From the Chief Investment Officer

European Politics and the Dollar

The EU referendum in France and the Netherlands turned out to be a major catalyst for currency markets. In the months ahead of the referendum, the markets seemed to be thinking that the economic implications of the EU constitution, whether rejected or not, would be small. However, immediately after the first exit polls in France, it became clear that the outcome was a major blow for the process of political integration in Europe and (more importantly) it exposed a polarization of continental European voters with regard to domestic reforms. The results of the German regional election as well as the French and Dutch referenda highlighted that parts of the Euroland population are not prepared to tolerate the hardships generated by the reform process. Others sectors of the population still support the “short term pain for long-term gains” to improve the longer term outlook for growth and employment. In the struggle between these two camps the current French, Italian and German governments have been significantly weakened. The common perception in financial markets is that the reform progress will likely slow – at least in the near term – and therefore economic growth will continue to disappoint.

This political uncertainty and the relative economic weakness in Europe, as well as the continued willingness of the Asian economies (particularly China) to purchase dollar-denominated investments, caused the dollar to appreciate. In addition, recent domestic economic data suggest that the dollar may continue to strengthen. Greenspan’s speech to the Joint Economic Committee and subsequent comments suggested that the Fed will continue to raise rates at the next few FOMC meetings. The June 30 meeting yielded the ninth such increase, a quarter percent, to a Fed funds rate of 3.25%, from only 1% a year ago. First quarter 2005 GDP was revised upward a second time to 3.8%, while inflation remained tame.

Nevertheless, this near-term market sentiment is not inconsistent with our longstanding view that the dollar will ultimately need to weaken further on a broad, trade-weighted basis over the medium- to longer-term. All markets are driven by a multitude of short-term (e.g., supply and demand) and long-term (equilibrium) factors. Among large, liquid financial markets, the global currency market is unusually resistant to equilibrium forces due to the presence of very large market participants who may not always be profit-maximizing (e.g., central banks). This causes market trends to be very long and makes forecasting the timing of exchange rate movements even more challenging. Clients therefore will benefit from the diversification of currency exposure built into their portfolio allocations.

The Interest Rate “Conundrum”

On May 31, the yield on ten-year Treasuries dipped below 4% for the first time since early February and the debate over bond yields, which began in February when Fed Chairman Greenspan called the level of rates a “conundrum,” has gained momentum.

There are two different, but related, topics of discussion. The first is the general level of bond yields. These are already low by recent standards – in the U.S., lower than the rate of economic growth (which many economists think they should roughly match). The second is the shape of the yield curve, the relationship between yields on Treasury securities of varying maturities. The curve is flattening: less than half a percentage point separates the yield on ten-year Treasuries from that on two-years, down from more than two percentage points a year ago. This is a global phenomenon – the curve is even flatter in Britain and Australia, and inverted in New Zealand.

The analysis of bond yields and the shape of the yield curve is complicated by the dual role of yields: they both affect economic performance directly and also reflect the market’s expectations of the future. Rates may be low and curves flat because inflation is currently low and expected to remain that way, or rather because economic activity is expected to decline.

In a new paper by Hong Kong Shanghai Banking Corporation (HSBC), Stephen King notes that economists have generally done a poor job of forecasting yields. Focused on determining “neutral” or “equilibrium” interest rates (sufficient to achieve price stability in the first instance and balance savings and investment in the second), many have concluded that bond yields should approximate nominal GDP growth rates over time. But historically, the relationship between bond yields and GDP growth has not been stable. In the 1950s and early 1960s, a time of relatively low inflation and robust economic activity, yields were well below nominal GDP growth rates. Through the 1970s, unexpected inflation and sluggish economic performance caused losses for bond holders as rates rose to far exceed GDP growth. And from 1980, hurt by that experience, investors demanded a premium for holding bonds. In the past two years, yields have again fallen below GDP growth. Could we be moving back into that much earlier pattern?

Mr. King thinks we are, even though the world looks very different now. He predicts that the yield on ten year notes will fall to 3.5% in 2006 and so does Stephen Roach, chief economist of Morgan Stanley. But why? US economic growth still looks strong, its fiscal deficit predicts continued high borrowing, its trade deficit implies an eventual weakening of the dollar and high oil prices suggest inflationary pressure – all of these would normally push bond yields up! Greater mobility of capital and labor, plus the new prominence of low-cost India and China in world trade, has dampened inflation. To support this new trading order, Asian central banks are content, for the time being, to buy dollar bonds with their savings. The world’s aging workforce is another support for bonds, as investors retire and at least gradually switch from growth securities into more stable, income-oriented securities. Central bankers have shaken off overt political control and are seen as invincible inflation fighters so the fear of any serious inflation is nowhere to be found. HSBC thinks that a number of these changes are more or less permanent, and that interest rates around the world are likely to remain low for a long while.

While we are not in complete agreement with the view that low rates and, in particular, a flat yield curve are here to stay, we must acknowledge some strong arguments that rates may stay low for longer than many economists and market commentators expect. Sustained low interest rates and a flattish yield curve would have important implications for investment returns, favoring cash and equities (including private equity) at the expense of longer-term fixed income and hedge (absolute return) funds, broadly defined. We have never been big fans of long maturity fixed income investments and our appetite for absolute return vehicles may need to be even more cautious than before.

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