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From "The Quants" (By Scott Patterson) http://www.linkedin.com/in/joerussell...
Electronic copy available at: http://ssrn.com/abstract=1480190
ECONOMICS RESEARCH
25September2009
PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 11
SPECIAL REPORT
The new global balance – Part II:2010: Higher rates rather thanweaker dollar
In
, 23 March 2009, we argued that the puzzling response of theUSD and US rates during the panic of Q4 08 – a stronger dollar and lower rates – wouldbe temporary and that the return of risk appetite and structural aspects of the newglobal balance – smaller gross capital flows and the savings drain resulting from globalfiscal policies – would steepen rates and weaken the USD. Since end-March, 10y USyields have increased 76bp, more than in other G7 markets (Figure 1), and a dollarindex relative to major currencies indeed weakened 7.5%, (13.8% relative to developingcountries, Figure 2) .
As the large swings in risk appetite are likely behind us, we believe global fiscal andmonetary policies are going to play a key role in determining the directional changes inrates and currencies in the coming year. We reiterate two key messages from ourMarch note. First, the narrowing of the US current account (CA) deficit may not be asbenign for the dollar as most believe. In our view, the CA adjustment partly reflectstemporary considerations, and global fiscal policy likely is not USD-neutral even if globalimbalances are reduced. Second, we document how QE has acted as a choice between“rates over currencies,” as we highlighted in our previous note. In particular, we arguethat the directional implications of global QE are behind the main breakdowns of the“recovery” trade over the summer months (eg, the fact that equities rallied but ratescontinued falling, and that the yen appreciated).Where does this leave us for 2010? For rates, our message is simple: as QE tapers off inearly 2010, we expect monetary and fiscal policy to join forces and push long-term rateshigher. Our views on the dollar, by contrast, are more nuanced following the largeadjustment that has occurred since March. Over coming months, fiscal and externalfactors should continue to put downward pressure on the dollar, but easy monetary policy,the main recent driver of the USD in our view, will gradually change from a dollar-negativeforce to a dollar-positive force throughout next year. This implies that the end of QE in2010 and the start of the tightening cycle in the US – both supportive forces for thedollar – should compensate USD-negative fiscal considerations.In short, monetary policy, which helps explain the low rates/weaker USD mix over thesummer, should continue to be a critical driver for rates and currencies. In comingmonths, we expect it to continue adding downward pressures to rates and currencies, butas QE ends, it could actually provide a USD-positive surprise in 2010.
For investors with aone-year horizon, our main message should be clear: Our confidence in further dollarweakening has ebbed, as our confidence in rising long-term yields has risen.
Christian Broda+1 212 526 8536christian.broda@barcap.comPiero Ghezzi+44 (0) 20 3134 2190piero.ghezzi@barcap.comEduardo Levy-Yeyati+1 212 412 5963eduardo.levyyeyati@barcap.comwww.barcap.com
Electronic copy available at: http://ssrn.com/abstract=1480190
Barclays Capital | The new global balance – Part II
25 September 2009
2
The misleading undoing of global imbalances: Dollar negative,rates negative
Even though the USD appreciated over the critical months of the crisis as Americansrepatriated their funds, the contraction in the US CA deficit accelerated in recent quartersimplying a sharp fall in the net supply of USD assets to the rest of the world (see Box 1 for adescription of the evolution of private capital flows in the critical quarters of the crisis). Whilethis would typically imply a dollar-positive event, we believe a large part of the adjustmentoccurred for reasons that are dollar neutral (eg, the fall in oil prices and the global uncertaintyshock), and for temporary factors that will be partially reversed (the collapse in world tradeand the delay in fiscal policies) in 2010. We continue to believe – as we argued in March – thatthe global fiscal stimulus (the so-called “savings drain”) may put upward pressures on ratesand downward pressure on the currencies of net borrowers like the US.Figure 3 shows that the US CA deficit fell from 6.5% of GDP in 2006 to about 3% of GDP in Q209. While public attention has focused on the rise of the personal savings rate in the US inrecent quarters, Figure 3 also suggests that this has been completely offset by the fall in publicsavings. Indeed, US total savings (both public and private) have
fallen
over recent months;therefore, the improvement in the US CA is entirely due to the collapse in investment. As wedocument in Box 2, this is typical in large CA adjustments in industrialized countries (and theopposite of what happens in emerging economies). The reduction in the US CA deficit impliesthat the US now requires 46% of the net savings in the world (the sum of all CA surpluses),relative to the 54% it required pre-crisis. While this is a large change, the US still demands asizable amount of the foreign borrowing around the world.But there are two reasons why we interpret the fall in the US CA deficit as being less benignfor the dollar as most commentators suggest. First, we believe a non-negligible componentof the reduction of trade balances is the result of the cyclical collapse in global trade. Aproportional contraction of imports and exports has the effect of moving deficits andsurpluses closer to equilibrium. As soon as global trade picks up, the process is likely to bepartially reversed. Moreover, as noted, most of the US CA improvement is attributed to asharp fall in investment that, if our constructive US view materializes, could be quicklyreversed. Thus, the sharp decline in the US CA deficit has temporary components that mayhave initially led to an overcorrection.
The contraction of US current account deficit accelerated recently but due to USD- neutral and temporary factorsImprovement in US CA deficit isentirely due to a collapse ininvestment
Figure 1: 10y yields in the US, UK, euro area and Japan Figure 2: The recent evolution of the USD
8595105115125135145 Jan-08May-08Sep-08Jan-09May-09Sep-09AdvancedEMIndex of currenciesagainst the USDMar 23, "NewGlobal Balance"published-13.8%01/08 = 100-7.5%
Source: Haver Analytics, Barclays Capital Source: Haver Analytics, Barclays Capital
First, temporary factors led toovercorrectionThere are two reasons tointerpret the fall in US CA as lessbenign than meets the eye:
Barclays Capital | The new global balance – Part II
25 September 2009
3
A second reason why the undoing of imbalances does not fully remove the weakeningpressures on the USD is a “structural” argument we made in our original March note. Weargued in March that fiscal stimulus worldwide would distort the adjustment in globalimbalances in a way that was unfavorable for the USD. Absent fiscal policies, the financialcrisis would have brought a reduction in global imbalances (ie, a narrowing of CA surplusesand deficits driven by the bursting of the commodity bubble, and a rise in US savings due toprecautionary motives and the wealth effect of the crisis) with a negligible effect on interestrates and currencies. We illustrated this rates/dollar-neutral adjustment with the effects of the swings in oil prices (
March 23): a lower oil price meant lowersavings from Saudi Arabia and higher savings in the US, as only part of the income transferfrom the lower oil price is consumed. This meant a lower US CA deficit to be financed bySaudi investments and a lower Saudi CA surplus to be invested in US assets, with no first-order implication for world interest rates or exchange rates. But we believe the impact of global fiscal policies is not rates/dollar neutral.Figure 4 shows how the expansionary global fiscal policies modify this benign USD scenario,as they alter the terms at which global savers are willing to lend to global borrowers. All elseequal, expansionary fiscal policy in the US and the rest of the world reduces savings both inthe US (left-hand side chart) and in the rest of the world (right hand side chart). This impliesa new global balance without larger deficits in the US or larger surpluses in the rest of theworld (for simplicity we ignore the relative magnitudes of the fiscal policies), but results inunambiguously
higher
interest rates as global savings have fallen. The implications of thisworldwide fiscal expansion for the dollar are less clear in theory, but empirically these fiscalshocks are typically associated with the
depreciation
of the currencies of countries with thelargest fiscal expansions. At present, this implies that the large US fiscal deficits are likely toput downward pressure on the dollar for some time, while having relatively mutedimplications for the US CA deficit. Thus, as the global public dis-saving continues in comingquarters – almost half of the global fiscal stimulus is still in the pipelines (please see theEconomic Outlook in
)– we believe thetemporary improvement of the US CA deficit does not imply that the pressure for higher USrates and a weaker dollar have abated.
Figure 3: CA deficit, and private and public savings (2002 –today), all as a share of GDPFigure 4: The impact of the global fiscal stimulus overglobal imbalances – the savings “drain”
-8-6-4-20246820022003200420052006200720082009-8-7-6-5-4-3-2Personal savings % disp inc. (LHS)Govt savings % GDP (RHS)CA balance % GDP (RHS)
r1r0Real Interest RateI(US)CA(US)S(US)I(non-US)S (non-US)S, IS, ICA(ROW) >0
Source: BEA, Barclays Capital Source: Barclays Capital
Second, continued US fiscal expansion will put pressure for higher rates and weaker dollar
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US Dollar Forecast
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