Grant's Interest Rate Observer - October 22, 1999
MACHINATIONS OF CERTAIN FOREIGN INTERESTS
Americans, being Americans, are prone to assume that the United States is the cause of all international phenomena, including the transatlantic rise in interest rates. However, there is another interpretation, and it happens to be the one we favor: The Europeans are leading this increase, the Americans are following. Like Roquefort, the bear market in U.S. fixed-income instruments is chiefly imported.
Under cover of the European Central Bank's easygoing 2 1/2% benchmark money rate, the euro-denominated forward markets continue to erupt. Thus, the euro money-market futures contract for settlement in December was quoted Monday at 3.53%, more than 100 basis points over the bank rate. Unless the cognoscentl in the futures markets have missed by a mile, a Continental monetary tightening is inevitable, if not imminent; the ECB was expected to meet Thursday (another meeting is set for November 4).
A further rise in euro-denominated interest rates would tend to tilt the odds in favor of higher dollar-denominated money rates. One big difference between Wall Street this fall and last is that Treasury yields are rising this year, the jittery stock market notwithstanding. Insofar as the world's investors continue to demand a premium for holding dollars, a rise in dollar money rates must follow a rise in European ones (the premium, incidentally, has been shrinking of late).
A continued rise in rates, moreover, would tend to close out another source of cheap financing for the kind of speculator who does what Long-Term Capital Management used to do. The world has partaken liberally of low, and ultra-low, interest rates for most of this decade, from the 3% federal funds rate giveaway of 1992-93 to 1% gold lease rates (recently discontinued) to zer-opercent Japanese overnight rates (still available). Europe, too, has provided its share of superlow-cost financing, including the 0.5% Swiss franc-denommated discount rate (also still available) and, of course, the 2 1/2% euro-denominated repo rate. Helping themselves to low-priced loans, speculators have purchased, or "carried," higher-yielding assets, such as bonds and mortgages, at a spread. Now, one by one, the sources of cheap, speculative funding are becoming less cheap. Add this to the list of bearish influences on the global fixed-income markets.
Habitually, American analysts look first to domestic causes when venturing an explanation (let alone a forecast) of dollar-denominated interest rates. However, the analytical focus is bound to move offshore in the months, and perhaps years, to come. As the European economy mends and the euro strengthens (Grant's International is adamant on the Subject), It follows that a creditor must think about more than events in the 50 states.
(A digression due east: In the past six or so weeks, euroyen futures rates have dropped even as Occidental ones have risen. Either the Japanese economy is sinking under the waves again -not the favored explanation here - or the international arbitrage markets have some adjustments to make. Watch this space.)
Perhaps without intending to, the new edition of J.P. Morgan's "World Financial Markets" forcibly makes the bearish case. Thus, it forecasts "boomlike growth" in Europe in the light of "[d]ouble-digit credit expansion." In the circumstances, the Morgan analysts proceed, a "neutral" ECB policy would imply a 4% money rate. "However," they conclude, "low inflation, and the projected rise in the currency, suggest that the ECB will move gradually toward this level." The bank may move gradually, but, as Kevin Ferry, of (,art Futures, Chicago, points out, the first tightening step, however hesitant, would likely propel the market to discount a succession of further steps. On form, the end result would be a speculative rush for the exits. The U.S. set the precedent in 1994.
The most obvious bearish fact about European rates, Ferry goes on, is that the ECB hasn't tightened yet. It's merely the expectation of tightening that, since September 1, has sent three-month "euribor" (that's the euro-denominated futures rate) up by some 25 basis points in the nearby contracts, and tip by 45 or so basis points in the distant ones. The takeoff in Swiss rates-also without an announced central-bank tightening - has been even more dramatic. The euro-Swiss franc contract for settlement in June 2000, for instance, has leapt to 2.96% from 2.18%. Ten-year cash bond yields, too, have risen, by 50 basis points in euros and 62 basis points in Swiss francs, over the same sixweek span. Not only has the fact of this colossal shift in rates received little or no attention in the dollar world, but also no major interest-rate victim has yet been identified. It would be miraculous if a change in rates of this magnitude (with all the attendant change in derivatives volatilities) did not blow a hole below the water line of somebody's balance sheet.
If Americans think they know anything about Europe, it's that the Old World economy has a permanent case of the glooms, a prejudice reinforced by the strikingly low level of European interest rates. However, this econo-cultural perception isn't the one that's moving the European futures and derivatives markets. Speculators on the Continent seem to be discounting not one, not two, but a succession of tightening moves by the European Central Bank, an institution that has never once raised an interest rate in its 10-month policy-making existence. Inasmuch as dollar yields tend to trade at a premium to European ones, the European disturbances may well play a significant role in the outcome of the current U.S. interest-rate drama. The auguries would, in that case, be bearish (as, indeed, we happen to think they are).
When a French farmer recently drove his tractor through a half-built McDonald's restaurant in protest against capitalist imperialism-and, of course, the food-bears on European economic growth felt a thrill of vindication. Yet, there are also stirrings on the Continent that a capitalist would regard as positive. The accompanying graph, for instance, points up a little-known fact about the euro-zone economy, namely, that it is operating at a higher level of industrial capacity utilization than either the U.S. or Japan.
"I think that the money markets in Europe are well aware that capacity utilization rates are higher than mythology would have it," says Chris Sanders, eponymous head of Sanders Research, a U.K.-based idea factory that has been correctly upbeat about economic prospects the world over. "What we call excess money growth-the difference between real money growth and industrial production-is shrinking rapidly right now," Sanders goes on. "When that turns negative, the financial markets don't like it. I think that is what European money rates are telling you."
Perhaps, they are also reminding us of the propensity of interest-rate speculators to react to a central-bank tightening in three distinct emotional stages, proposes Ferry. No. 1, contained panic in the expectation of a change in the policy. No. 2, complacency and relief in the face of the event. No. 3, shock and horror. upon consideration that the anticipated cycle of tightenings may never end. The U.S. market in 1993-95 was a laboratory of these attitudes, Ferry notes. Whereas the federal funds rate climbed to 6% from 3%, start to finish, the eurodollar futures market ultimately discounted a rise to 8% and, in the distant contract months, much higher.
To apply this psychological template to the present day, Ferry goes on, the Europeans are plainly in stage one, the Americans in stage two. Everybody knows that the ECB will act, but nobody knows when (the overwhelming majority of ECB watchers surveyed by Bloomberg expects a tightening on November 4; "Bankers eager to prove hawkish machismo," the Financial Tiimes reported Tuesday, disapprovingly). In the United States, a tightening cycle is under way. It started last June 30, with 25 basis points, to 5%. A second 25 basis-point rise was announced on August 24, and the Fed recently served notice about a possible third. Yet, to judge by the decline since September I in eurodollar yields in the longer-dated futures contracts, complacency reigns. It shouldn't, however, Ferry and we agree.
"The Fed is preparing the stock market that it may have a job to do that really won't sit well with them," says Ferry. "This is no longer a matter of taking back last year's ease. I think what people forget is that the Fed had a tightening bias before Russia blew up [late in the summer of 1998]. And our [funds] rate is still 25 basis points below where it was when the economy was running at a lower rate and the Fed had a tightening bias."
Neither the ECB nor the Swiss National Bank has overtly moved. But each institution publishes a balance sheet, and both show a sharp deceleration in growth. This is a time-honored sign that policy has tightened in fact if not in word. As noted last issue, the ECB had been openhanded; over the summer, its balance sheet was growing at three-month annualized rates of 20% or so. The prudent Swiss, meantime, topped even that growth; in early July, the Swiss National Bank was expanding at three-month annualized rates in excess of 40% (year-over-year rates were then running at close to 20%). Both the Continental Europeans and the Swiss were trying to exorcise deflationary devils, staving off recession and (particularly in the case of the SNB) beating back unwanted currency appreciation. On the evidence, policies have tightened.
As a refresher, when a central bank creates credit, it buys assets-bills, notes, bonds or anything else, up to and including office furniture. The track of this expansion is marked on its balance sheet. Contrariwise, when a central bank tightens the screws, it refrains from buying, or actually sells. And in recent weeks, growth in the assets of the ECB and the SNB, measured at three-month annualized rates, has slipped into negative territory. Not that most investors are prepared to accept the bitter truth. Then, again, observes Ferry, "No one thought it was going to be an easing cycle when it started with us last year. But it was. It was a global easing cycle. It became the answer to the world's problems. Hey! it worked, to the point that it stabilized things. But no one's willing to embrace the opposite, which is where we are now."
Sooner or later, Sanders points out, most of the bulls on European interestrate markets cite the slow, 5% to 6% rate of expansion in broad money supply as a top reason not to worry. "There's a problem with that," he contends. "Credit growth and narrow money growth in Europe are both in double digits, very firm. Bank lending is extremely robust and becoming more so, [thanks to increased M&A activity] and also from strong industrial production, fueled by demand from abroad as well as a stronger domestic demand. The only reason why broad money growth has been so subdued is because, up until now, European asset allocators have been of the mind that expected rates of return will be higher in North America than in Continental Europe. So there's been a net portfolio outflow from Europe that has been fairly steady....
"We think that is on the cusp of reversing," Sanders goes on. "When that happens, broad money growth ought to pick up quite substantially, and quite suddenly as well, depending on the speed and size of that reversal in flows." In short, the days of comforting (or partially comforting) money-supply data are numbered.
We asked Sanders, in a leading way, about the flip side of this scenario: How will it affect the U.S.?
"The flip side is that you will see U.S. interest rates a good deal higher," he replied. "What is going to have to happen then is that rather than funding the current account deficit through the Foreign Direct Investment account and the portfolio capital account, the U.S. is going to find itself in the position of having to fund the current account deficit through the banking system. And that implies that rates will have to go a good deal higher."
Can you speak euro?