Figure 1
PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(November 17, 1997) FINANCIAL INSTRUMENTS: INTEREST RATES–RISK AVERSE STRATEGIES GETTING RISKIER–Iraq, Japan, Korea, Brazil. Where will it all lead? Based on the Treasury market action last week, all roads appear to lead to a flatter yield curve. The two-year/thirty-year spread narrowed to 42 basis points late last week as investors sought safety and liquidity in a risky global environment with decidedly disinflationary overtones. Now that a worst-case scenario for the global economy appears to be priced into the market, has a new form of risk been created? In other words, if the global gloom and doom scenario does not occur, where will interest rates be by early next year?
The Treasury market has done a good job of discounting the pessimistic scenario for the world economy in 1998. The current level of bond yields near 6% suggests that the market is discounting a recession in Asia, further downward pressure on prices for tradable, goods and a slowdown in the U.S. It also assumes that Fed policy will remain steady at a minimum, if not ease down the road. Yet, there are risks to this scenario. What if the impact of Asia's problems is “modest but not negligible” as Fed Chairman Greenspan says? It is extremely difficult to quantify what Asia's problems might mean to the U.S. economy. It is clear that the trade deficit will probably expand because exports to the region will slow and imports will be priced cheaply enough to attract a higher quantity of buying. It is also clear that declining import prices should continue to hold down inflation in the goods sector, as has been the case for the past two years. That is probably worth about 0.2% off of expected GDP growth and 0.2% off of next year's CPI. However, it doesn't really bring you to 6% bonds. Clearly the market is assuming that Southeast Asia's problems push Northern Asia into recession and that other emerging markets such as Brazil will falter as well. Ultimately if a global downward spiral were to develop, then the Treasury market is at risk because presumably Asian banks would have to sell to shore up their currencies and banking sectors.
In fact, Fed custodial holdings have declined in the past quarter, presumably on selling from Asian central banks using reserves to support their currencies. More to the point, however, is what will happen in Japan. Late on Friday, there were numerous unverified reports that Japan was preparing a bailout package for the banking system. Given the fragile condition of the Japanese economy, the threat of a sharp downturn in Korea and the potential for a bank failure, something needs to be done. Japanese officials have to date resisted bold efforts to set the economy straight, but the recent decline in the Nikkei has increased the risk that one of the “Big Four” banks will become insolvent. The banks hold highly leveraged positions in Japanese equities so as the Nikkei declines, their capital is eroded. If their capital were to fall below the standards set by the Bank for International Settlements (BIS), presumably they would be downgraded and that could result in financial panic. It is not a big stretch of the imagination to think that Japanese officials are finally prepared to take bold action given the current state of affairs.
There are obvious implications if the unsubstantiated reports are true. First, a bailout package would undoubtedly make the gloomiest scenario for the global economy look less likely. If Japan can boost its domestic economy and get the financial sector back on its feet, then the rest of Asia will benefit. Equity markets would presumably rally which in turn would boost confidence in the region. Secondly, a bailout package could be funded with taxpayer money but there could be some sales of U.S. Treasurys held as collateral to offset realized losses in real estate and equities. Since Japan holds U.S.$321 billion in Treasurys, even hinting at the possibility of some sales would likely send the market lower, particularly with long-term rates hovering at just over 6%. Table 1 and Figure 1 illustrates the high level of foreign holdings in U.S. Treasurys as of the end of the third quarter.
Major Foreign Holders Of Treasury Securities
As Of August 31, 1997
As A % As A % Of Total Of Total Country $ Bln. Foreign Private Japan $321.22 5.1% 9.5% United Kingdom 255.11 9.9% 7.5% Germany 78.66 .1% 2.3% OPEC 55.64 .3% 1.6% Spain 53.64 .2% 1.6% Neth. Antilles 48.33 .8% 1.4% Hong Kong 46.53 .6% 1.4% Mainland China 43.13 .4% 1.3% Taiwan 34.72 .7% 1.0% Singapore 34.12 .7% 1.0% Belgium 28.22 .2% 0.8% Canada 27.02 .1% 0.8% Switzerland 25.42 .0% 0.7% Mexico 17.91 .4% 0.5% France 9.20 .7% 0.3% Other 200.21 5.8% 5.9% Estimated Total Foreign 1218.61 00.0% 37.6%
Source–U.S. Department of Treasury
Figure 1
But perhaps of most importance is that the market is priced for a very gloomy global outlook and if the outlook changes, then the market has to re-price once again. As a result, the outlook for the domestic economy would once again become more important. Right now, most economists are predicting a slowdown in the U.S. economy in 1998. Of course, most economists have been predicting a slowdown for the past two years, but it has yet to materialize. But if the slowdown amounts to a “modest, not negligible” 0.2% to 0.5% of GDP off of a trend rate of 3.5%, how significant will that be? The economy would still be running well above the level where the Fed is comfortable, the labor market will remain tight and inflation in the service sector and wages will continue to rise.
A MODEST PROPOSAL–Consider where rates should be if the global economy does not implode into a deflationary spiral. The U.S. economy would probably continue to grow at a 3% or greater rate in 1998. The major reason it will continue to grow at a healthy rate is that there is no reason to stop the recent trend. Monetary conditions are still very accommodative as evidenced by the fact that interest rates are at cycle lows, money supply growth is exploding to the upside and loan demand continues to rise. If there is no exogenous outside shock to slow things down, then the liquidity provided over the past few months alone will be enough to boost growth even further. In turn, the Fed would have to drain liquidity by tightening policy sometime early next year.
Meanwhile, inflation is likely to remain well-behaved in goods because of the impact of foreign currency devaluations to date. Even if global trade remains healthy, prices of imported goods should continue to decline pulling down overall inflation at the wholesale level. In fact, prices at the intermediate goods processing level have been rising steadily for several months. Moreover, inflation in services and wages would likely continue to push higher. Hence, interest rates would move higher but not back to the levels of early last year because inflation would remain generally moderate. The yield curve would likely steepen as rates moved up across the curve. The new trading range for the bonds would presumably be closer to 6.5% than near 6%.
WHAT WE DON'T KNOW CAN HURT US–Of course, we don't know what may or may not transpire in Japan or Korea or Brazil or Iraq. Looking at next week's economic data won't help much either since the reports will generally confirm that the economy is currently in good condition. Industrial production is expected to post another healthy gain of 0.3% for October and capacity utilization is likely to hold near last month's 84.4 reading. Housing starts are likely to remain at very high levels based on the surge in mortgage activity seen recently. The Philadelphia Fed Index will probably rise, reflecting a strong manufacturing sector. Meanwhile, CPI is expected to post a modest 0.2% rise keeping the overall modest inflation outlook intact. These reports are unlikely to have a major impact on the market.
What will affect the market is the degree to which the outlook for the rest of the world changes over the course of the next few weeks. In light of where the market is priced, it is probably prudent to take to the sidelines and wait out the results of Japan's economic proposals next week. If there is some substance to the reports of a major financial sector restructuring, then the U.S. bond market will most likely have to re-price and re-focus on the domestic economy. The bond market is overbought and vulnerable to a correction but the driving force will be events outside the U.S.
Kathy Jones
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