Re: King of the Horizontalists ?

["ÁÎ×Ó¹â HenryC.K.Liu ¹ù¤l¥ú" <hliu@xxxxxxxxxxxxxx>]

Barry Riley wrote last year in FT 11/12/98:

As the crude oil price tests the $10-a-barrel level, and the energy-rich Goldman
Sachs Commodity Index shows a year-on-year decline of 30 per cent, some curious
paradoxes in the securities markets are highlighted.

First, consumer price inflation has fallen almost everywhere but asset price
inflation has continued. Gavyn Davies, chief international economist of Goldman
Sachs, calculates that global financial wealth has risen by 30 per cent in the
past 12 months.

Well, maybe it is not so paradoxical. A transfer of wealth from raw materials
producers to consumers should be positive for demand and profits.

But there is a worry that markets are responding principally to the injection of
liquidity by the leading central banks. The latter only have one main policy
tool,  interest rates, and in seeking to head off a global economic slowdown they
may be inflating bubbles in securities markets.

This brings us to paradox two. Bond market credit spreads, which are wide, but
had been narrowing, have begun to widen again.

This partly reflects another emerging markets scare, which follows the upset to
the Brazilian bail-out plan and the appearance of clear signs that Latin America
is following Asia into recession. But mainstream corporate  bonds have suffered
too.

This leaves the bond markets seemingly discounting a recession, or even a
depression, with all that implies for a decline in credit quality. Yet the
Western stock markets, especially Wall Street, are apparently in denial.

George Magnus, chief economist at Warburg Dillon Read, says that there is clearly
a bubble here, and indeed the US Federal Reserve has injected an element of moral
hazard into the market place. But the bubble could yet be inflated further.

CrossBorder Capital, the London consultancy that tracks global liquidity, says
its G3 liquidity indicator bounced up in October to an above-neutral 51.9 per
cent, well up from an August low point of 46.9 per cent. Fed policy is "very
loose", says CrossBorder.

But global liquidity, it adds, follows a strong cycle with an average period of
9.7 years. Given that the last significant low was in March 1989, followed by a
mid-cycle dip in December 1994, a serious liquidity squeeze may be imminent.

Gavyn Davies insists, however, that there is no bubble - not yet, anyway. Current
values can be fully explained in terms of sharply falling risk premiums on both
bonds and equities, after four years in which global inflation expectations have
declined by 100 basis points.

It is hard to understand, however, why equity risk perceptions should be so low.
Risks of recession are surely quite high. Moreover, Mr Davies offers a third
paradox: on his model, equity prices are vulnerable both to the appearance of
deflation, or to the reacceleration of higher inflation. The path of
righteousness is narrow indeed.

In fact others could question the whole paradigm. Perhaps the equity market is
being priced off the risk-free bond yield and not the more appropriate corporate
bond yield, which is in fact capturing the recession risk, whereas government
bond yields are being held low by "flight to safety" considerations.

The equity risk premium certainly appears to be much higher for second-line
stocks than for blue chips.

An important underlying theme is that of excess capacity, which is now afflicting
not only manufacturing and natural resources production worldwide, but is also
spreading to distribution and services too.

George Magnus points out that in previous postwar cycles, cuts in interest rates
have reflected the abatement of inflationary pressures and have signalled the
return of growth.

This time it is different: the easing is a reflection of persistent economic
weakness in large parts of the global economy.

Japanese investors have absorbed this lesson since 1990.
Fans of Wall Street should keep a wary eye on those commodity prices.  End.

Now OPEC has finally put its act together, in inventory management if not in
long-term pricing policy, pushing oil prices toward $30/barrel, the ECB is
declaring that the weakness of the euro has created concerns about "price
stability" (inflation).  The main factor on European inflation is the price of
dollar denominated oil.

The ECB raised the benchmark refinancing rate to 3.25% from 3%, way ahead of
market expectation that it would not do so until April.  The ECB insisted that
the timing, one day after the Fed raising the Fed Funds target rate to 5.75% and
the discount rate to 5.25%.  Last November, the ECB raise the RR to 3% from
2.75%, but the official rationale was to stimulate the economy rather than to
cool it down.
Clearly, the relationship of interest rates to inflation is driven by esternal
faactors such as oil prices.  OPEC also does not have any incentive to see global
inflation, but it does not want the battle against inflation to sit solely or
mainly on its shoulders.

The ECB's timing raises question about its market independence and thus
jeopardizes the anticipation of a bi-polar monetary regime.

Henry C.K. Liu


GGard97342@xxxxxx wrote:

> In a message dated 26/01/2000 16:15:38 GMT Standard Time, lprochon@xxxxxxxx
> writes:
>
> > Second, there is little and only indirect relationship between interest
> rates
> >  and the money supply, surely we know that by now!
> >
> Surely there is a kind of relationship, but it has not been generally
> recognised because it does not accord with standard monetarist theory.
> ("Palmer's Principle" and the like.) It seems to be recognised in Germany, to
> judge by an incident when Gavyn Davies of Goldman Sachs was one of the British
> Chancellor's "Six Wise Men". Davies said that the German M3 was growing and the
> Bundesbank should raise interest rates. The Germans replied, "No. When interest
> rates are low, big industrial borrowers will borrow long in the bond market,
> but when they are high they will borrow short from the banks while they wait
> for interest rates to fall. High interest rates therefore cause M3 to rise."
> This was a bit of a simplification as the interest rate curve also comes into
> the equation, but what they were saying is largely true. Moreover it is
> standard teaching in investment theory. For some reason, what students of
> investment theory have been learning for centuries has not been communicated to
> monetarist economists.
>
> Geoffrey Gardiner