Goldman Sachs: kortsiktig skada

July 8, 2005

• We expect no lasting impact of yesterday’s attack on asset markets.

• Central banks will not likely modify the path of policy, unless attacks are reiterated.

• Data to watch today include US NFP, German IP and Brazil IPCA.

• Monetary policy cycles look out of synch: the Fed tightens while most others get ready to ease.

• This may be desirable and possibly driven by varying business cycle patterns across countries.

• Massive increase in EM global savings may alone have depressed ”equilibrium” global real yields by as much as 50-75bp.

• Industrial recovery likely to push real yields higher, but perhaps by less than previously thought.

• Released Asian bilateral trade data hint at another possible narrowing in US May BOT deficit.

1. Overview

(This section reproduces yesterday’s Daily Financial Markets Comment by Bill Dudley and Jim O’Neill.)

Financial markets reacted initially as one would expect in the immediate aftermath of yesterday’s events in London. Equity markets declined, safe assets, especially government bonds rallied, and the Swiss Franc, as often, strengthened against many currencies, including the Dollar. As often when these events happen, we do not think it is appropriate to write much about the incident, and we shall not on this occasion.

In terms of market consequences, we have the tragic events of 9/11 and Madrid, amongst others, to give us guidelines. It is probably important to decide which of those two events bare more comparison, as well as the underlying environment at the time of the event. However, and in order for this event to have lasting market consequences, we think that three further things would be necessary: further terrorist activities in the near term, signs of a notable deterioration in consumer spending, and a major shift from any central banks in terms of their policy priorities. The Bank of England made a statement yesterday that no additional liquidity was necessary in UK markets, which of course implies that if needed, they would provide it.

9/11 had a major impact because of its massive scale, the shock nature and the resulting policy response, which in the case of the Fed’s monetary policy was big and quick. Madrid, while a terrible shock again, was not of the same scale and did not result in any major policy response. This London event, so far, seems more akin to the latter.

In a broad sense, the question is whether this event will influence any major central bank and the Fed in particular. If the Fed were due to meet today, perhaps this event might have caused it to consider a pause until news became clearer. However, given that the Fed moved last week and will not meet again for a few weeks, yesterday’s events are not likely to be influential. If you do not believe that the US economy or Fed policy will be affected, then it is probably the case that this is more of an issue for UK markets, if any. Therefore, and without further near-term terrorist activities, markets will probably reverse course from yesterday’s reaction.

Additional near-term terrorist activities in the UK or elsewhere would probably see the consequences being much bigger, along the lines of post 9/11 amid fears of a significant loss in business and consumer confidence. For the UK, we thought that the Bank of England would cut interest rates in August anyhow, and at the margin, this probably adds to the likelihood.

2. On the Calendar Today

In the US, June non-farm payrolls and average hourly earnings are key releases to watch today. For NFP, we expect a reading of +200K, which is in line with consensus, compared to +78K in May. The risks to our forecast are skewed toward the upside. On earnings, we anticipate a +0.3% rise, slightly above consensus forecasts of 0.2%.

In Europe, we would focus on the release of German industrial production data for May. We expect a monthly decline of -1.0% in German industrial production after +1.3% in April, consensus expectations are -0.2%. Business surveys are consistent with a flat underlying trend in industrial activity. The German trade balance for May, released earlier today, showed a marked increase in imports, hopefully signaling improvements in underlying domestic demand.

In the emerging markets, the release of June IPCA inflation will be key in determining the outlook for monetary policy in Brazil. We forecast that IPCA inflation eased considerably to 0.15% in June from 0.49% in May; and that IPCA-15 amounted to 0.10% in June.

Finally, Japan reported disappointing machinery order numbers overnight. In conjunction with Taiwan’s weak export data yesterday this casts a shadow over the strength of Asian growth.

3. The Puzzling Behavior of the Global Monetary Policy Cycle

At first sight, something looks odd on the global monetary policy stage: the Fed, the ”global” central bank if there is one, remains fully committed to tightening monetary conditions, while most of the other major (and many emerging) central banks are either easing already or leaning in that direction.

Much has been argued that such a divergence in the stance of monetary policies is precisely what is needed to reduce global imbalances. The United States, the largest external borrower, definitely needs to tighten financial conditions and cool off domestic demand (and the opposite is broadly true about the rest of the world) if global imbalances are to be reduced. Yet, in a world where global policy coordination is largely absent, the fact that asynchronous monetary policies are desirable does not explain why they are coming to be.

We believe that this is happening because different economies are not only at varying stages of their business cycles but, moreover, the length of those business cycles has traditionally varied in quite a regular fashion. Using 40 years of quarterly data, we have examined in detail the length of the business cycles in the US, the UK, Canada, Australia, Germany, and Japan, as well as in a sample of important emerging economies (Brazil, Mexico, and Korea). With the help of Hodrick-Prescott filters, we have found that over the past four decades, the US and the UK have experienced five recessions (1970, 1974, 1981, 1991, and 2001), Germany has had six, Canada seven, Japan eight, and Australia nine. We have also found that Mexico and Brazil appear to lag the US business cycle by a couple of quarters.

Given the varying features of business cycles across the world, the diverging stance of monetary policies begins to make sense. Periods of US monetary easing tend to push other economies into expansionary cycles, necessitating tighter money to compensate for easier global liquidity. By contrast, because the US tends to move later into the global downswing, it may continue to tighten money when other economies are already in need of easier monetary conditions.

A similar, if exaggerated version of that story, appears to be taking place in some of the emerging economies, and especially in those like Brazil and Mexico, decidedly within the Dollar block, and recent adopters of inflation-targeting type frameworks. The easing of US monetary conditions led there to a massive expansion of output and significant inflationary pressures, and required from BACEN and Banxico a significant tightening of monetary conditions, well ahead of the Fed. That is now changing, and those two central banks are getting ready (Banxico in September and BACEN sometime in 4Q2005) to ease monetary conditions. By contrast we expect the Fed to keep tightening policy through the first half of 2006 leaving rates at 4.5% by mid year.

If our analysis proves to be right, global monetary conditions may again be gradually entering an easing cycle. Such an environment, combined with moderate levels of risk aversion, should continue to support investments in high-yielding assets.

4. Another Look at the Bond Conundrum

We, along with the markets, have participated in the discussion of the so-called ”bond conundrum,” namely, the decline in US treasury long-term interest rates over the past year despite a 225bp increase in the Fed funds target. Temporary economic weakness (especially in manufacturing), combined with pressures by pension funds to make significant additions to their longer-term bond portfolios, and foreign central bank accumulation of reserves have all been singled out by the Fed as possible explanations for the low level of real yields in a context of gradual but persistent monetary policy tightening.

We have written ourselves about some of these issues in the past, and have allowed for some discussion in recent Dailies. In fact, on Wednesday, Francesco Garzarelli and Dominc Wilson downplayed the importance of Asian central bank purchases in keeping bond yields low, while yesterday, Thomas Stolper discussed how low global bond yields have helped perpetuate US external imbalances. One issue that we have not discussed at length, however, is the extent (in basis points) to which the increase in global savings since 2001 may have contributed to the decline in global real rates. This is important not only to understand what has happened but also the likelihood of real rates staying low going forward.

To understand why, it is important to realize that, ultimately, global real interest rates are determined by the need to clear the market for global savings and investment. In other words, one can think of a global savings supply curve, with savings being an increasing function of the global real interest rate, and of a global investment demand curve, with global investment being a decreasing function of the global real interest rate. In equilibrium, global savings equal global investment (the world is a closed economy after all), and the resulting real interest rate clears the market.

Between 1991 and 2001, global savings and investment have averaged about 23% of world GDP. Since then, global savings have been on a steady increase, and estimated to have reached close to 25% of world GDP last year, with all of the increase concentrated in the emerging economies. This represents an additional $800bn of savings supply every year, which is quite significant compared to the normal flow of savings, and also to the accumulated increase in Asian reserves since 2001 ($1.2trn ”only”). Not surprisingly, the impact of such a positive shock on equilibrium real yields can be quite massive. Using econometric estimates of global savings and investment by Barro and Sala-i-Martin (”World Real Interest Rates,” NBER Working Paper No. 3317), we find that the positive savings shock would have been enough to depress equilibrium global real yields to about 2.2%, compared with consensus estimates of equilibrium real yields of 2.8-3.0%.

If anything, these findings suggest that 10-year Tips yields, currently trading at a yield of 1.73%, may still have room for upside once the global industrial cycle gathers momentum. However, upside of short bond positions may be more limited than previously thought, at least until either savings behavior in the emerging economies returns to historical averages, or global investment demand experiences a significant revival.

5. Next Week’s Super-Focus: US May Trade Balance on Wednesday

All eyes will be set next week on the release of US trade data for May, after two consecutive better-than-expected data points. Not only will the announcement be important in shaping views on the outlook for trade and the Dollar, but could also influence second quarter growth forecasts.

Available information on bilateral balances from some of the major US trading partners suggest some room for another positive surprise. Using data for the past 12 months, we find that bilateral trade balances with Canada and the European Union have been rather stable, accounting for about 35% of the overall US trade deficit. By contrast, bilateral balances with the Asian economies have fluctuated quite a bit over the past six months and, in particular, with Japan and China.

Five of the most important Asian trading partners for the US have already released their bilateral trade figures for May, including Japan and China. We should take these figures with a grain of salt, as trade discrepancies among countries are large and seasonal issues are present. That said, the consolidated non-seasonally adjusted US trade deficit (seen from the Asian side) appears to have narrowed to $21.4bn in May, compared to $23.5bn in April, and an average monthly deficit for those same five countries of $23.7bn over the past 6 months. Provided there are no big surprises among other important partners, these figures suggest that the May trade deficit may narrow by as much as $2bn relative to April’s $57.0bn reading, on a non-seasonally adjusted basis.

6. Current Trading Views

These trading ideas, from the Global Markets Group, reflect shorter term ideas, which are not necessarily related to the longer-term ”structural” trades included in our Top 10 list below. Below is a list of our outstanding trading recommendations.

In FX spot:

1. Stay short EUR/¥ with a 1-day stop on a close above 135.00.

2. Stay short GBP/SEK with 1-day stop on a close above 14.25.

3. Stay short NZ$/$ with a 1-day stop on a close above 0.71.

4. Stay long A$/NZ$ with a 1-day stop on a close below 1.08.

5. Stay short EUR/$ with a 1-day stop on a close above 1.21.

On rates:

1. Stay long 2-yr Hungarian swaps for a target of 6.30%. Stop on a close above 7.15%. (opened at 6.73%, now 6.59%)

2. Hold shorts in 5yr US$ swaps for a target of 4.75% and stop on a close below 4.15%. (opened at 4.30%, now 4.27%).

7. ”Top 10” Macro Trades for 2005

1. Dollar `Sell-Off Basket’: Long a call on a basket of Swiss Franc, Euro, Japanese Yen, Taiwan Dollar against the US Dollar (opened on 9/12/04 at 100.0).

2. Long EUR/HUF (opened on 9/12/04 at 247.0).

3. Long a `BRIC’ Basket of BRL, RUB, INR & CNY vs. USD (opened on 9/12/04 at 100.0).

4. Short GBP/SEK (opened on 9/12/04 at 13.0).

5. Close Dec-05 Euribor (opened on 7/12/04 at 97.6 closed on 8/6/05 at 97.995).

6. Short 2% 7/2014 TIPS (opened on 7/12/04 at 1.7%)

7. Close positions shorting the `Wavefront’ Consumer Basket (opened on 9/12/04 at 100 closed on 4/5/05 at 105.3).

8. Long AUD/NZD (opened 7/01/05 at 1.09)

9. Short EUR/JPY (opened 10/01/05 at 136.8)

10. (-)

Alberto Ades

Monica Fuentes