image page global fx and interest rate outlook michael r. rosenberg october 2010

Global FX and Interest Rate Outlook

Michael R. RosenbergOctober 2010

Interest Rate Outlook

2FCW <go>

Financial Conditions and the Monetary Policy Transmission Mechanism

Change inPolicy Rate

Change in Economic Activity

Financial Shock

Change in Financial Conditions

Real (Output) Shock

Relative Price Shock

Change in Inflation

“Monetary policy works in the first instance by affecting financial conditions, including the levels of interest rates and asset prices. Changes in financial conditions in turn influence a variety of decisions by households and firms, including choices about how much to consume, to produce, and to invest.” Federal Reserve Chairman Ben S. Bernanke, March 2, 2007

3Source: Bloomberg

How Financial Conditions Typically Respond to Federal Reserve Policy Changes

Change inCredit Spreads


Change in Money-Market Rates

Change in PolicyRate

Change in Bank Lending Conditions

Change in Inflation

Change in Government Bond Yields

Change in Asset Prices


4Source: Bloomberg

5

Bloomberg’s Financial Conditions Index

BFCIUS index <go>Source: Bloomberg

Significantly Below Normal

Significantly Above Normal

Normal

6

Tracking Financial Conditions –Bloomberg’s Financial Conditions Index

Bloomberg's U.S. Financial Conditions Index Components and Weights

Weight

Money Market

Ted Spread 11.1%

Commercial Paper/T-Bill Spread 11.1%

Libor-OIS Spread 11.1%

33.3%

Bond Market

Investment-Grade Corporate/Treasury Spread 6.7%

Muni/Treasury Spread 6.7%

Swaps/Treasury Spread 6.7%

High Yield/Treasury Spread 6.7%

Agency/Treasury Spread 6.7%

33.3%

Equity Market

S&P 500 Share Prices 16.7%

VIX Index 16.7%

33.3%

Total 100%

Source: Bloomberg

Bloomberg Financial Conditions Index as a Leading Indicator of Bank Lending Conditions

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

U.S. Bank Willingness to Lend U.S. Financial Conditions

U.S. Bank Willingness to Lend(Smoothed Index)

Financial ConditionsIndex

Bank Lending Conditions

Financial Conditions(Smoothed Index)

Source: Bloomberg

7

Bloomberg Financial Conditions+ Index as a Leading Indicator of Real GDP Growth

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

U.S. Real GDP (yoy %) U.S. Financial Conditions (Plus)

U.S. Real GDP Growth (yoy % chg.)(Smoothed)

Financial ConditionsIndex

Bank Lending Conditions

Financial Conditions(Smoothed Index)

Source: Bloomberg

8

9

Monetary Policy Works by Affecting Financial Conditions, Even When the Policy Rate is Zero

Change inPolicy Rate


Alter Size and Composition of Central Bank’s Balance Sheet


Commit to Keep Policy Rate Low for a Considerable Period

Change in Inflation Rate

Quantitative Easing Channel

Expectations Management Channel

Traditional Channel

Source: Bloomberg

10

Federal Reserve Targeting Long-Term Rather than Short-Term Interest Rates

Change inShort-Term Policy Rate



Change in Long-Term Interest Rate

Change in Inflation Rate

NewApproach

Traditional Channel

Source: Bloomberg

11

Taylor Rule Estimates of the Fed Funds Rate –1990-2010

TAYL <go>Source: Bloomberg

12

Fed Funds Rate and U.S. Core Inflation Rate

G <go>Source: Bloomberg

Core PCE Inflation

Rate

Fed Funds Rate

U.S. Real Fed Funds Rate and the U.S. Unemployment Gap

-2

-1

0

1

2

3

4

5

6

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

-6

-5

-4

-3

-2

-1

0

1

2

Real Fed Funds Rate U.S. Unemployment Gap

Unemployment Gap

Real Fed Funds

Rate

Fed Funds Rate less PCE Inflation (%)

Source: Bloomberg

U.S. Unemployment Rate less NAIRU (%)

13

14

CBO Projections of U.S. Output Gap

Source: Board of Governors of the Federal Reserve System and Bureau of Economic Analysis;Note: Output gap equals actual minus potential GDP.

Output GapProjections

Output Gap (%)

15

CBO Projections of U.S. Unemployment Gap

Source: Board of Governors of the Federal Reserve System and Bureau of Economic Analysis;Note: Actual minus the Natural Rate of Unemployment.

Unemployment Gap Projections

Unemployment Gap (%)

Fed Funds Rate Outlook – A Taylor Rule Perspective

-2

0

2

4

6

8

10

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Fed Funds Rate Taylor Rule Estimates

Fed Funds Rate (%)

Modified Taylor Rule Estimates

Fed Funds Rate

Source: Bloomberg

16

Estimates Using Fed Projected

Inflation & Unemployment

Federal Reserve Bank of San Francisco’s Fed Funds Rate Outlook

Source: Glenn D. Rudebusch“The Fed's Exit Strategy for Monetary Policy”, FRBSF Economic Letter, June 14, 2010

17

Fed Funds Rate and U.S. Bank’s Commercial & Industrial Loans Following the 1990-91 and 2001 Recessions

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

Fed Funds Rate C&I Loans (y-o-y % chg.)

Fed Funds Rate (%)

C&I Loans

Fed Funds

Rate

Source: Bloomberg

18

First Rate Hikeafter 2001 Recession

First Rate Hikeafter 1990-91 Recession

Growth in C&I Loans (y-o-y %)

-4

-2

0

2

4

6

8

10

1993 1995 1997 1999 2001 2003 2005 2007 2009

U.S. 5-Year Yields U.S. Nominal GDP Growth

U.S. Five-Year Treasury Yields and U.S. Nominal GDP Growth – 1993-2010

(%)

Source: Bloomberg

Long-term interest rates were too low relative to the level of economic activity throughout 2002-06

19

Private Economist and FOMC Projections of Nominal GDP Growth

20

Forecasts of Private Sector Economists FOMC Projections2010 2011 2012 2010 2011 2012

Real GDP Growth Rate 3.1 2.9 3 3.3 3.9 4

Inflation Rate 1.6 1.6 2.4 1.1 1.4 1.4

Implied Nominal GDP Growth Rate 4.7 4.5 5.4 4.4 5.3 5.4

Source: Bloomberg ECFC Composite Analyst Forecasts; Federal Reserve Board

Key Drivers of U.S. Bond Market Rally

21

1. Signs of renewed U.S. economic weakness

2. U.S. inflation expectations have fallen sharply

3. Downward revision in where the market see U.S. short-term interest rates heading

4. Surge in the demand for safe-haven assets in the wake of the sovereign debt crisis

5. Mutual fund portfolio flows out of equities and into bonds

6. Expected increase in Federal Reserve purchases of U.S. Treasuries as part of a new, stepped-up quantitative easing initiative

Source: Bloomberg

22

ECRI Leading Economic Indicator of U.S. Economic Growth

ECRWGROW Index GP <go>

2001-02 Worldwide Recession

2007-10 Financial

Crisis/Recession

1990-92 Recession

1974-75 Recession

1980-82 Recession

Source: Bloomberg

U.S. 10-Year Implied Breakeven Inflation Rate

23

70+ Basis-Point Decline in 10-Year Breakeven Inflation

Rate

USGGBE10 Index GP <go> Source: Bloomberg

Expectations of Three-Month T-Bill Rates in Two-Year’s Time

24

Downward Revision in Expectations of Three-Month T-Bill Rates

in Two-Years’ Time

G0025 2Y3M Curncy GP <go>Source: Bloomberg

2.00

2.50

3.00

3.50

4.00

4.50

5.00

5.50

2007 2008 2009 2010

0.00

1.00

2.00

3.00

4.00

5.00

6.00

10-Year Yield 3-Mo. Rate, Two Years Forward

U.S. Long-Term Interest Rates and the Projected Path of Short-Term Interest Rates

25

Expectations of Three-

Month T-Bill Rates

10-Year Treasury Yield

Source: Bloomberg

26

Mutual Fund Portfolio Flows into Bond Funds Soar in 2010

Source: ICI, “Trends in Mutual Fund Investing”, July 2010.http://www.ici.org/research/stats/trends/trends_07_10

Dec. 2009

(US$ bn)

Dec. 2009

Dec. 2009

July 2010July 2010

July 2010

Estimating the Impact of the Federal Reserve's Large-Scale Asset Purchase Program on Long-Term Interest Rates

27

Increase in Size of LSAP

Estimated Impact on

10-Year Government Bond Yield

Estimated Impact on U.S.

GDP after Eight Quarters

$1 trillion -39 basis points +1.5%

$2 trillion -78 basis points +3.0%

Source: Joseph Gagnon, "The World Needs Further Monetary Ease, Not an Early Exit", Peterson Institute for International Economics Policy Brief, December 2009.

28

U.S. Bond Market Rally – A Supply and Demand Perspective

Source: Bloomberg

Outstanding Stock of Publicly Held

U.S. Government Debt

U.S. Long-Term Interest Rates

Debt Level1

Debt Level2

Bs1 Bs

2

i1

i3

A

Bd1

B

C

Bd2

i2

Despite the increase in publicly held debt outstanding (from Bs

1 to Bs

2), an increase in the demand for U.S. Treasuries (from Bd

1 to Bd2)

has pushed interest rates down (from i1 to i3).

29

Federal Reserve Large-Scale Asset Purchase Program – A Supply and Demand Perspective

Source: Bloomberg


Debt Level2

Debt Level1

Bs2 Bs

1

i2B

Bd1

Ai1

Fed purchases reduce the supply of publicly held debt outstanding (from Bs

1 to Bs2),

thereby pushing interest rates down (from i1 to i2).



30

Supply and Demand for U.S. Government Debt and the Risk Premium on U.S. Debt

BDemand

Investors require higher interest rates as they are asked to add significant amounts of additional debt to their portfolios

(i3)

D1 D2 D3

BSupply1 BSupply

2 BSupply3

(i2)

(i1)




Source: Bloomberg

Estimating the Interest-Rate Effects of Changes in Outstanding U.S. Government Debt

Estimated Impact on Future Long-Term

Interest Rates

For Each One Percentage Point Increase in Debt/GDP Ratio 4-5 Basis Points

25%-30% Total Increase in Debt/GDP Ratio Over Next 10 Years 100-150 Basis Points

Source: Federal Reserve Board Discussion Paper 2003-12.

31

IMF Estimates of U.S. Treasury Bond Issuance on U.S. Long-Term Bond Yields

32

2010 2011 2012 2013 2014 2015

Projected Ex-Ante Demand (US$ bn) $8,111 $8,303 $8,551 $8,800 $9,186 $9,492Projected Supply (US$ bn) $9,683 $10,800 $11,771 $12,735 $13,767 $14,900

Excess Suppy (US$ bn) $1,573 $2,497 $3,221 $3,855 $4,581 $5,408Excess Suppy (% of GDP) 11% 16% 20% 23% 26% 29%

Estimated Yield Impact (basis points) 20-55 30-80 40-100 45-115 50-130 60-150

Source : Oya Celasun and Martin Sommer, "The Financing of U.S. Federal Budget Deficits", IMF Country Report No. 10/248, July 2010.www.imf.org/external/pubs/ft/scr/2010/cr10248.pdf

U.S. Federal Debt Held by the Public – 1790-2035

33

Source : Congressional Budget Office, Economic and Budget Issue Brief, “Federal Debt and the Risk of a Fiscal Crisis”, July 27,2010http://www.cbo.gov/ftpdocs/116xx/doc11659/07-27_Debt_FiscalCrisis_Brief.pdf

34

Median Real GDP Growth and Debt/GDP Ratios in Select Advanced Economies – 1790-2009

Source: Carmen Reinhart and Kenneth Rogoff, “Debt and Growth Revisited”, VOX, August 2010. http://www.voxeu.org/index.php?q=node/5395

Real GDP Growth (yoy %)

Exchange Rate Outlook

35FXMI <go>

36

FX Trader Performance – 1994-2010

FXTP <go>

1.6% Average Annual Return

2004-2010

6.9% Average Annual Return

1995-2003

Source: Bloomberg

37

Long-Term Trends in the U.S. Dollar’s Value

USTW$ index GP <go>

8-YearDowntrend

5-YearUptrend

6-YearUptrend

7-YearDowntrend

10-YearDowntrend

2008-10 Uptrend ?

Source: Bloomberg

The Dollar and the Euro-U.S. Two-Year Yield Spread

U.S. and Euro-area

two-year bond yields

reflect expectations

of Fed and ECB

policy rates for the

next two years

1.10

1.20

1.30

1.40

1.50

1.60

1.70

2006 2007 2008 2009 2010

-200

-150

-100

-50

0

50

100

150

200

250

US$/Euro Exchange Rate Euro-U.S. 2-Yr. Yield Spread

(US$/Euro) Euro-U.S. 2-Year Yield Spread (basis points)

Source: Bloomberg

38

Key Drivers of U.S. Bond Market Rally

39

1. Signs of renewed U.S. economic weakness

2. U.S. inflation expectations have fallen sharply

3. Downward revision in where the market see U.S. short-term interest rates heading

4. Surge in the demand for safe-haven assets in the wake of the sovereign debt crisis

5. Mutual fund portfolio flows out of equities and into bonds

6. Expected increase in Federal Reserve purchases of U.S. Treasuries as part of a new, stepped-up quantitative easing initiative

Source: Bloomberg

The U.S. Dollar’s 2010 PPP Undervaluation

40

The Dollar’s PPP Over/Under-valuation vs. the Euro – 1990-2010

41

42

A Stylized Model of the Dollar’s Long-Term Cycles

From undervalued to fair valued to overvalued and back again

Time

US$ Value

Maximum Overvaluation

Maximum Overvaluation

Maximum Undervaluation



5+ Years 5+ Years 5+ Years 5+ Years5+ Years

European Debt Crisis – Greece Credit Default Swap (CDS) Rate

43

Key Determinants of the Long-Term Trend in the U.S. Dollar’s Value

44

Valuation

Carry

Risk Premia

Momentum

3x3 Passively Managed G-10 Carry-Trade Basket

Three-Month Euro-Deposit Rate (%)

Source: Bloomberg; as of October 5, 2010

45

G-10 Short-Term Interest Rates

Long the 3 Highest Yielders

Short the 3 Lowest Yielders

46

Long-Term Profitability & Drawdowns of a 3x3 G-10 Carry Trade Basket

FXFB <go> Source: Bloomberg

1992ERM Crisis

1998Unwind of the

Yen Carry Trade

2005-06Unwind

2007-08Financial

Crisis

3x3 Passively Managed Emerging-Market Carry-Trade Basket

Three-Month Euro-Deposit or NDF Rate (%)

Source: Bloomberg; as of April 13, 2010

47

EM Short-Term Interest Rates

Long the 3 Highest Yielders

Short the 3 Lowest Yielders

48

Long-Term Profitability & Drawdowns of a 3x3 EM Carry Trade Basket

FXFB <go> Source: Bloomberg

2005-06Unwind

2007-08Financial

Crisis

Fundamental Drivers of Long-Run Carry-Trade Performance

Time

Cumulative Carry-Return Performance

Wide Short-Term Spreads Attract Capital Inflows

(1)

Trend Decline in Inflation Expectations

Trend Decline in Currency Risk Premium

(2)

(3)

(4)

t0 t1 t2 t3 t4

Gradual Rise in Real Long-Run Equilibrium Exchange-Rate

49

Explaining the Persistence of Positive Excess Returns on Carry-Trade Strategies

50

High-yield currencies are more sensitive to changes in market volatility and asset-price trends. (High-yield currencies behave similar to high-beta stocks.) Because they entail greater systematic risk, they command higher expected returns.

High-yield currencies are subject to periodic crash risk. Excess returns represent the compensation for taking on that crash risk.

The Response of High-Yield and Low-Yield Currencies to Changes in Market Volatility

51

Excess Return

Market Volatility

Low Yielders

Level of Volatility Required to Insure

that Uncovered Interest Rate Parity

Holds

High Yielders

Vol1

Average Level of Market Volatility

Low Yielders Avg. Return

High Yielders Avg. Return Excess

Return of High Yielders

over Low Yielders

Vol2

The Negative Skew in the Distribution of G-10 3x3 Carry-Trade Monthly Excess Returns

52

0

10

20

30

40

50

60

-12% -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% 12%

Monthly Excess Return

Number of Months

The Negative Skew in the Distribution of EM 3x3 Carry-Trade Monthly Excess Returns

53

0

5

10

15

20

25

-14% -12% -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% 12% 14%

Monthly Excess Return

Number of Months

Active Management of Carry Trades

54

Volatility filters

Valuation yardsticks (such as PPP and FEER)

Moving-average crossover trading rules

Filters/Yardsticks/Strategies for Determining Whether a Carry-Trade Position Should be Opened or Closed

Actively Managing a Carry-Trade Portfolio with a Moving-Average Crossover Trading Rule

55

Time

Cumulative Excess Return Index

Long-Run Moving Average

Short-Run Moving Average

Open all Positions Open all PositionsClose (or Reverse) all Positions)

Crossover --Close All Positions

Crossover --Open All Positions

Long LongFlat (or Short)

Excess Returns of an Actively Managed G-10 Carry-Trade Portfolio for the Past Four Years

56

Excess Returns of an Actively Managed EM Carry-Trade Portfolio for the Past Four Years

57

Long-Term Valuation Yardsticks for Carry Trades

58

Purchasing Power Parity

Long-Run Uncovered Interest-Rate Parity (LRUIRP)

59

A$ PPP Over/Undervaluation – 1989-2010

PPP <go> Source: Bloomberg

60

NZ$ PPP Over/Undervaluation – 1989-2010

PPP <go> Source: Bloomberg

61

Long-Run Excess Returns on a Long-A$/Short-US$ Position–1989-2010

FXCT <go> Source: Bloomberg

62

Long-Run Excess Returns on a Long-NZ$/Short-US$ Position–1989-2010

FXCT <go> Source: Bloomberg

image page global fx and interest rate outlook michael r. rosenberg october 2010

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