January is the time to take your view for the year, and most of my conversations with Wall Street players (or “playaz”,depending on their self-image) in recent weeks have consisted of exchanging guesses about the macro prospects. Of course, one 12-month period should be not be different from any other but the outcome at the end of a calendar year sets much of the compensation for Wall Street employees or hedge fund managers. So I am going to make my bet for how 2005 turns out, in particular for the fixed income and currency markets.
I think the first part of the year will be as benign and calm as the waiting room of some New Age therapist. You know what I mean – the burbling of a miniature stone fountain, boring music heavy on the wind chimes, Harper’s Magazine on the table, no clock. Gentle declines in the US Treasury 10-year yields, a further slow tightening of credit spreads and measured progress towards the return (and bonus) targets for the year.
The second part – and it may come in the third or fourth quarter – will be like the scene in Scarface in which the Miami club is invaded by machine gun-toting assassins. A mixture of greed and terror, heavy on the terror.
The trend that is Wall Street’s friend is supported by two perpetual motion machines. One is Asian central banks’ policy of keeping exchange rates for their currencies below market-determined levels. That means that they will continue to pile up dollar deposits that are periodically turned into US government bonds and government-backed mortgage securitisations.
The other perpetual motion machine is the yield panic among European and Asian private investors facing imminently insolvent, rather than prospectively insolvent, social security systems. Their yield hunger is colliding with risk aversion among US corporate managers, who will probably redeem more bonds this year than they will issue. The US corporate people also want a nice, stable, early retirement, and the way to get that is to take as few risks as possible. Mergers or acquisitions, yes, but only to lock in a competitive position rather than create hoped-for synergies or enter new markets.
Susan Sterne, a leading US consumer economist, has been on top of the falling rate trend. “Aging populations should have lower interest rates,” she says, “and the Europeans are having their benefits cut back now, not 10 or 15 years from now as we are debating here. Our problems are minuscule compared with those of older Europeans, and they want our higher coupons.”
What should make anyone even more bullish about near-term prospects for Treasury bonds is the widespread bearishness and positioning for a bond decline. There aren’t many bond bulls left out there, which leaves room for you.
The decline in Treasury bond yields in turn contributes to the compression in the interest rate margins of riskier bonds over Treasuries. Retiring on a 4.2 per cent 10-year yield does not seem like a lot of fun, especially when pension plan actuarial assumptions are some 200 to 500 basis points above that. So, directly or indirectly, people are buying riskier products, particularly collateralised debt obligations, or packages of bonds, and synthetic CDOs, which are packages of credit default swaps, and can distill risk (and return) from low-yielding packages of corporate paper.
Eric Feinstein, a managing director of credit derivatives research at JP Morgan Chase, says: “I think the CDO market will remain strong. Investors are either moving out the credit curve or using structured products [to distill that higher risk and reward]. There are many more participants in CDOs than there were and the market share of banks has declined. That is a good thing, diversifying the base.”
Of course, as Mr Feinstein says, “When you have periods of market concern, credit derivatives will sell off even faster than bonds, since it is easier to buy protection in the CDS market than to sell the bonds.”
Hmm, yes, what about periods of market concern? What is likely to set off the equivalent of the 1997 Asian crisis, or the 1998 Russia/Long-Term Capital crisis?
Leaving aside another big terrorist attack on the US, (for which market participants are far better prepared than last time), you are probably looking at the sort of extreme market disruptions that occur towards the end of a recovery cycle.
We are likely to be in a short growth pause here, heralded by indicators such as the decline in UK housing prices, car inventories, weak European numbers and lower oil prices. Yet the market still expects Fed tightening. If the growth pause leads to stock market weakness and commodity market declines that will just set up the world economy for another acceleration in the final stretch of the year.
The resulting commodity inflation, and accelerated tightening, will not be good for financial assets. Gold, therefore, will be weak in the near term but finish out the year with a bang.
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