[A-List] Yield Curve Conundrum

["Anne Williamson" <annewilliamson@xxxxxxx>]

Interesting comments imparticular regarding Ivy League advisors'
'prejudices' at end of interview - Michael Hudson, your input would
certainly be of interest regarding the issue mentioned. -A.




Yield Curve Conundrum
By Chris P. Dialynas
PIMCO Spotlight, February 2006


Q: Incoming U.S. Fed Chairman Ben Bernanke has suggested that today's
relatively low interest rates are the result of a global savings glut that
is flowing into U.S. and global bonds. What are your thoughts on the
"savings glut" theory?

Dialynas: The idea of the savings glut is that there is an abundance of
savings in the world and that this abundance of savings has caused interest
rates to drop to low levels globally and for risk premiums on financial
assets to dissipate, leaving us in a financial environment where risk
premiums are quite low and real interest rates are quite low. The basic
tenet underlying the savings glut hypothesis is that there is more saving
than investment and that savings is maldistributed. We know that saving
equals investment, so today's situation is characterized as actual
investment falling short of "intended investment". The savings glut is
essentially Professor Bernanke's, and others', answer to Chairman
Greenspan's yield curve conundrum.

But to me, the notion that there is a savings glut is an incomplete and
inadequate theory. The International Monetary Fund recently published data
on world savings, and what we observe is that world savings rates have
actually declined from the 1970's to the present time (see Chart 1). So the
crude notion of a savings glut doesn't seem to reconcile the data with the
theory because if there is a savings glut now then there would have been a
much higher savings glut in the 1970's, and yet real and nominal rates were
high in the late 1970's and extremely high in the early 1980's. Ironically,
the savings glut concept, global aggregate demand shortfall, insufficient
consumption discussions dominated the economic discussions of the 1930's.
The 1930's were dominated by global recession, accentuated by extreme stress
in the U.K. and the emergence of the U.S. economy on a relative scale, in
sharp contrast to today's global prosperity but similar in that the
emergence of China is similar to the emergence of the U.S. at the beginning
of the 20th century.




Q: If the savings glut theory doesn't fit the data, what might explain
today's interest rate structure?

Dialynas: In thinking about the causes for low rates and low risk premiums
in bond markets globally, it seems to me that there is something else going
on that relates to global trade and to global capital flows that is somewhat
independent of global savings rates and more dependent upon the risk of
investment in plant and equipment relative to financial assets. Certainly
savings rates in individual countries are important but the quantity of
global capital flows and abundant access to credit enables global arbitrage
of investment opportunities.

My basic premise is that investment projects, as we all know, need to be
evaluated on a risk-adjusted basis and that the risk of investment in plant
and equipment and capacity has increased for a few reasons. One reason is
that war and terrorism increase the risk of investment. The second reason is
the fact that capital cannot freely flow into and out of China and even if
it could, property laws don't seem to be well developed in China and the
risk of expropriation by the government would appear to be quite high.
Additionally, China's government does not permit the free flow of investment
into the country. Finally, the twin deficits and the pension industry
problems pose future policy risk uncertainty.

In an ideal world, investment capital would flow into China because of their
vast amount of people and extraordinarily low labor compensation rates, and
unconstrained global investment would be re-established, out of financial
assets into plant and equipment in China. Hard investment elsewhere would
immediately become obsolete if China opened fully, including freely floating
its currency. So there is, in essence, a barrier to optimal investment and
investment returns need to be calibrated for the higher risk. The failure of
the S&P 500 price-to-earnings multiple expansion at present is indicative of
a higher risk premium. In Keynesian/Hicks parlance, the investment/saving
curve in the U.S. is almost vertical and will remain that way until changes
in China occur. High risk causes the investment/saving curve in the U.S. to
go to a vertical slope, causing investment in plant and equipment to be
insensitive to interest rates, as you can see in Chart 2, where the "LM"
curve indicates equilibrium between money demand and money supply.




If China opens, floats its currency, insures property rights, etcetera, the
investment/saving curve will become horizontal in China and remain vertical
in the U.S.

Viewed alternatively, and an obvious hypothetical, if U.S. companies were
able to freely import labor, for as long as they desired, from China at
Chinese wage rates (including benefits), then the U.S. investment/saving
curve would flatten and the slope of the investment/saving curve in China
would steepen. Investment into the U.S. would increase substantially and
subside in China.

The barrier to investment in China could evaporate tomorrow or that barrier
may become infinite tomorrow. So the uncertainty associated with the war in
Iraq, the war on terror and the political/economic future of China causes a
lack of hard investment by savers and the money flows into more liquid
assets, such as bonds in industrialized countries. As the money flows into
bonds, it gets recycled through trade and interest rates decline. Moreover,
it instills a sense of tranquility in the receiver nations such as the U.S.
Tranquility relieves any impetus for policy action.

This process has continued, unabated, because of the fixed exchange rate in
China and some quasi-fixing of other exchange rates in the Asian region to
the Chinese currency, which in essence means other Asian exchange rates are
fixed to the dollar. This situation has obviously led to greater and greater
trade imbalances, greater debt in the U.S. and a tremendous amount of
reserve accumulation for Asian countries and oil-producing countries and
commodity-rich countries as well. The Asian fixed exchange rate is a
critical element to the imbalances, to the dynamics, and creates the analogy
of the U.S.-China peg today to the U.K. adherence to the Gold Standard in
the 1920's.

The analogy to the huge exports of gold from the U.K. in the 1920's and
early 1930's is the $2 trillion reserve accumulation by other countries
during the past few years. In the past few years, there has been in excess
of a couple trillion dollars of dollar reserve accumulation by other
countries. As a result, the global economy is, and has been, awash with
liquidity because of the increased risk of investment and fixed exchange
rate in China (see Chart 3).

Finally, the increased uncertainty of future U.S. policy associated with
large fiscal and current account deficits as well as under-funded private
pension systems also substantially increases investor risk. While it may be
difficult to conceive of a solution to the deficits, a very large number of
policy combinations are imaginable, each with a very different implication
for capital returns.




Q: Let's talk about some of the implications of this excess global
liquidity. What happens if the barrier to investment in China is removed?

Dialynas: A tremendous inflow of capital into China would occur if
investment barriers were removed. The inflow of capital would bid up the
value of the economy, the exchange rate and the price of labor. The inflow
of capital into this utopian investment regime would result in an outflow of
capital from industrialized countries and a reduction in wages in those
countries. The "exploitation" of low-cost Chinese labor would enrich western
capitalists to the detriment of the Chinese holders of production
facilities. This process is in progress today-in slow motion. The present
process, while politically comfortable, is an economic disaster. The U.S.
will cross over from a "control" economy and world leader to a "controlled"
economy and world follower. An outflow from the U.S. of high quality human
capital will occur as this process progresses.

Q: If the global economy is awash in liquidity, wouldn't that normally lead
to inflation?

Dialynas: The inflation has occurred. The inflation is in the housing
market. The inverse of the current account deficit has been debt creation,
and debt has accumulated in the consumer side and federal component of the
economy. So the inflation that we have realized in the U.S., the U.K.,
Australia and other current-account deficit countries, but also in some
surplus countries like China with low-priced labor and undervalued exchange
rates, has been huge price inflation in the real estate markets. Housing
price inflation is, in essence, the externality of this global liquidity and
fixed exchange rate regimes.

Housing price inflation has some very important longer-term implications. A
housing bubble leads to more investment in housing, which contributes to
current GDP growth. However, if that investment were in plant and equipment
of equal magnitude then we would have a productive resource with which
production could be utilized to repay the current account deficit. In the
case of a housing bubble and construction boom, no such product is
available. The economic prospects for the national economy will rise and
fall with the housing market. A pop in the housing bubble may invoke a
ruinous downward multiplier reduction in the U.S. economy while the debts
remain. Ultimately, the houses themselves may need to be liquidated to
settle debts with foreigners.

Q: There has also been inflation in commodity prices, and oil in particular.
What is the relationship between global liquidity and commodity prices? And
how do you think about the implications of this relationship when trying to
forecast global economic growth and other factors?

Dialynas: The boom in industrial commodities is another result of the
abundant global liquidity and that has important implications as well. Some
of the stock markets in countries that export these commodities have had
their prices inflate upward quite a bit, especially in the Middle East,
where the geo-political risk actually fell as a result of the U.S. invasion
of Iraq. Given the dramatic increase in oil prices, there has been a fair
amount of wealth transferred from the U.S. (and all net consumers of oil,
but the U.S. is the largest consumer of oil by a large amount) to these
oil-producing and many industrial-commodity-rich countries, including
Russia, Middle East countries and South American countries.

For some of these Asian countries, reserve accumulation is a new process but
reserve accumulation for oil-producing nations is something that Middle
Eastern countries in particular have been accustomed to for decades. The
explosion in energy prices is a big windfall to oil-rich countries. So, in
trying to forecast future risk premiums and relative asset valuation, yield
curves and inflation rates it is important to understand how the future
consumption and investment behavior of some of these oil-producing countries
will differ from future consumption and investment by countries in the Asian
bloc.

It seems to me the Middle Eastern countries will be much more likely to
consume, and the consumption will probably be tilted toward
technology--aircraft and military equipment --as well as consumer goods,
than might be the case if we contrast them with some of the Asian countries,
where they are more concerned with actually producing goods and selling
goods, but also desirous of advanced technologies --military and otherwise.
And if you consider these natural resources, such as oil, for example, as
inventory that the commodity-producing countries are simply drawing down,
there is very little risk capital investment associated with that process as
contrasted with traditional spending and investment that is tilted more
toward building new factories or producing goods.

Another important implication of this idea that commodity-producing
countries are merely drawing down inventory relates to the fact that one of
the common prescriptions for curing global imbalances is for emerging market
residents to become consumers. If we believe the inventory-draw-down
hypothesis, then this transformation is very difficult because the
hypothesis implies the emerging market countries are the beneficiaries of an
economic and financial windfall that could end tomorrow.

In fact, those countries are also suffering a hollowing out of their
production by China and are becoming economically obsolete, which should
retard consumption rather than encourage it. If they are able to liquidate
their resource inventories for a very long time, such that they become
extremely wealthy, and figure out a way to hold the wealth in a secured way
(if such a notion exists), then this hollowing out becomes irrelevant and
their consumption can increase. That prospect is very distant in my view.
They will continue to feed the Chinese production machine the best they can,
for as long as they can. The stronger they become, the greater they can
charge for marginal commodity production.

Q: What role are the financial markets playing in the global liquidity glut?

Dialynas: We know the primary source of the global liquidity glut is the
extremely stimulative fiscal and monetary policies in the U.S., post-2000,
and the transmission of U.S. monetary policy to China, Japan and other
"fixed exchange rate" regimes via the currency peg.

It may also be the case that some of this global savings glut is the result
of leverage. With the proliferation of derivative instruments, and
unregulated swap markets in particular, in conjunction with low risk
premiums and investors' ingenuity in trying to engineer higher absolute
rates of return, financial leverage has been one of the presumed solutions
to low returns. And we see this with the proliferation of the hedge fund
industry.

The proliferation of derivative instruments and products may be offering a
very cheap and abundant, but potentially transitory, source of funding to
the demanders of capital through the leveraging of investment risk in
conjunction with derivative vehicles. And the flip side of this cheap
capital is that the suppliers of capital may be, and probably are, taking
inordinate market risk.

If the market should be confronted with an external shock, we might in fact
find that capital can be destroyed rather rapidly because of the past
complacency of the market and the inherent capacity for virtually anybody to
employ leverage via the derivatives market. In former times, the
qualifications for leverage were much more onerous and not as readily
available or custom-made as they are today.

One of the secular risks facing the global economy is the potential for an
exogenous shock that hits at our tremendously levered capital structure, in
the U.S. in particular. With leverage at unprecedented levels, such a shock
would hit both the borrower's ability to service the debt and hit the
investor's wealth simultaneously as negative investment returns prevail.

Q: How would you characterize today's global economy? Is it a so-called
"Goldilocks" economy, with good growth, low inflation and low risk premiums,
or is it a situation fraught with risk?

Dialynas: It's both, depending on your time horizon and who you're talking
to. If growth with low conventional "core" inflation is your metric, then
it's a Goldilocks world. The question is how long can it persist? The
Goldilocks people will tell you it can persist for a very, very long time.
But the problem that I explained earlier, which is the problem of a lack of
investment because of the very high geopolitical risk associated with
investment, implies that capital is depleted with time. So the potential to
repay the debt dissipates with time and finally, although we don't know
when, Goldilocks runs into the Big Bad Wolf and the wolf eats Goldilocks.

Q: We've talked about a lot of variables, but what is the bottom line in
terms of the outlook for bonds and the shape of the yield curve?

Dialynas: The outlook is very path-dependent. There is this notion that the
U.S. in particular, but other industrialized countries as well, has received
a subsidy from the global savers in the form of lower rates. The estimates
are that rates are 50-100 basis points lower than they would otherwise be as
a result of this symbiotic trading and financing relationship between
surplus countries and deficit countries and that if something should disrupt
this process, then rates would go up substantially. On the surface, this
seems pretty logical, and certainly if things unwound slowly, that would
probably be the path. As the subsidy dissipated, assuming the capital needs
were consistent, you would need higher interest rates or a lower currency to
continue to attract capital, particularly because, as we've discussed, the
successful transformation of China would result in massive outflows of U.S.
capital to China.

But if things were disrupted by some sudden surprise event, then it seems to
me rates would probably decline across the curve, and probably more so for
short rates than long rates. Economic growth would most likely slow
substantially and you'd probably go to recessionary conditions. It could go
either way and that's why trying to forecast the investment behavior of
those who hold the dollar reserves and those who continue to have huge trade
surpluses is really a very, very important call for us to make.

If you look at the volatility of the market and the price of options on
currencies, interest rates and stocks, volatility premiums are quite low.
And a flat yield curve would be indicative of, at least for a while, lower
volatility premiums.

In terms of the yield curve, part of what we are seeing with the flatter
yield curve is lower term premiums but it is very hard to assign cause and
effect because we have a re-regulation of the pension system that is
resulting in better asset liability management on the part of defined
benefit pension plans. So we have all of these factors with respect to trade
flows. But then we have also got this huge stock of assets in the pension
industry that are horribly mismanaged with respect to asset/liability
management. Pensions are very short duration and regulations are being
tightened to make it much more costly to be mismatched, and so one of the
responses is to better match and that means buying more long bonds,
resulting in lower rates and a flatter yield curve. So it is hard to dissect
the inferences that one might normally make about the yield curve shape with
respect to the economic cycle, with respect to trade flow influences and
with respect to asset liability management.

And finally, in terms of risk premiums, I think it's interesting to note
that from an economic point of view, other than the growth in debt, it seems
to me we have been completely insulated from the economic hardship we might
expect to be normally associated with fighting a war and financing a war. So
there is a question as to whether some of the complacency in the financial
markets is not only a function of capital flows but also a function of the
fact that most Americans seem completely unaffected by the fact that we are
engaged in a serious war.

And it's interesting to wonder whether it makes a difference in risk
premiums and the financial markets in one regime versus the other, as to
whether part of what we see with low risk premiums is the situation where we
are engaged in a war but with good growth, low inflation, and low risk
premiums even as we finance the war through the debt accumulation and the
trade flows.

Q: Well Chris, now that Chairman Greenspan has passed the baton to Professor
Bernanke ? any comments?

Dialynas: As you can infer from my comments in this interview, from the
discussion of "Bretton Woods II" last year and from my lengthy, detailed
December 2004 paper "Trouble Ahead, Trouble Behind...", I am a pessimist who
believes the imbalances in the world are grave and dangerous. I attribute
part of the responsibility to the Federal Reserve as their "insurance
company/bail-them-out" policy-making philosophy skewed incentives, which
resulted in the mispricing of risk and the misallocation of global capital.
The tremendous imbalances today are the result of this philosophical
viewpoint.

This ad-hoc philosophical viewpoint, to the best of my knowledge, was
conceived in the 1920's by Federal Reserve economist Charles D. Henry. There
was much debate at the time about the role of the Fed and rules-based
policies. The Fed proceeded with its mission using conventional methods,
recognizing the effect low interest rates had on asset values, asset values
on consumption and the destabilizing effect of asset bubbles.

The Greenspan Fed has rationalized its lenient, expansionary bail-out with
the "productivity miracle" which, in my view, is mostly a result of the
labor supply shock of China, India, Russia, Eastern Europe and extremely low
interest rates.

Thus, there has never been a good rationale for sucking it up and absorbing
the pain of rebalancing. Rather the policies of multiple bailouts were
undertaken with a yet-to-be-known underwriter. Professor Bernanke of
Princeton inherits a global political economy extremely unbalanced with no
solutions in sight.

The Clinton and Bush administrations, as well as the Greenspan Fed, have
relied upon any internal and external advisors. Without doubt, most of these
advisors are of Ivy League vintage. It is particularly noteworthy to
understand that the endowments of most of those universities--endowments
that substantially accrue to the benefit of the respective professors--are
primarily invested in very high-risk assets and high-risk strategies (as are
numerous other investors in their quest for high returns in a low interest
rate world). It is, consequently, of little surprise that policy advice has
tended to aggressive stimulus. A disciplined,
"take-your-medicine/rebalance-the-economy" set of policies would most likely
be detrimental to the endowments of many of this country's leading
educational institutions. As long as these institutions maintain high-risk
portfolios, the policy advice from the ivory towers will be highly
stimulative based upon new, bizarre economic ideas. The global imbalances
will grow. Professor Bernanke is a member of this fraternity. He is a very
thoughtful economist who was an expert guest speaker at a PIMCO Secular
Forum a few years ago. He was impressive then and impressive subsequently.
There is an extraordinary challenge for a very high-quality person. My
concern is his presumed pro-reflationary bias.

Q: If now-Chairman Bernanke were to ask you for advice, what would it be?

Dialynas: First, I do not know that I'm qualified to offer advice but I
would be flattered and wouldn't hesitate. My advice would be simple.

Number one: beware of advice from advisors holding risky portfolios.
Understand their biases. Who is paying their rent?

And number two: announce that all helicopters have been grounded and the
pilots dismissed!

I am honored and emphasize these are my opinions and, while well-known to my
PIMCO colleagues, are not regularly accepted but are well-debated to the
benefit of our clients. Thank you for this forum.

Q: Thank you, Chris. We look forward to checking back with you in the future
for updates on how these very important issues are progressing.