Stories for 2008
[Update added below: Brad Setser and his 2008 outlook]
[Update 2: A comment from FI Trader clarifies some of my remarks below on the issuance of Samurai bonds and more specifically whether these contracts who are subsequently swapped into USD are hedged or not.]
In my line of business you rarely get a moment's rest I am afraid and if I ever thought that 2008 would start off on a soft mark I was wrong by some margin. This is not so strange however since where individuals can and companies try to enter the new year with a clean slate (for some mortgage desk traders and dealers a very clean one I'd imagine) markets on a whole on the other hand barely took a breather before sending oil to 100 USD a barrel. As we move along into 2008 I will of course carve out my views in detail on the general topics and trends to look out for in the crooked timber of the global economy and her many markets. But here, as it were, follows some immediate observations on a seemingly random range of topics.
- Let me begin with a topic I (and others) have already covered extensively in my first post in 2008. Japan is likely to have just entered a very meager year with respect to top line GDP growth. As we know, ups and downs are the way of life in economics but in Japan a tough year in 2008 with respect to the economic conditions as well as a muddy political year are sure to bring forth old ghosts and issues of the past. These would most plausibly include the question of whether Japan should return to ZIRP, the government debt issues (a downgrade on the sovereign debt perhaps), and most likely a lot of flurry about a low Yen and carry trade where the G7 will be sure to wade in as they did in 2006 albeit with somewhat less legitimacy now that the Fed, the BOE and possibly the ECB are looking downwards too.
- Turning to the patchwork which makes up the Eurozone countries I should begin by congratulating Malta and Cyprus with their ascession into the fine community. Well, I don't know whether an actual congratulation is in order but for better or worse these two mini nations are now subject to the whims of Trichet and his colleagues in the great tower which oversees Frankfurt's streets. As per tradition I am coming in behind two of my traditional sources on the Eurozone Sebastian Dullien and Daniela Schwarzer who already have their 2008 forecast up as well as of course the Eurozone team over at Morgan Stanley (still go for the last permalink in 2007) have a slew of notes on the coming year in the Eurozone. In next week when the ECB and the BOE sit down (separately of course) to decide on monetary policy I will have more. In general and as I emphasised in my recent notes on the Q3 GDP releases I am looking primarily towards Italy and Portugal for the really low growth rates. Eastern Europe as ever also has my gaze as 2008 very well could see some unforeseen events unfold. I will have more next week where I expect the ECB to hold and the BOE to ... hmm hold as well
- Another big topic which is sure to pass through into 2008 is going to be Bretton Woods II and the steady erosion or more aptly re-formulation of ties of global capital flows. Now, all this essentially shores up in FX market as the most direct proxy although of course those ever watchful SWFs and their hunger for yield juicy assets remain an important part of story. However, the first immediate question I guess would be the extent to which USD will continue to fall and if so against what and who? The latter part of 2007 saw the USD tumble against almost everything which moved with EUR/USD being the most prominent currency pair. It is amazing how fast new conditions become everyday life but with the EUR/USD trading at around 1.47 it is still mighty high in relative terms compared to past values. Of course, as Jessica Hupp from Currencytrading.net notes recently nothing is so bad that it isn't good for something, the USD version, but as I have always argued the shift in global capital flows towards the notion of the traditional thesis of de-coupling would not be sustainable. I think 2008 will be the year where I am proven right on this but in the meantime the EUR/USD is still tugged in comfortably at above above 1.45 and the USD/YEN seems very reluctant to beat 110. Moreover, yesterday's minutes from the FOMC did not seem to send a decisive signal to the cutting exercise at the Fed (quite the contrary it seems) and today's round of news and data on most notably the NFP are likely to provide yet another dent to the USD. Turning towards the more finer silver linings of the BWII system we have the possibility, as it was also raised at times in 2007, that China and the Petroexporters decide to loosen the peg so to speak. The argument in favor of this is surely mounting with inflation becoming a serious concern but old habits as we know die hard. As for the petroexporters I hada note up recently in which I explored the consequences and effects of a looser peg between the Middle East and the US dollar. In this note I especially emphasised that de-pegging did not mean diversification although by definition the two are not mutually exclusive since it could be a situation of a bit of both. That was back then however and only yesteday we learned how the U.A.E. has decided that their inflation problem does not rest on the shoulders of their peg to the US. Old habits indeed it seems but more importantly it does not mean that those hitherto eager financers of the US current account deficit could not decide to put other money in their vaults. This brings us into the financing of the external US balance and thus into Brad Setser land. Now, Brad has already made great strides to express his concern about the fact that as the private inflows into the US have almost retreated completely over the last part of 2007 the US is now completely dependant on official foreign inflows (read: foreign central banks/SWFs). This would also clearly bring China into the equation which like the petroexporters are faced with a severe and mounting inflation headache and thus must see the potential for an increasingly looser peg against the USD as an ever more attractive option. Well, perhaps not. At least if you look at the recent post by Macro Man in which Brad Setser makes the following very interesting point in the comments section ...
A faster but still controlled pace of rmb appreciation is, i think, fully consistent with a very fast pace of reserve growth. indeed, if more hot money floods in, it might even coincide with a stronger pace of reserve growth. In the gcc (edit: GCG), for example, expectations of a change in the pushed reserve growth way way up.
So, we can get it both it seems which brings me to Macro Man's equally interesting point highlighting the fact that BWII watching is not a job for the faint of heart but more so for a good detective or perhaps a keen Stereophonics fan?
Brad, I think the interesting thing to see is what happens over the next 2 weeks. As the chart shows, these periods of rapid appreciation tend to last for only so long then slow down dramatically. I presume the slowdowns are when a lot of the reserve accumulation occurs. Eyeballing the chart suggests that we're rapidly approaching the time when a "typical" appreciation burst starts to decelerate. If it doesn't happen, then perhaps we should conclude that something has changed. The real proof, of course, will be when we get December's reserve data in a few weeks.
Meanwhile we should not for one minute let our eyes drift away from the other big story in the context of global capital flows and how the likes of India, Brazil, Turkey, etc are now set to take their part of the load and probably whether they like it or not too. This I think will also be a big story for 2008.- Last but not least inflation and more accurately stagflation is going to be a big topic for 2008 too I think. A lot will depend on the connection between a slowdown in growth and commodity prices (food will continue go up I think) but in essence the honeymoon stage of central banking in the new era of modern growth where importing deflation was the big story is now over I think. At least the picture is going to change a lot on this front and a debate will ensue I think as to the contruction of inflation indices not to mention what central bankers should do about headline inflation.
If the topics above sort of represent the main locus of consistent attention here at Alpha.Sources, other things have also caught my eye recently; one in particular. Consequently, this Reuters piece back in September alerted us to the fact that corporations eager to raise funds in the midst of a looming credit crisis were turning to Japan and issuance of samurai bonds. In the context of the immediate conditions on the credit markets this of course made perfect sense as a sort of modern financial market version of Ghostbusters (or Debtbusters perhaps) and the well known mantle 'who you gonna call?' In this case the Japanese savers would be the ones picking up the phone it seems. And of course it was a lucrative option ...
Reflecting Japan's calmer markets, the three-month TIBOR ZTIBOR interbank lending rate stands at 0.839 percent, up about 7 basis points since early August when the strains first struck the dollar and euro money markets. Over that time dollar three-month LIBOR LIBOR rates have soared about 35 basis points to 5.72 percent, while euro three-month LIBOR rates have surged about 45 basis points to 4.763 percent.
Citigroup Inc., Bank of America Corp. and 30 other issuers from Iceland to Australia drove yen- denominated bond sales in Japan to a seven-year high as they took advantage of the lowest rates in the industrialized world. Sales of samurai bonds, debt sold by overseas borrowers mainly to Japanese investors, tripled to 2.2 trillion yen ($19.3 billion) this year, from 741 billion yen in 2006, according to data compiled by Bloomberg.
Now, will this continue in 2008 and why might it? Well, if we look at the following small but important detail from the Reuters piece linked above ...
The funds from the offering of five-year floating-rate notes by Citibank (C.N: Quote, Profile, Research) were believed to be swapped back into dollars via the derivatives market, traders said, and it may be a precursor to other banks doing the same thing in coming days and weeks.
The issue of hedging notwithstanding here the fact that the proceeds from these contracts are swapped into USD seems to be a straight bet on a Yen funded US carry or more precisely that the BOJ will not raise. Coupled with the general outlook for Japan in 2008 and the more structural point about a decline in home bias amongst Japanese investors we might just see more of this especially if credit markets remain tight as I would argue is very likely.
Brad Setser also chimes in with his bid on important topics of 2008. A couple of things caught my attention in particular. Will de-coupling à la traditionelle continue? Well, first of all we need to talk about the EU27 here and not the Eurozone where the external balance is in modest surplus albeit not with China which seems to be the main point in all this. 2006 was indeed a year of de-coupling, in some sense at least, seeing that Chinese exports grew much faster towards Europe than towards the US. Also the rapid rise of the EUR/RMB is a case in point here. Yet, how much can this process of traditional de-coupling continue, that is the question. My guess is not long and we will see significant weakness in key European countries this year.
Actually this brings me to one of Brad's personal watchlist points in the sense that he notes how Eastern Europe needs ardent watching citing a piece by the IMF published last October. I couldn't agree more and I will also be watching Eastern Europe with great vigilance in the months to come. Edward has the latest from Romania this morning which certainly does not look good at all, not at all I am afraid. Apart from that Setser promises to keep a weary eye on the Bretton Woods II system and that seems timely since who should do it if he did not :)?