Monday November 28, 2005 - 13:07:10 GMT
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Forex: There could be trouble ahead - from global imbalancesEconomics Weekly: There could be trouble ahead - from global imbalances
Are imbalances getting worse?
Financial market anomalies that are sending signals about conflicting views held by investors about trends in inflation, interest rates, equity prices, profits, and economic growth are proliferating and getting more pronounced. This suggests that there is scope for some pretty severe financial market turbulence in the months or years ahead. This could start before the end of 2005, but equally it could begin to happen in 2006. One thing for sure, in our opinion, is that some imbalances cannot continue to get more pronounced without some correction in the period ahead. The scope for market participants taking these positions getting it wrong is becoming so large that it is almost worth some others in the financial markets betting against the consensus view. If increasing numbers take that option, then there could be some severe market disruption ahead. We look at some of the main anomalies in the UK and US in this week’s briefing.
Equity markets are rising…
As chart A shows, equity markets have rebounded in recent months (using the UK as an example). This is despite higher interest rates in the US, the expectation of rate rises in the euro area, a move away from expecting rate cuts in the UK and unchanged interest rates in Japan. The strong rebound is reflecting a fall in the risk premium attached to equities and / or an expectation of faster earnings growth based on a better economic performance in 2006. But this begs the question as to why bond markets are still so relatively strong.
But so, puzzlingly, are bonds…
In bond markets, there is a view that inflation will stay low and so therefore that fixed income securities are compensating investors for the risk of inflation going forward. As chart A shows inflation expectation are at very low levels. This is also shown by the fact that benchmark bond yields are still below the short official interest rate of 4.5%. This implies that these markets are looking for economic growth to fall sharply, for inflation to drop and therefore for interest rates to be cut. None of these may happen, equity markets might be right and growth and earnings rise; in which case the risk is of higher inflation and higher interest rates. Thus there remains a big risk of a sharp turnaround in these markets.
But the biggest imbalance is still US based
In the currency markets, the biggest anomaly has to be the rise in the US dollar despite a wider trade and current account deficit, which is in turn the biggest international imbalance that weighs ticipants are implicitly expecting in terms of likely economic outcomes. In other words, the widening current account deficit but strong dollar imbalances are suggesting there is a lot of desire to hold US assets and little appetite to hold others. But trends in gold prices suggest that some are hedging their bets, see chart C, and do not believe that inflation is beaten or that there are few risks of a sharp fall in the US dollar, as suggested by what are still low bond market yields.
UK economic data this week are few but are likely to concentrate on the release of lending data on Tuesday, where the rise in house prices could herald a rise in borrowing by individuals. Off the back of the recovery in the housing market and continued low interest rates and growth in employment, consumer confidence is expected to bounce back, to -6 in November or better. In last week’s second estimate of economic growth in Q3 was the news that domestic demand rose by 0.8%, the fastest pace since Q2 2004 and bang in line with the trend rate of growth. This means that this week’s manufacturing PMI data could see a further rise, partly driven by higher export expectations as suggested in the recent CBI industrial trends survey. The impact of improved domestic confidence could also lift the November distributive trades’ survey, due on Thursday. on prospects for the global economy in the years ahead, see chart B. How long can this situation last? The answer is probably for some time, but at some stage there will be a reckoning. And the likelihood is that the dollar will fall quite sharply when that occurs. That might happen at a time that complicates the job of the US Fed in setting the right level of interest rates for the domestic economy in 2006 - just when it is running out of the spare capacity that has helped to keep inflation low over the last few years. In turn, that will have an impact on other economies, leading to a reassessment of growth prospects in countries heavily dependent on the US for their expansion and that compete with US firms in third markets. The net effect could then be weaker US growth and so dimmer global economic prospects.
Price and interest rate trends in various financial markets can tell us a lot about what market par-
Trevor Williams, Chief Economist
Lloyds TSB Bank,
London EC3R 8BQ
0207 283 - 1000
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