan-Asian economy that could have a very important bearing on both global growth and inflation. As I noted last week, there is now a compelling case for a China slowdown later this year that could last well into 2006 (see my 23 May dispatch, "What If China Slows?"). Two sets of forces appear to be at work -- domestic policies that bear down on China's property bubble and external policies that squeeze Chinese exports. Collectively, fixed asset investment and exports make up 80% of China's GDP. There is now good reason to stress the downside risks to this huge piece of the Chinese economy that is currently expanding at nearly a 30% y-o-y rate. For the past six years, China's GDP growth has fluctuated in the 6-9% range. Currently, it is growing at the upper end of this range. By the time the China slowdown plays out, I suspect that its GDP growth could be near the lower end of this range."

"With China now accounting for only 4% of world GDP (at market exchange rates) but 8% of crude oil consumption, 20% of world aluminum consumption, and 30-35% of steel, iron, coal, and a broad array of other industrial materials, a slowdown in the pace of Chinese industrial activity is hardly without consequence for commodity inflation. The Journal of Commerce spot index of industrial materials has already done a round trip -- moving from a peak rate of inflation of nearly 35% in early 2004 to an outright decline of -3% y-o-y in late May of this year. In the event of a China-led Asian slowdown, recent downward pressures on commodity prices could intensify. That could have an important impact on tempering the inflationary expectations embedded in bond markets."

"But what about the interest rate implications of America's coming current account adjustment? This has been my own personal stumbling block on the bullish call for bonds. I have thought long and hard about this and have now concluded that I may be guilty of having overlooked a critical aspect of the interest rate piece of an external adjustment. In the end, what foreign creditors seek in a current-account adjustment is a relative premium for taking currency risk. The key aspect of this premium is the word "relative." As long as spreads widen between the US and other international interest rates, that may be sufficient compensation for America's foreign lenders. In other words, US interest rates need not rise sharply in the absolute sense in a current-account adjustment. All that is needed is that they remain attractive in comparison to rates elsewhere around the world."

"Consequently, given the likelihood of a China-led compression of inflationary expectations, another leg to the secular rally in bonds can hardly be ruled out. At some point over the next year, I wouldn't be shocked to see yields on 10-year governments test 3.50% in the US, 2.50% in Europe, and 1% in Japan."

On the other hand, for the same reason he believes rates will go lower he is still in the bear camp as far as the US dollar is concerned.

"One number says it all: In March 2005, US imports were fully 54% larger than exports. In my view, there is no conceivable dollar adjustment -- or should I say no politically acceptable dollar adjustment -- that would eliminate America's excess import problem. The only effective way to temper an import overhang of this magnitude lies in a real interest rate adjustment that would squeeze excess consumption -- and its import content -- out of the system. At a minimum, this would entail a normalization of real US interest rates -- both short and long. Specifically, I believe that would require the term structure of real rates to move upward by about two percentage points from present rock-bottom levels. Not only would that hit the interest-sensitive components of domestic demand -- consumer durables, capital spending, and residential construction -- but it would also cool off frothy asset markets and the wealth-dependent consumption (and imports) such market excesses are fostering."

"In my recently revised view of US interest rate prospects, America's long overdue normalization of real rates is likely to be aborted (see my 30 May dispatch, "Rethinking Bonds"). In the face of the coming China-led slowdown in global growth and its collateral impacts on reduced inflationary expectations, a decidedly pro-growth and market-friendly Fed is unlikely to have much of an appetite for additional monetary tightening. Moreover, the combined impacts of a global growth shortfall and further declines in commodity prices point to a likely compression in the inflationary premium embedded at the long end of the yield curve. As I now see it, given the urgency of a US current account adjustment, further dollar depreciation is a logical outgrowth of such a benign climate in the bond market."

"The next downleg of the dollar should be very different from the first one. The euro has borne the brunt of the dollar's decline over the three years ending January 2005. Most Asian currencies -- especially the yen and renminbi -- were completely unscathed. If the dollar resumes its downward descent, as I suspect, that will have to change. Not only do I look for a politically driven change in Chinese currency policy that would allow for an RMB revaluation, but I also suspect that the yen-dollar cross-rate could move into the mid-90s."

But doomsday is only delayed.

"Three new mega-forces are now at work in reshaping the world: First is what I have called the “global labor arbitrage” -- the increased integration of offshore employment pools that fundamentally alters the worldwide mix of job creation and wage determination (see my 5 October 2003 essay, The Global Labor Arbitrage). For most of the modern-day era, job and wage competition has been confined to the manufacturing, or tradable goods, sector. Now, courtesy of the Internet, real-time connectivity with offshore pools of low-wage, highly skilled knowledge workers has pushed the arbitrage into once sacrosanct services, or nontradable, sectors. The hyper-speed of this IT-enabled transformation of global nontradables is unlike anything seen in the past. Five years ago, it was concentrated at the low end of the value chain in data processing and call centers. Today, it is also occurring at the high end of the value chain -- software programming, engineering, design, and professionals in the legal, actuarial, medical, accounting, financial services, and a broad array of consulting occupations. Such offshoring activity is still small in terms of the absolute numbers of workers involved -- especially when scaled against the size of the developed world’s work force. But it is now growing and spreading rapidly -- underscoring a powerful change at the margin that is rewriting the rules of employment and wage determination.

A second force at work is the “global price arbitrage.” Gone are the days when inflation is driven by trends in domestic cost structures. As Dick Berner recently noted, the old cost mark-up models are relics of a once closed US economy and, as such, are hopelessly out-of-date; at work is what Dick calls a new “market-pricing paradigm” -- in effect, a price-setting mechanism that reflects the balance between global supply and demand (see Dick’s 3 June 2005 dispatch, “Inflation Model Uncertainty”). Little wonder that the US inflation rate has continually surprised on the downside. Are price setters (or wage-setters) at the margin still in America? Or do they now reside in Guangzhou and Bangalore? Here, again, the Internet has played an important role in redefining long-standing macro relationships. IT-enabled cost- and price discovery has spread like wildfire in goods and services, alike -- adding an entirely new element to the global price arbitrage.

The “global saving arbitrage” is a third new macro force that is turning our old models inside out. It reflects a world that is near desperate in its efforts to keep funding the excess spending of the income-short American consumer. At today’s level of the US current account deficit, that desperation takes the form of capital inflows into the US of approximately $3 billion per business day. Nor is this coming from private portfolio investors who are dying to get a piece of the excess returns of America’s high-productivity economy. The bulk of these flows are now “policy buying” of foreign central banks -- especially Asian authorities, who feel compelled to maintain undervalued currencies in order to keep their externally-led economies growing. Fed Governor Ben Bernanke argues that America is doing the world a favor by consuming this saving glut (see Bernanke’s 14 April 2005 speech, “The Global Saving Glut and the US Current Account Deficit,” available on the Fed’s website). I would maintain, instead, that the non-US world is asking for serious trouble by suppressing domestic consumption and fueling the excesses of the over-extended American consumer. This saving transfer breaks the mold of earlier globalization models. A global saving arbitrage that finds the consumption excesses of the world’s economic leader being funded by poor countries such a China is the mirror image of trends that prevailed in the late 1800s and early 1900s -- when rich nations ran current account surpluses and transferred wealth to the world’s “settlement” economies (see my 18 April 2005 essay, Enough!)."

"At least for the time being, the saving-rich developing world has been more than willing to fund the massive current-account deficit that underpins America’s Asset Economy -- providing capital inflows into the US that effectively subsidize real interest rates at historically low levels. The global price arbitrage that has been spawned by the emergence of low-cost production centers in the developing world helps keep inflation low, thereby reinforcing the staying power of this low interest rate regime. This then provides support to frothy financial markets -- the crux of the Asset Economy. Ultimately, both of these anomalies -- unsustainably low real interest rates and excess asset appreciation -- will need to be corrected in order to put the world on a more sustainable path. However, given the likelihood of a global slowdown made in China emerging over the next year, I now believe this correction will come later rather than sooner (see my 31 May 2005 essay, Rethinking Bonds)."

Categories: economy, interest rates, bond market, real estate