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Global market overview – November/December 2009

Although the global economy is starting to show signs of recovery, the drivers behind this growth are largely artificial. This month we look at the true impact of economic stimulus packages on sustained global growth. We also examine the future prospects of gold and contrast the current economic situation in Europe and the US with that of Japan in the early 1990s.

Credit contraction continues

Economic data is improving around the world. Financial markets are discounting a further improvement as Q3 growth in the US and Europe was higher than many anticipated and the Chinese growth rate is fast approaching the 10% mark. So why are a fair number of economists still pessimistic about future growth prospects?

Their biggest concern is that the current recovery is based primarily on fiscal and monetary policy. Stimulus measures like the cash-for-clunkers car trade-in schemes and tax rebates for first time home buyers have pushed up consumption and stimulated the housing market in the US. When these programmes end, however, growth will fall back. For positive growth to be sustained, it has to result from higher consumption, exports or investments without government stimulus. This is unlikely until employment increases, real estate prices recover or foreign growth rates translate into higher exports.

Chart 1: A self sustainable recovery is unlikely so long as credit and employment contract
Chart 1: A self sustainable recovery is unlikely so long as credit and employment contract

Source: Reuters EcoWin/ECR

In the meantime, governments and central banks have to maintain the stimulus measures to avoid a deflationary spiral. Without (artificial) growth, asset prices decline, banks suffer more losses and tighten their lending standards even more, and unemployment increases. In the past year, the authorities have quite easily managed to prevent an economic nightmare by implementing stimulus measures. However, the question is whether they will continue to be able to do this in the coming quarters to years. Developments in credit supply and long-term bond yields are key in this regard.

In both the US and Europe, total private credit is contracting, which is deflationary (debt repayment reduces the money supply). Governments and central banks need to counter the reduction in credit by increasing fiscal deficits and printing more money. However, when the decline in credit accelerates, this will become more and more difficult. The bond market will become increasingly sensitive to the risk of higher inflation, if authorities err on the side of stimulating too much; or loss of purchasing power due to a debased currency.

Therefore, so long as long-term interest rates do not rise considerably and credit only contracts moderately, the authorities can succeed in staving off deflation. However, if the long-term interest rate rises significantly (ie the 10-year treasury yield moves towards 4%) and credit deflates too rapidly, the risk of another recession and a new bear market in stocks will increase sharply. We do not anticipate another recession, but we do expect a new bear market in stocks.

Asian central banks hoarding gold?

The investment community is beating the drums of a prolonged bull market in gold. As the ultimate store of value in the world (contrary to ‘fiat’ currencies, the value of gold cannot be debased by money-printing central banks), the rise of gold is not surprising given increasing concerns over the effect of very loose monetary policy. Add to this a depreciating dollar and very low short-term interest rates, and gold is indeed in a sweet spot.

At the beginning of November, the IMF announced that it had sold 200 metric tons of gold to the Reserve Bank of India. This implies a whole new source of demand for gold and, indeed, a prolonged bull market. Compared to the Fed or the Bundesbank, Asian central banks, ex the Bank of Japan, hold on to only a very small amount of gold as a percentage of total reserves. Given the huge reserves of China and the limited supply of gold, however, it is not surprising that bullish investors are translating these fundamentals into gold prices of $2,000 and higher.

We have our doubts however. First of all, sentiment of gold investors has reached extreme levels. More often than not, this is an important indicator of a trend reversal. A big decline in gold prices would not surprise us as we expect a stronger dollar and rising (real) interest rates. Instead of becoming rich by borrowing dollars and going long on gold, we feel more comfortable with selling gold and buying the dollar.

US treasury yields to follow in the footsteps of JGB yields?

Long-term Japanese government bond yields are the lowest among the industrial world nations. This is despite the fact that the country’s government debt (178%) is not only the highest worldwide but is also projected to rise towards 200%, nearly twice as much as Italy’s current government debt.

Chart 2: Japan’s post bubble experience of rising debt, declining yields unlikely to be repeated by the US
Chart 2: Japan’s post bubble experience of rising debt, declining yields unlikely to be repeated by the US

Source: Reuters EcoWin/ECR

This raises the question as to whether significantly higher government debt in Europe and the US is really a problem at all and whether fear of higher yields is exaggerated. Some economists agree and expect lower yields for the coming years. However, to put one’s faith in this kind of reasoning is based more on hope than on a fair comparison. Indeed, there are some big differences between Japan and the US.

In the aftermath of the real estate and stock market bubbles bursting in the early nineties, the Japanese government was rather slow to stimulate the economy and help the banking system, even though the credit bubble was arguably bigger than it was in the US a year ago. Furthermore, as soon as the Japanese economy started to recover, the authorities pulled back their stimulus measures.

As a consequence, the economy fell back and the deflationary spiral revived and lasted longer than many economists deemed necessary. In contrast, the US authorities were quicker to stimulate on a large scale and are not willing to pull back before a self sustaining recovery has taken off.

Secondly, Japan started its crisis with a much higher domestic savings rate than the US. Furthermore, Japanese investors (and predominantly the pension funds) hold more than 90% of Japanese government bonds and are willing to accept a much lower yield than on comparable US or European government bonds.

The US savings rate was below zero at the onset of the crisis and economists estimate the biggest chunk of US government debt is in foreign hands. These investors are likely to be less generous to the US government by accepting a low yield when the risk of higher inflation has not disappeared and a dollar crisis remains a possibility.

This means that US and European long-term interest rates are unlikely to unfold in the same way as Japanese long-term rates have. For the coming quarters, a pick up in the growth rate will prevent a decline in long-term rates. In the longer term, an ageing society and a rebalancing of the world economy (in which Asian countries save less) will limit the availability of foreign capital to finance the growing government deficits.

From this perspective, long-term bond yields are most likely to rise considerably, even if growth prospects look dim compared to the high growth rates of the last decades. In our view, even Japan will be confronted with higher long-term yields.