Global FX and Interest Rate
Outlook
Michael R. Rosenberg
October 2010
Interest Rate Outlook
FCW <go>
1
Financial Conditions and the
Monetary Policy Transmission
Mechanism
Change in
Policy Rate
Financial
Shock
Real (Output)
Shock
Relative Price
Shock
Change in
Financial
Conditions
Change in
Economic
Activity
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
Source: Bloomberg
2
How Financial Conditions Typically
Respond to Federal Reserve Policy
Changes
Change in Financial Conditions
Change in
Money-Market
Rates
Change in
Government
Bond Yields
Change in
Policy
Rate
Change in
Credit
Spreads
Change in
Economic
Activity
Change in
Inflation
Change in
Asset
Prices
Change in
Bank Lending
Conditions
Source: Bloomberg
3
Bloomberg’s Financial Conditions
Index
Significantly Above Normal
Normal
Significantly Below Normal
BFCIUS index <go>
Source: Bloomberg
4
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%
Source: Bloomberg
Total
100%
5
Bloomberg Financial Conditions
Index as a Leading Indicator of
Bank Lending Conditions
U.S. Bank Willingness to Lend
(Smoothed Index)
Financial Conditions
(Smoothed Index)
2.0
2.0
1.0
0.0
0.0
-2.0
-1.0
Bank
Lending
Conditions
-4.0
Financial
Conditions
Index
-2.0
-6.0
-3.0
-8.0
-4.0
-5.0
1992
-10.0
1994
1996
1998
2000
U.S. Bank Willingness to Lend
2002
2004
2006
2008
2010
U.S. Financial Conditions
Source: Bloomberg
6
Bloomberg Financial Conditions+
Index as a Leading Indicator of
Real GDP Growth
U.S. Real GDP Growth (yoy % chg.)
(Smoothed)
Financial Conditions
(Smoothed Index)
6.0
4.0
4.0
2.0
2.0
0.0
0.0
Bank
Lending
Conditions
-2.0
Financial
Conditions
Index
-2.0
-4.0
-4.0
-6.0
-6.0
1992
-8.0
1994
1996
1998
U.S. Real GDP (yoy %)
2000
2002
2004
2006
2008
2010
U.S. Financial Conditions (Plus)
Source: Bloomberg
7
Monetary Policy Works by Affecting
Financial Conditions, Even When
the Policy Rate is Zero
Alter Size and
Composition of
Central Bank’s
Balance Sheet
Change in
Policy Rate
Commit to
Keep Policy
Rate Low for a
Considerable
Period
Source: Bloomberg
Quantitative Easing
Channel
Traditional
Channel
Change in
Financial
Conditions
Change in
Economic
Activity
Change in
Inflation Rate
Expectations
Management Channel
8
Federal Reserve Targeting LongTerm Rather than Short-Term
Interest Rates
Change in
Short-Term
Policy Rate
Change in
Long-Term
Interest Rate
Source: Bloomberg
Traditional
Channel
Change in
Financial
Conditions
Change in
Economic
Activity
Change in
Inflation Rate
New
Approach
9
Taylor Rule Estimates of the Fed
Funds Rate –1990-2010
TAYL <go>
Source: Bloomberg
10
Fed Funds Rate and U.S. Core
Inflation Rate
Fed Funds
Rate
Core PCE
Inflation
Rate
G <go>
Source: Bloomberg
11
U.S. Real Fed Funds Rate and the
U.S. Unemployment Gap
Fed Funds Rate
less PCE Inflation (%)
6
U.S. Unemployment Rate
less NAIRU (%)
2
Unemployment
1
Gap
0
5
4
3
-1
2
-2
1
0
Real
Fed Funds
Rate
-3
-4
-1
-5
-2
-6
1987
1989
1991
1993
1995
1997
Real Fed Funds Rate
1999
2001
2003
2005
2007
2009
U.S. Unemployment Gap
Source: Bloomberg
12
CBO Projections of U.S. Output Gap
Output Gap (%)
0
-1
-2
-3
-4
-5
-6
Output Gap
Projections
-7
2006
2007
2008
2009
2010
2011
2012
2013
2014
Source: Board of Governors of the Federal Reserve System and Bureau of Economic Analysis;
Note: Output gap equals actual minus potential GDP.
13
CBO Projections of U.S.
Unemployment Gap
Unemployment Gap (%)
6
Unemployment
Gap Projections
5
4
3
2
1
0
-1
2006
2007
2008
2009
2010
2011
2012
2013
2014
Source: Board of Governors of the Federal Reserve System and Bureau of Economic Analysis;
Note: Actual minus the Natural Rate of Unemployment.
14
Fed Funds Rate Outlook –
A Taylor Rule Perspective
Fed Funds Rate (%)
10
8
Fed Funds Rate
6
4
Estimates Using
Fed Projected
Inflation &
Unemployment
Modified
Taylor Rule
Estimates
2
0
-2
1990
1992
1994
1996
Fed Funds Rate
1998
2000
2002
2004
2006
2008
2010
2012
Taylor Rule Estimates
Source: Bloomberg
15
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
16
Fed Funds Rate and U.S. Bank’s
Commercial & Industrial Loans
Following the 1990-91 and 2001
Recessions
First Rate Hike
after 1990-91 Recession
First Rate Hike
after 2001 Recession
Fed Funds Rate (%)
Growth in C&I Loans (y-o-y %)
9.0
30
8.0
25
20
7.0
15
6.0
C&I Loans
10
5.0
5
4.0
0
-5
3.0
Fed
Funds
Rate
2.0
-10
-15
1.0
-20
0.0
1990
-25
1992
1994
1996
1998
Fed Funds Rate
2000
2002
2004
2006
2008
2010
C&I Loans (y-o-y % chg.)
Source: Bloomberg
17
U.S. Five-Year Treasury Yields and
U.S. Nominal GDP Growth – 19932010
Long-term interest rates
were too low relative to the
level of economic activity
throughout 2002-06
(%)
10
8
6
4
2
0
-2
-4
1993
1995
1997
1999
U.S. 5-Year Yields
2001
2003
2005
2007
2009
U.S. Nominal GDP Growth
Source: Bloomberg
18
Private Economist and FOMC
Projections of Nominal GDP Growth
Forecasts of Private Sector Economists
2010
2011
2012
FOMC Projections
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
19
Key Drivers of U.S. Bond Market Rally
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
20
ECRI Leading Economic Indicator of
U.S. Economic Growth
1980-82
Recession
1990-92
Recession
1974-75
Recession
ECRWGROW Index GP <go> Source:
Bloomberg
2001-02
Worldwide
Recession
2007-10
Financial
Crisis/Recession
21
U.S. 10-Year Implied Breakeven
Inflation Rate
70+ Basis-Point Decline in
10-Year Breakeven Inflation Rate
USGGBE10 Index GP <go>
Source: Bloomberg
22
Expectations of Three-Month T-Bill
Rates in Two-Year’s Time
Downward Revision in Expectations
of Three-Month T-Bill Rates
in Two-Years’ Time
G0025 2Y3M Curncy GP <go>Source:
Bloomberg
23
U.S. Long-Term Interest Rates and
the Projected Path of Short-Term
Interest Rates
6.00
5.50
5.00
5.00
4.50
10-Year
Treasury Yield
4.00
4.00
3.00
3.50
2.00
3.00
Expectation
s of ThreeMonth TBill Rates
2.50
2.00
2007
1.00
0.00
2008
10-Year Yield
2009
2010
3-Mo. Rate, Two Years Forward
Source: Bloomberg
24
Mutual Fund Portfolio Flows into Bond
Funds Soar in 2010
(US$ bn)
2100
$2,023
2000
1900
1800
Dec. 2009
July 2010
$1,749
1700
Dec.
2009
July
2010
Dec. 2009
July 2010
1600
Bond Funds
Source: ICI, “Trends in Mutual Fund Investing”, July 2010.
http://www.ici.org/research/stats/trends/trends_07_10
25
Estimating the Impact of the
Federal Reserve's Large-Scale
Asset Purchase Program on LongTerm Interest Rates
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%
$2 trillion
-78 basis points
+3.0%
Source: Joseph Gagnon, "The World Needs Further Monetary Ease, Not an Early Exit",
Peterson Institute for International Economics Policy Brief, December 2009.
26
U.S. Bond Market Rally – A Supply
and Demand Perspective
U.S. Long-Term
Interest Rates
Bs 1
Bs 2
Bd1
Bd2
B
i2
i1
A
C
i3
Debt Debt
Level1 Level2
Source: Bloomberg
Despite the increase in publicly
held debt outstanding (from Bs1 to
Bs2), an increase in the demand for
U.S. Treasuries (from Bd1 to Bd2)
has pushed interest rates down
(from i1 to i3).
Outstanding Stock
of Publicly Held
U.S. Government Debt
27
Federal Reserve Large-Scale Asset
Purchase Program – A Supply and
Demand Perspective
U.S. Long-Term
Interest Rates
Bs 2
Bs 1
Bd1
A
i1
i2
Fed purchases reduce the
supply of publicly held debt
outstanding (from Bs1 to Bs2),
thereby pushing interest rates
down (from i1 to i2).
B
Debt
Level2
Source: Bloomberg
Debt
Level1
Outstanding Stock
of Publicly Held
U.S. Government Debt
28
Supply and Demand for U.S.
Government Debt and the Risk
Premium on U.S. Debt
U.S. Long-Term
Interest Rates
BSupply1 BSupply2
BSupply3
BDemand
(i3)
Investors require
higher interest rates as
they are asked to add
significant amounts of
additional debt to their
portfolios
(i2)
(i1)
D1
Source: Bloomberg
D2
D3
Outstanding Stock
of Publicly Held
U.S. Government Debt
29
Estimating the Interest-Rate
Effects of Changes in Outstanding
U.S. Government Debt
Estimated Impact on
Future Long-Term
Interest Rates
For Each One Percentage Point
Increase in Debt/GDP Ratio
25%-30% Total Increase in
Debt/GDP Ratio
Over Next 10 Years
4-5 Basis Points
100-150 Basis Points
Source: Federal Reserve Board Discussion Paper 2003-12.
30
IMF Estimates of U.S. Treasury
Bond Issuance on U.S. Long-Term
Bond Yields
2010
2011
2012
2013
2014
2015
Projected Ex-Ante Demand (US$ bn)
Projected Supply (US$ bn)
$8,111
$9,683
$8,303
$10,800
$8,551
$11,771
$8,800
$12,735
$9,186
$13,767
$9,492
$14,900
Excess Suppy (US$ bn)
Excess Suppy (% of GDP)
$1,573
11%
$2,497
16%
$3,221
20%
$3,855
23%
$4,581
26%
$5,408
29%
20-55
30-80
40-100
45-115
50-130
60-150
Estimated Yield Impact
(basis points)
Source : Oya Celasun and Martin Sommer, "The Financing of U.S. Federal
Budget Deficits", IMF Country Report No. 10/248, July 2010.
www.imf.org/external/pubs/ft/scr/2010/cr10248.pdf
31
U.S. Federal Debt Held by the
Public – 1790-2035
Source : Congressional Budget Office, Economic and Budget Issue Brief,
“Federal Debt and the Risk of a Fiscal Crisis”, July 27,2010
http://www.cbo.gov/ftpdocs/116xx/doc11659/07-27_Debt_FiscalCrisis_Brief.pdf
32
Median Real GDP Growth and
Debt/GDP Ratios in Select Advanced
Economies – 1790-2009
Real GDP Growth (yoy %)
5%
4%
3.9%
3.1%
2.8%
3%
1.9%
2%
1%
0%
Below 30%
30%-60%
60%-80%
90% and Above
Central Government Debt as a % of GDP
Source: Carmen Reinhart and Kenneth Rogoff, “Debt and Growth Revisited”, VOX, August 2010.
http://www.voxeu.org/index.php?q=node/5395
33
Exchange Rate Outlook
FXMI <go>
34
FX Trader Performance – 1994-2010
6.9% Average
Annual Return
1995-2003
1.6% Average
Annual Return
2004-2010
FXTP <go>
Source: Bloomberg
35
Long-Term Trends in the
U.S. Dollar’s Value
5-Year
Uptrend
10-Year
Downtrend
6-Year
Uptrend
8-Year
Downtrend
7-Year
Downtrend
2008-10
Uptrend ?
USTW$ index GP <go>
Source: Bloomberg
36
U.S. and Euro-area
two-year bond yields
reflect expectations
of Fed and ECB
policy rates for the
next two years
The Dollar and the Euro-U.S. TwoYear Yield Spread
(US$/Euro)
Euro-U.S. 2-Year Yield Spread (basis points)
1.70
250
200
1.60
150
1.50
100
50
1.40
0
1.30
-50
-100
1.20
-150
1.10
2006
-200
2007
2008
US$/Euro Exchange Rate
2009
2010
Euro-U.S. 2-Yr. Yield Spread
Source: Bloomberg
37
Key Drivers of U.S. Bond Market Rally
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
38
The U.S. Dollar’s 2010 PPP
Undervaluation
39
The Dollar’s PPP Over/Undervaluation vs. the Euro – 1990-2010
40
A Stylized Model of the Dollar’s
Long-Term Cycles
From undervalued to fair valued to
overvalued and back again
US$ Value
Maximum
Overvaluation
Maximum
Overvaluation
Time
Maximum
Undervaluation
5+ Years
Maximum
Undervaluation
5+ Years
5+ Years
Maximum
Undervaluation
5+ Years
5+ Years
41
European Debt Crisis – Greece
Credit Default Swap (CDS) Rate
42
Key Determinants of the Long-Term
Trend in the U.S. Dollar’s Value

Valuation

Carry

Risk Premia

Momentum
43
3x3 Passively Managed G-10
Carry-Trade Basket
G-10 Short-Term Interest Rates
Three-Month Euro-Deposit Rate (%)
6.0
5.0
Long the 3
Highest Yielders
4.8
4.0
3.2
3.0
Short the 3
Lowest Yielders
2.4
2.0
1.2
1.2
0.9
1.0
0.7
0.5
0.3
0.2
0.2
tze
rl a
nd
Sw
i
Ja
pa
n
U.
S.
De
nm
ar
k
U.
K.
Eu
ro
Sw
ed
en
Ca
na
da
ay
No
rw
N.
Z.
Au
st
ra
li a
0.0
Source: Bloomberg; as of October 5, 2010
44
Long-Term Profitability & Drawdowns
of a 3x3 G-10 Carry Trade Basket
2005-06
Unwind
1992
ERM Crisis
2007-08
Financial
Crisis
1998
Unwind of the
Yen Carry Trade
FXFB <go>
Source: Bloomberg
45
3x3 Passively Managed
Emerging-Market Carry-Trade Basket
EM Short-Term Interest Rates
Three-Month Euro-Deposit
or NDF Rate (%)
9.0
8.0
7.0
Long the 3
Highest Yielders
8.1
7.4
7.3
7.1
6.8
6.7
6.2
6.0
5.0
4.0
4.4
3.7
3.6
Short the 3
Lowest Yielders
3.6
3.0
3.0
2.1
2.0
2.0
1.8
0.9
1.0
0.7
0.6
0.4
0.4
0.3
0.3
Br
az
il
Tu
rk
ey
In
di
Ar
ge a
nt
in
a
In
do
ne
s
Ro i a
m
a
S. n ia
Af
ric
Hu a
ng
ar
y
Po
la
n
M d
ex
ic o
Pe
ru
M
al
a
Ph ys ia
i li p
pi
Sl
ov n es
ak
Re
p.
C
Cz
h
e c i le
h
Re
Co p.
lo
m
b
Ta ia
iw
an
S.
Ko
re
Si
ng a
a
Ho por
ng e
Ko
ng
Th
ail
an
d
0.0
Source: Bloomberg; as of April 13, 2010
46
Long-Term Profitability & Drawdowns
of a 3x3 EM Carry Trade Basket
2005-06
Unwind
FXFB <go>
Source: Bloomberg
2007-08
Financial
Crisis
47
Fundamental Drivers of Long-Run
Carry-Trade Performance
Cumulative
Carry-Return
Performance
Decline in
(4) Trend
Currency Risk Premium
Trend Decline in
(3) Inflation Expectations
(2) Gradual Rise in Real Long-Run
Equilibrium Exchange-Rate
(1) Wide Short-Term Spreads Attract
Capital Inflows
t0
t1
t2
t3
t4
Time
48
Explaining the Persistence of
Positive Excess Returns on CarryTrade Strategies

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.
49
The Response of High-Yield and
Low-Yield Currencies to Changes in
Market Volatility
Excess Return
Average Level of
Market Volatility
High Yielders
Avg. Return
Excess
Return of
High Yielders
over Low
Yielders
Low Yielders
Level of Volatility
Required to Insure
that Uncovered
Interest Rate Parity
Holds
Low Yielders
Avg. Return
High Yielders
Vol1
Vol2 Market Volatility
50
The Negative Skew in the
Distribution of G-10 3x3 Carry-Trade
Monthly Excess Returns
Number of Months
60
50
40
30
20
10
0
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
Monthly Excess Return
51
The Negative Skew in the
Distribution of EM 3x3 Carry-Trade
Monthly Excess Returns
Number of Months
25
20
15
10
5
0
-14% -12% -10% -8% -6% -4% -2% 0%
2%
4%
6%
8% 10% 12% 14%
Monthly Excess Return
52
Active Management of Carry Trades
Filters/Yardsticks/Strategies for Determining Whether
a Carry-Trade Position Should be Opened or Closed

Volatility filters

Valuation yardsticks (such as PPP and
FEER)

Moving-average crossover trading rules
53
Actively Managing a Carry-Trade
Portfolio with a Moving-Average
Crossover Trading Rule
Cumulative Excess
Return Index
Long
Flat (or Short)
Long
Crossover -Close All Positions
Short-Run
Moving Average
Crossover -Open All Positions
Long-Run
Moving Average
Open all Positions
Close (or Reverse)
all Positions)
Open all Positions
Time
54
Excess Returns of an Actively
Managed G-10 Carry-Trade Portfolio
for the Past Four Years
55
Excess Returns of an Actively
Managed EM Carry-Trade Portfolio
for the Past Four Years
56
Long-Term Valuation Yardsticks for
Carry Trades

Purchasing Power Parity

Long-Run Uncovered
Interest-Rate Parity (LRUIRP)
57
A$ PPP Over/Undervaluation –
1989-2010
PPP <go>
Source: Bloomberg
58
NZ$ PPP Over/Undervaluation –
1989-2010
PPP <go>
Source: Bloomberg
59
Long-Run Excess Returns on a
Long-A$/Short-US$ Position–1989-2010
FXCT <go>
Source: Bloomberg
60
Long-Run Excess Returns on a
Long-NZ$/Short-US$ Position–1989-2010
FXCT <go>
Source: Bloomberg
61