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MERRILL LYNCH & CO.
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(November 26, 1997) FINANCIAL INSTRUMENTS: INTEREST RATES–In our economic perspective we discuss the potential for growth, wage pressures and inflation to impact interest rates. Were it not for the Asian financial situation rates would likely move up somewhat.
Of course we can not avoid the impact of the Asian situation and, indeed, we think it is currently the dominant determinate of recent rate moves in the U.S. It is responsible for the widening of credit spreads between Treasuries and other instruments. It is the reason the Fed chose not to raise rates at its November meeting. It is an important factor in narrowing the yield curve lately, as long bond yields have fallen from near 6.25% to near 6.0%.
While the Fed may continue to resist tightening, absent a considerable worsening of the financial crisis in Asia and more of a spillover into North and South America, the Fed is not likely to ease. Further, as long as the economy continues to grow at a healthy pace we do not see long-term rates falling to the 5.5% level that some are now forecasting in the short run. At the same time, we think that the presence of the crisis will keep rates from rising much. The most likely near-term range for Treasury bond yields is likely to be, say, 5.85 to 5.90% on the downside and a return to the 6.25 to 6.30% rate on the upside.
Looking forward, we see both the potential for rates to rise or fall. The Japanese plan to recapitalize their banking system will entail the Bank of Japan and the postal savings institution to exchange some of their present assets for preferred shares in Japanese banks. On the one hand this will provide capital for those banks to lend. However the assets to be sold will likely be JGBs and foreign securities, the bulk of which will be U.S. Agencies and Treasuries. The cost of the recapitalization is estimated to be a minimum of 800 trillion yen which at 125 yen per dollar is $64 billion.
It might appear that the impact of the recapitalization plan would be negative for U.S. notes and bonds. However, that is not clear. First, we think that most of the dollar sales by the BOJ will be made by rolling off maturing securities. Further selling by either the BOJ or postal savings will likely be mostly from short duration paper. Finally, until a mechanism for creating demand causes a substantial rise in loan demand, most of the money will be re-circulated by the banks and some is likely to be parked in, you guessed it, U.S. Treasuries. As far as we can tell, then, the impact of the recapitalization plan may simply be to flatten the yield curve even more.
Another concern of the market will be the IMF bailouts of Korea and other Asian and emerging market nations. Assuming the bailouts require $80 to 120 billion collectively, world capital markets will have to be tapped. To the extent that these loans will replace existing “shaky” loans there may be no net funds raised. However, the quality of these loans, by definition, will be far superior to the ones that they are replacing, much of which is potentially bad debt. Thus, they might compete more with Treasury paper which is virtually risk free.
Of course, the impact of the entire Asian situation will leave the G7 central banks less likely to raise rates as much as might otherwise be the case. In fact this has already happened in the U.S. and probably Canada, although both the Bundesbank and the UK have recently raised rates and the UK will probably raise rates a bit further. We also think that Canada will soon raise rates. On the other hand, Germany will probably not follow-through with further rate rises at this time unless the dollar/mark rises back through the 1.80 level.
We think the risk to U.S. Treasuries comes either at the point where the Asian situation is resolved enough to allow growth to resume there or, alternatively, if the impact of the Asian situation is so negligible that it does not act as a brake on U.S. growth and the labor market tightens further. It will be several months before this is determined.
Tentatively, our operating assumption is that growth will slow enough in 1998 to prevent a significant rise in rates. If so, and given our belief that real rates are still high relative to those that will be needed to sustain healthy growth once the economy slows down, we think there is scope for a limited further fall in long-term rates in 1998. Thus, our year ahead forecast is likely to be for rates to be in a range of approximately 5.5 to 6.5%. This implies a nearby futures range of about 114 to 126.
(Reprinted by permission. Coypright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
David Horner
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