24 April 2006

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Alan Greenspan, who retired in January as one of the longest-running and most-successful chairmen of the US Federal Reserve, will be remembered for many things, including his addition to the lexicon of finance - "irrational exuberance".

It is also likely that he will be remembered for his famous conundrum, wherein long term U.S. interest rates remained low - indeed declined - throughout the long, steady and almost continuous tightening of monetary policy by the U.S. Fed over two years. There were many explanations touted for this - for instance, Asian central banks had huge surpluses, which were being invested in long term U.S. Treasuries; globalization had increased capacity of labor in both manufacturing and services (China and India, respectively), so inflation expectations remained muted, and so on.

However, none of these explanations provided real comfort, and the market kept expecting that one day bond yields would jump shedding blood everywhere, and most notably in the U.S. housing market. There were, to be sure, a few skirmishes, notably in June 2003, when short term yields shot up, nearly doubling in a matter of a few months. But, all in all, the market has remained remarkably calm, part, I guess, owing to the broad level of comfort prevailing in global markets about risk. Volatilities in most markets - except, of course, commodities - are at multi-year lows, suggesting low risk perception, which is reinforced by the low levels of emerging market bond spreads, another classic indicator of risk appetites. And, of course, everybody knows about the tsuamis of money that are chasing assets all over the world, apparently heedless of valuation and risk.

Indeed, it is this apparent disregard of risk that has RBI - and, for that matter, central banks all over the world, not to speak of the IMF and the World Bank - worried. Have markets lost their mind, they say. Aren't markets supposed to price risk appropriately so that investors will be able to take informed decisions about risk and return? Have markets somehow stopped functioning?

To my mind, these are questions that only a blinkered technician would ask. Any normal person would answer the last question - which is the most comprehensible - with a loud "NO, OF COURSE NOT, WHAT ARE YOU TALKING ABOUT?"

And yet, the world's central banks appear transfixed by the possibility that markets are not pricing risk correctly - they believe that given the huge amount of analytic skill at their disposal (and, make no mistake, the skills at most central banks, specifically including RBI, are prodigious), they are more likely to be correct regarding the potential for financial trauma, than financial markets which are merely composed of millions of profit-seeking investors.

Having said that, however, let us look at another possible explanation for the Greenspan conundrum, which has been commented on by a few observers, including, significantly RBI in its most recent monetary policy statement. While they have noted loudly that high and highly volatile oil prices are one of their primary causes of concern, they also reported that the oil surpluses created this time - of the order of $700 billion a year at $ 60/bbl - are not being spent largely on imports. During the 1980s oil shock, over 90% of oil surpluses were spent on imports; currently, it is not much more than 40 or 45%. [Incidentally, on an inflation-adjusted basis, we are not yet at peak price levels that prevailed back then.]. So where are the balance of these surpluses going then? Clearly into investment assets, most notably - of course - U.S. (and other) Treasuries. The graph shows the movement of oil prices (since 2003) and that of the 10 year minus 2 year Treasury spread. The correlation is a massive -94%!

This means that whenever oil prices rose by 1%, the interest rate spread (which measures the relative cost of long-term borrowings) declined by nearly as much. Now, while correlations are notoriously fickle, and, in any case, do not provide a definitive causative link, it is clear that oil producers today are more financially savvy and, rather than burning their surpluses, as they did the last time around, are more effective market players. This speaks to the increased efficiency of financial markets in recirculating surpluses, and would certainly add one more "global investor" confirmation of Greenspan's conundrum.

In other words, the expected downward pressure on world growth as a result of sky-high oil prices is being counterbalanced by the upward pressure on world growth as a result of low long-term interest rates which are - partly at least - sustained by high oil prices. Very nice, wouldn't you say?

Yes, indeed, but - and here I come back to my central banker approach - can this go on forever? If oil prices were to rise to $ 100/bbl, would yields decline further counterbalancing growth? What about at $ 200/bbl? [Incidentally, I spoke with one of the captains of the "ol" industry in India, and he said he has long believed that while current prices in no way reflect genuine supply demand factors - in other words, that there is a huge amount of speculative money driving the market - the problem right now is that the supply side surplus has become extremely thin, so that any sudden disruption could see prices shooting up to $ 100/bbl.]

Well, theoretically speaking, if we accept the current process, it should - at least, to some extent. But reality doesn't always follow processes linearly. In most processes, there are what could be called boundary conditions - levels at which the rules change. In the current context, it could be driven by a need felt by oil producers to diversify their assets. It could be driven by continued and ncreased conflagaration in the Middle East - although I have read an article that suggested, not unreasonably, that war would actually increase the attractiveness of U.S. assets in the current world context. Who's to tell? Financial markets are, largely, continuing to play Jiminy Cricket, hardly concerned about all this.

Except that it is beginning to appear that the long downward trend in the (10 - 2) spread may be coming to an end. Since the end of March, the 10 year yield has moved substantively ahead of the 2 year - and it is a testament to the times, that 15 basis points is today considered substantive. And contrariwise (to the earlier correlation argument), oil, during this same period, has surged to its all-time nominal high of over $ 73/bbl. [Incidentally, gold has also moved more sharply than it has in several years over these few weeks.] Could it be that we are reaching - or have reached - a boundary condition where oil producers' portfolios are saturated with U.S. Treasuries?

While this may not immediately lead to a collapse in the dollar - there are still strong other buyers of U.S. Treasuries - it could certainly lead to increased nervousness, reflected in higher volatility in global markets and rising inflation.
Perhaps the central banks will turn out to be right after all.
It's probably not a good time to get into any exotic structures without a well-defined exit.

Currency Markets View - Rupee and Majors

USD/INR

Fortnightly movement: O-44.7100 H-45.4000 L-44.6775 C-45.1400
Sentiment: Inflows to push rupee towards appreciation, RBI may pull back
Expected range for 1 Month: 44.25-45.50
Expected range for 3 Months: 44.00-45.50

Yet another move towards depreciation was witnessed this week as domestic unit ended the fortnight 45 paise lower amid constantly rising oil prices. The dollar lost strength against the pound and the Euro did not cheer the rupee much as the Nationalised banks remained buyers throughout primarily for oil demand and the Reserve Bank of India. The central bank has been intervening to absorb foreign fund flows into India's booming stock market and keep rupee gains in check. Foreign reserves data released on Friday showed reserves rose to a new record of $155.2 billion on April 14. The liquidity remained well in control this fortnight as call hovered around 5.50%. As a result the forward premiums eased down largely. The 6-month benchmark forward premium, which stood around 2% last fortnight, closed at 0.9% this weekend.

With Reserve bank likely to continue its accumulation phase, the rupee may not strengthen much despite strong flows that are likely into the system. Volatility to remain high as worries of rising global oil prices and foreign fund inflows likely to continue its tug of war on rupee movement.

EUR

Fortnightly movement: O-1.2074 H- 1.2394 L-1.2066 C-1.2342
Sentiment - positive and may improve
Expected range for 1 Month: 1.2200 -1.2650
Expected range for 3 Months: 1.2200 - 1.2900

After clinging to the 1.21 level defiantly in the face of some good US data viz. trade deficit, retail sales, industrial production, consumer sentiment, etc. the Euro eventually seems to have managed a decisive upside breakout over 1.2325 largely on dollar negative data, a Wall Street story that 3 Fed Governors are not commited to a rate hike in June despite supporting a hike next month and FOMC minutes showing that most members consider the tightening cycle to be nearing its end.

So long as the market expects that the almost-certain Fed rate hike next month will probably end the Fed's current tightening cycle, the sentiment is likely to remain dollar negative. In that event, any downticks in the euro may be limited to 1.22 before rising to 1.2650 or, perhaps, even higher towards 1.29.

GBP

Fortnightly movement: O-1.7424 H- 1.7934 L-1.7373 C-1.7824
Sentiment: positive and may improve
Expected range for 1 Month: 1.7650 -1.8150
Expected range for 3 Months: 1.7650 - 1.8300

Sterling tracked the euro and reached a 3-month high of 1.7934. Last Wednesday's report of UK annual inflation having eased to 1.8% in March from 2% in February may have revived hopes of a Bank of England rate cut. Consequently, Sterling slumped to about 1.7750 but later recovered to finish last week around 1.7825.

As long as dollar sentiment remains negative, Sterling is likely to rally to around 1.8150 and, perhaps, even higher towards 1.83.

JPY

Fortnightly movement: O-118.17 H- 118.89 L-116.44 C-116.46
Sentiment: sentiment and may improve
Expected range for 1 Month: 115.50 -119.50
Expected range for 3 Months: 113.50 - 119.50

The yen finished last week a bit weaker around 118.65. The yen might have probably slipped more but for the speculation that finance ministers and central bankers from the G-7 industrial nations will increase pressure on China to let its currency gain more rapidly.

The actual G-7 communiqué urging Asian nations to let their currencies strengthen and reduce reliance on export growth. It is unlikely that USD would be pushed below the strong support level of 117 as the Chinese have always resisted political pressure. Consequently, dollar/yen could still be trapped in a 115.50 - 119.50 range for a while.

Dr Risk's Prescription

Euro comes back with a vengeance

Last week that ended on Good Friday, was a quiet one with the Euro trading in a very narrow 1.2066 - 1.2167 range and ending marginally up just above 1.21. But the fact is that the Euro stood defiant in the face of some good US data such as lower than expected trade deficit and stronger than expected retail sales etc. This week the Euro again shrugged off upbeat US data on capital inflows and instead capitalized on negative US data - worse than forecast housing data and a tame core PPI number - a Wall Street story that 3 Fed Governors are not commited to a rate hike in June as also FOMC minutes showing most members deemed the tightening cycle to be nearing its end. Market expectations of a June Fed rate hike have tempered quite a bit though a hike on May 10 is considered to be almost certain.

The Euro rallied very smartly to break above the 1.1825 - 1.2325 range and reach about 1.24. It did dip under 1.23 on a fall in US jobless claims and a rise in the Philadelphia Fed's manufacturing index. However, the Euro recovered again yesterday and closed just under 1.2350 on the news of the Swedish central bank cutting the proportion of USD reserves from 37% to 20% and the comments of the Russian Finance Minister that the US dollar is not an absolute reserve currency.On the upside, the nearest target is just above 1.25 but if the sentiment continues to be against the dollar for the next few weeks, the Euro may well rise even higher towards 1.29 before finding itself at the crossroads.

Will the yuan lead the yen or will the yen lead the yuan?

The yen finished last week a bit weaker around 118.65. The yen might have probably slipped more but for the Chinese President's visit to Washington and caution/expectations as to the dollar/yuan exchange rate. The yen firmed to about 117.50 on the abovementioned dollar negative factors and further to about 116.50 yesterday on speculation that finance ministers and central bankers from the G-7 industrial nations will increase pressure on China to let its currency gain more rapidly.

Yet, there could be follow-through yen buying early next week. It remains to be seen whether this alone can push the dollar below the strong support at 115.50 -which is unlikely since the Chinese have always resisted political pressure. Consequently, dollar/yen could still be trapped in a 115.50 - 119.50 range for a while. And, so long as US data is mixed, it is unlikely to fall below 113.50 without concrete action from Bank of Japan or the Chinese authorities.