Sunday, December 13, 2009

Life is All About Real Interest Rates.......Isn't It?

1. Real interest rates and CURRENCIES.

In a former life, I used to have as two of my five economic "Never Ignore" mottos, never ignore, short term real interest rate differentials, and never ignore long term interest rate differentials. (others were PPP, the G7 and current accounts, and I added, another, never ignore the charts). When I started here at GS, I introduced GSDEER, a fundamental valuation methodology which , luckily in recent years, Thomas Stolper and others have upgraded considerably in quality………..

Back in the 1990's, we also used to work with something called " Adjusted GSDEER" which would take our underlying valuation, and adjust it for 10 year real bond yield differentials, and we regarded this as an excellent guide to how $/DM actually moved. In the mid 1990's, about the same time, the Bundesbank actually published an econometric model, which was effectively the same. In the early years of the Euro, it seemed as though an Adjusted GSDEER approach worked even better, as all that seemed to matter ( given little change in relative US-European productivity) was a large actual or perceived move in real interest rates.

As it relates to major currencies, we used to find that for the Yen, our adjusted GSDEER did NOT work at all.

Now what is interesting in recent years, and Dominic Wilson is always correct to point out, is that $/Yen appears to have -dramatically compared to the old days- increased its correlation with interest rate differentials, with short term ones especially.

Now I say all of this, because one of the things I might have got wrong in my silly thick head, is that I have stopped thinking a bit about real interest rate differentials as it could relate to the Yen. While it seems increasingly idiotic from a medium term to long term perspective for the Yen to carry on this relentless rally, if Japanese real yields continue to rise relative to the US- and elsewhere, then maybe the stupid Yen will rally, for now, even more. Indeed, as a number of clients have pointed out to me, the temporary rise in JGB yields and selloff in Japan CDS simply contributed even more to this, by raising the attraction of local real yields at the expense of overseas ones for Japanese investors.

Given that the Japanese Government has now formally acknowledged " deflation " is back, you would think that they might do something about it- such as raising their JGB purchases, deliberately weakening the Yen given that this is the main transmission mechanism for inflation/deflation in Japan, but alas……….they simply make these statements.

Perhaps the Yen might go pretty close to its all time highs before reality finally takes over, and we get what is necessary to start the long, and inevitable Yen decline………

More broadly, as and when US real interest rates turn ( whatever the reason), so will the Dollar….

2. Real interest rates and GOLD.

Gold is a currency of course, in many ways. Tuesday night this week, I had the pleasure of attending a rather lively dinner discussion with a bunch of hedge fund commodity investors. I had forgotten just how "lively" many commodity market players can be, and certainly when it comes to Gold, it just does something to us all, and gets the emotions going more than virtually anything ( unless you come from a certain town by the coast in the north west of England of course………at one time in life, I believe they used to think they were good at footie there).

Anyhow, as our own Gold guru David Greely shows in his own modeling, Gold is essentially driven by real interest rates. I hear all these views about central banks buying, and supply issues, etc, etc, and they are no different than I have heard in the past. Flow things in all markets come and go, don’t get sucked in by them. If US, and G7 real interest rates decline, Gold tends to go up, and vice versa…….

Now, for some odd reason, some of you seem to think that I have some kind of pathological dislike of Gold……….you obviously haven't known me for long. I have managed to get Gold wrong many times, including back in the mid 1990s when I tried to get bullish about 2 years too early……

The issue for you-increasingly trend influenced buyers of Gold - for 2010 is easy. DO you expect real interest rates to rise, or fall? If the answer is rise, then what on earth are you buying it for?

3. Real interest rates and GDP.

Now let's expand further into the broader world. In economic theory, at least pre Alan Greenspan and Ben Bernanke, it is believed that the real interest rate should be reasonably similar to the long term growth performance of an economy, or at least the equilibrium real rate.

Both the current and previous Fed Chairman would have us, for a long time, believe that there were "special" reasons why US ( nominal and real) interest rates were below where they should , all for reasons that had nothing to do with the US. It used to baffle me for many years why Mr Greenspan would talk so optimistically about the productivity miracle but seemed so relaxed about low real rates. Here's one to ponder? How come, if US rates were so low because of some kind of " savings glut" from other countries, Asia especially, now that the US current account deficit is half what it was, and China's current account surplus is half what is was, real rates aren't higher?

Answer also on a postcard please………….

My own view is that, in fact, it is quite likely over coming years that aspects of Ben Bernanke's conundrum will pan out, and as people start to realise Chinese growth is both sustainable and profitable ( including the policymakers in Beijing) then Chinese and G7 real interest rates will rise, and this year's huge improvement in global imbalances will continue.

But, rather naughtily let me put this one to you, as one very smart investor inadvertently did for me yesterday. Could it be that the decline in US real rates in the past decade had nothing to do with the savings glut etc, but actually reflected increasing belief that there is less domestic growth potential in the US and less creativity taking for a whole generation?

4. Real interest rates and the ERP.

Which brings me full circle to markets and the equity risk premia. Whatever the answers above, looking at current valuations and all the constant worries you all have- now including Dubai and Greek CDS again- the fact of the matter is......

Even in a low global growth environment, the current equity risk premia is still above the past 25-30 year average, and unless real interest rates suddenly rise a lot , then equities should do fine. ( and by the way, all this debt that everyone worries about won't be as big a problem, as the debt servicing is so low).

Now think of a 4pct, BRIC influenced world, then the ERP is ridiculously high, and until the real interest rates rise, equities will remain staggeringly attractive……….

5. Where are real interest rates going?

Which frankly, dear reader, is an even bigger question for 2010 markets, than it was this time last year, when the answer was , in my opinion, easy, they went down, and hence why it was so easy to be bullish "stuff"……….

Now even if real interest rates, as eventually they must do unless we are going to be stuck with a permanent depression, then equities will have to deal with that, but so long as it is , in circumstances of the GDP growth consensus being revised up towards, and not too violent, this is not an issue for equities. It will be, however, for $ bears and almost definitely, lovers of the yellow metal…….

By: Jim O’Neill of Goldman Sachs

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