Markets not moving interest rates to correct global imbalance

Low interest rates are increasingly recognised as a worldwide phenomenon. There have been several reasons advanced for the low rates -- global savings glut, weak global economy -- to which another reason has been added: the failure of capital markets.

A recent purveyor of this view is The Economist. On 18 August, it wrote the following in an article on its website:

The world currently displays an alarming number of large economic and financial imbalances. America's current-account deficit is forecast to widen to over $800 billion this year, while Germany, Japan and China look set to run record surpluses. Total government debt in rich economies has risen to a new high as a percentage of GDP, and in many countries households are sliding ever further into debt. Meanwhile, the growth rates of America and other rich economies have diverged to an unusual degree.

Many economists try to explain these trends in terms of underlying structural factors, such as differences in demographic trends or productivity growth. An alternative, more worrying, explanation is that the price signals that are supposed to bring the world economy back into balance have become distorted.

The Economist argued that countries with current account or budget deficits should face higher yields to compensate investors for the higher risk of a currency depreciation. However, using the case of the United States, which suffers from both a current account as well as a budget deficit, this has not happened. The Economist attributed the failure of bond yields to rise to Asian central banks buying US Treasury bonds to prevent their currencies rising and to cheap goods from emerging economies keeping inflation down and resulting in central banks holding interest rates down as well.

The Economist further argued that the liberalisation of international capital flows should have enabled markets to "punish economies where governments or households borrow recklessly with higher bond yields, prompting them to tighten their belts". However, this does not appear to have happened.

This is not really surprising. As I said in my previous article concerning the diminishing US personal saving rate (see "US saving deficit leads to trade deficit"), deficits that appear unsustainable over the long term can still last for a considerable period of time.

While the market will very probably eventually move to a sustainable equilibrium, the timing of such a move is always highly uncertain. Remember that Federal Reserve chairman Alan Greenspan declared that there was "irrational exuberance" in the stock market as early as 1996. The US stock market bubble, however, did not burst until four years later. Even today, US stock market indices remain above their levels in 1996.

Therefore, with ample capital inflows at the moment, countries like the United States can sustain their deficits and maintain low interest rates at the same time for quite a while more.

Certainly, as The Economist pointed out, central banks play an important role in keeping interest rates low. That includes the Federal Reserve. In fact, by keeping the federal funds rate substantially below the inflation rate until recently, the Federal Reserve has played a key role in keeping long-term bond yields low.

There is no secret to this phenomenon. The federal funds rate directly affects the cost of short-term funds, that is, short-term interest rates. The cost of short-term funds obviously affects the cost of long-term funds, that is, long-term interest rates. When short rates fall far below long rates, arbitrageurs swoop in, borrowing at the short rate and lending at the long rate, which tends to close the gap and push the long rate down.

When the Federal Reserve started its interest rate hikes in June last year, the spread between the 10-year Treasury note and the federal funds rate was well over 300 basis points. That is far above its average over the previous 50 years of below 100 basis points. Such a spread might be sustainable in a powerfully-expanding economy, but not at the mature stage of the cycle that the economy is now in where growth is expected to moderate.

The spread has since fallen, partly due to a rise in the federal funds rate, but partly also due to a fall in the 10-year yield as the outlook for economic growth moderated (see "Outlook for stocks and bonds may depend on PMI").

Alan Greenspan has called the fall in long-term rates a "conundrum". But it is partly of his own making. The slow or -- in the Federal Reserve's own words -- measured pace of rate hikes has surely been a factor. A slow rate of Federal Reserve hikes in the presence of a large spread between the 10-year yield and the federal funds rate has historically not been conducive to increases in the former.

The following chart shows how, over each of the 50 years from 1955 to 2004, the change in the 10-year Treasury yield (shown on the vertical axis) has varied with the difference between the change in the federal funds rate and the spread at the beginning of each year (shown on the horizontal axis).


From the above chart, it can be seen that, over the course of a year, when the increase in the federal funds rate has fallen well short of the spread (reflected as a data point well to the left side of the chart), the 10-year yield has often fallen in that year. In other words, if the federal funds rate cannot come up to the 10-year yield, the 10-year yield will come down to it.

Since the start of its rate hikes a little over a year ago, the Federal Reserve has raised the target federal funds rate by 250 basis points, well short of the spread at the beginning of its rate hikes. Little wonder that long-term rates have fallen.

However, with the spread between the 10-year yield and the federal funds rate now at about 70 basis points, a few more rate hikes by the Federal Reserve should see the former finally start to respond in the desired direction -- that is, up. Unless, of course, the economy weakens more than expected.

In any case, the upshot of this is that while the market may not be doing a very good job at moving interest rates in the direction required to correct long-term global imbalances, its behaviour has not, in fact, been very different from its historical pattern.

(Update on 13 February 2006: Corrects error on the spread at the start of interest rate hikes.)

US saving deficit leads to trade deficit

The US trade deficit in June was near record levels. Considering that oil prices and US consumer spending were at record levels in June, this was not exactly unexpected. Consumer spending's rising share of the US GDP in particular -- and its corollary, a declining personal saving rate -- has been a major driver of the expanding US trade deficit in the past several years.

On 12 August, the US Commerce Department reported that the US trade deficit for June was US$58.8 billion on a seasonally-adjusted basis. That is the second highest monthly deficit in 2005 and the third highest on record.

The record oil prices in June, when NYMEX crude oil futures broke through US$60 a barrel, was a major contributor to the increase in the deficit. Petroleum imports hit a record US$19.9 billion as imported crude oil prices in June averaged US$44.40 a barrel.

However, non-petroleum imports were also very high. The June figure of US$45.0 billion was the second highest on record.

The reality is that US consumer spending is at very high levels, and high overall imports largely reflect this fact.

Earlier, on 2 August, the Commerce Department had possibly given a taste of what was to come in the trade report when it reported that personal consumption expenditures for June had hit a seasonally-adjusted annual rate of US$8,723.5 billion, the highest on record and close to all-time highs even as a percentage of GDP. As a result, the personal saving rate for the month dropped to zero percent.

The fall in the personal saving rate to zero can be considered a milestone event. It is part of a longer decline in the US personal saving rate that began in the 1980s, as the following table illustrates.

	Average personal saving rate %
1961 - 1970	8.5
1971 - 1980	9.6
1981 - 1990	8.7
1991 - 2000	4.7
2001 - 2005 (June)	1.8

There are several reasons given by economists for the fall in the personal saving rate.

One explanation involves the "wealth effect". Rising asset prices -- in stocks for the past two decades or so until arrested in 2000, and in housing more recently -- caused Americans to feel wealthy and feel more able to spend.

Another explanation is the rise in labour productivity since the 1990s. With persistent productivity increases, Americans became more confident of continually rising income, encouraging them to spend more.

A third explanation is that innovations in finance has given Americans increased access to credit, which enables them to increase spending.

A fourth explanation is the fall in interest rates over the past two decades or so. Together with money illusion, it makes people think that they are getting lower returns on saving and incurring lower cost in using credit, thus discouraging them from saving and encouraging them to use credit instead. Lower interest rates also feed into higher asset prices and reinforce the wealth effect.

Whatever the reason, if the saving rate continues to decline into negative territory, consumer spending will very likely take an increasing share of GDP, and that must translate to a rising trade deficit unless other components of the GDP -- investment and government spending -- are sacrificed. As it is, the past years' rise in consumer spending and concomitant fall in the personal saving rate has contributed to a rise in the trade deficit from an average of 1.5 percent of GDP from 1991 to 2000 to 4.5 percent thereafter.

Common sense tells us that the personal saving rate cannot keep falling and the trade deficit cannot keep rising indefinitely. Eventually, Americans will run out of personal wealth and national assets.

How can investors position themselves for the eventual reversal in trends? Here are a few ideas.

A reversal of the falling saving rate implies a reduction in consumer spending and a probable slowdown in growth, even possibly a recession. This suggests a move out of equities.

A reversal of the rising trade deficit implies a weaker US dollar. This suggests a move into foreign assets.

Both might be associated with higher interest rates, at least initially, which suggests a move out of bonds.

The problem is that while common sense tells us that there will eventually be a reversal in the trends, it does not tell us exactly when that will take place. The United States is big and rich enough relative to other countries to be able to afford to run down its wealth for a long time.

A rise in interest rates might be the signal of an impending reversal in consumer spending. In this regard, the Federal Reserve seems willing enough to lend a helping hand. It certainly has been reversing its loose monetary. On 9 August, the Federal Reserve raised its target for the federal funds rate by 25 basis points to 3.5 percent, its tenth such hike since June last year. It also released a statement simultaneously suggesting that it would continue do so for at least a while more.

Having said that, longer term interest rates -- the ones that matter to consumers -- have stayed stubbornly low despite the Federal Reserve's persistent raising of the federal funds rate. Instead, the rate hikes appear to be attracting capital into the US and boosting the US dollar, hardly a recipe for correcting the trade deficit.

So investors who position themselves now for the eventual reversal of the declining saving rate and rising trade deficit might have to be very patient.

Stocks fly in July

The Singapore stock market had a good July, shaking off not one but two terrorist incidents in London to hit new five-and-a-half-year highs. And there are no compelling reasons why the good run cannot continue in the medium term. The long-term trend, however, suggests a limit to the upside.

The Straits Times Index (STI) gained 6.3 percent in July, closing on the last trading day of the month at 2,352.56, the highest close since January 2000, the month in which the previous bull market peaked. The two bombing incidents in London and the potentially crucial introduction of a new regime for the Chinese renminbi hardly made an impact on the stock market.

The Singapore stock market had good company in its optimism. The following table shows that all major stock markets rose in July. In Asia, the South Korean market, as represented by the KOSPI, did even better than Singapore's, rising 10.2 percent and hitting a decade high in the process.

	30 June close	29 July close	Percent change
S&P 500	1,191.33	1,234.18	3.6
Nikkei 225	11,584.01	11,899.60	2.7
FTSE 100	5,113.20	5,282.30	3.3
DAX	4,586.28	4,886.50	6.5
CAC 40	4,229.35	4,451.74	5.3
Hang Seng	14,201.06	14,880.98	4.8
KOSPI	1,008.16	1,111.29	10.2

Global stock markets have no doubt been supported by the recent spate of good economic news.

The US economy, the engine of world economic growth, grew 3.4 percent in the second quarter. Although this was slower than the 3.8 percent in the first quarter, it was marked by healthy growth in both consumer and business spending. Excess business inventories were drawn down. Price pressures moderated.

Forward-looking indicators have also looked good recently. The Conference Board's US leading index and the Chicago Purchasing Mangers' Index rose in June and July respectively. US home sales and durable goods orders for June also increased. US consumer confidence indicators moderated in July, though.

Perhaps more importantly, the positive news flow has spread to the rest of the world. Last week saw reports of both Japan's NTC Research/Nomura/JMMA Purchasing Managers' Index and Germany's Ifo business climate index rising in July, adding to earlier evidence that these two major world economies may be seeing a significant upturn.

Most importantly from the Singapore stock market's point of view, the Singapore economy has also been looking better recently. On a seasonally-adjusted annualised basis, real GDP expanded by 12.3 per cent in the second quarter, reversing the 5.5 percent contraction in the first quarter. June in particular saw turnarounds in Singapore's manufacturing output and exports, which rose 9.2 percent and 1.3 percent respectively. Non-oil retained imports of intermediate goods, a short term leading indicator of overall manufacturing activities, rose a strong 11.3 percent in June.

An announcement by the Singapore government on 19 July that it was easing rules on property financing and foreign home ownership also boosted market sentiment, especially in property and finance stocks.

Valuation-wise, the Singapore market is probably trading at a price-earnings ratio of about 16 based on 2005 earnings. It is not particularly cheap, but not high enough to suggest that low interest rates and momentum cannot bring it substantially higher.

And yet, it is important to remember that this bull cycle is already more than two years old. At this stage of the cycle, with the market looking at a likely moderation in the economy and corporate earnings growth in 2006, it is prudent to at least have an idea where the market is likely to peak.

As I have mentioned in previous commentaries, when the stock market last peaked in 2000, the STI had initially found support at around 2,000. Rebounds from that level had found resistance at around 2,200. Earlier, I had considered the possibility that the current cycle would peak between these two levels. However, after struggling for much of this year with the 2,200 level, the STI has now broken convincingly above it, so this target is obviously no longer valid.

Beyond 2,200, I see no obvious target for the STI. In last week's issue of The Edge Singapore, Goola Warden suggested a target of 2,400. To which I say: why not 2,583, the level of the last peak? This seems a more natural target to me.

This means that there is potential for the STI to rise over 200 points or almost 10 percent. Mature bull market or not, nimble traders may still fancy their chances in trying to eke out more gains on the long side.

However, if the longer-term trend holds, the STI may have trouble breaking its previous high in this cycle. Because for all its impressive showing over the past two years, over the longer-term, the Singapore stock market has looked more like it is in a secular bear market rather than a secular bull market.


The above chart shows the STI since 1993. In terms of its raw numbers, the STI has looked, at best, as if it has been going sideways. If adjusted for changes in the US$/Sing$ exchange rate or CPI inflation, the trend for the STI, if anything, looks worse. While the raw STI hit its highest level in early 2000, the exchange-rate-adjusted and inflation-adjusted STIs reached their highest levels in 1996 and 1994 respectively, and despite subsequent peaks, have not recovered those highs.

Looked at from these perspectives, one could quite plausibly argue that the Singapore stock market has been in a secular bear market for the last decade or so. The July surge notwithstanding, who is willing to bet that this is about to change?