The year of the ‘exit strategy’

Next year is likely to be the year of the ‘exit strategy’ for central banks. In a twospeed world economy, those economies with large debt burdens will exit through fiscal tightening, while others will rely on monetary tightening. This difference will have a profound effect on the bond and currency markets, and should lead to some significant investment opportunities.

A slow improvement in a variety of leading indicators and business confidence surveys across western economies is consistent with a return to positive economic growth across much of the globe. Unemployment, however, will remain high across the West, with job insecurity and the spectre of increasing fiscal austerity likely to ensure consumer confidence remains subdued. Monetary policy is already being tightened in those less indebted economies which are supported by high commodity prices.

The West tightens its belt

One consequence of the growing deficit problem in western economies is the need for interest rates to stay lower for longer; another is the inevitable focus on higher taxes and lower government spending. Given its fragility, a tightening of fiscal policy in the West may have to wait for more convincing signs of economic recovery; indeed, some countries are still talking of further fiscal stimulus. The housing support scheme in the US has come to an end, but Congress is expected to vote in another group of measures which could deliver another US$90 billion of fiscal stimuli over the next 12 months. After that, a series of tax changes come into effect that should entail a tightening of fiscal policy and help rein in growth.

In the UK, there are already measures in place to increase the overall tax burden – in the form of value added tax, national insurance and income tax – in the first four months of 2010. However, these measures alone will not be enough to reverse the dramatic build-up in deficits or to stem the tide of government bond issuance. The next UK government will be obliged to put in place reduced spending plans and tax increases that start to fully address the problem.

For now, the view of the rating agencies is that sovereign debt servicing costs are moving closer to the edge of their ‘comfort zone’ but, providing that they can see a credible ‘glide path’ (through fiscal measures, asset sales and growth) back to a lower level of future debt costs, even a sharp rise can be tolerated in the interests of re-invigorating economic growth.

Meanwhile, a prolonged period of nearzero interest rates will push investors into bonds. Pension funds, insurance companies, endowments and retired individuals living on an income have already been steady buyers of government debt. These buyers, together with bond-hungry banks, have taken up the extra new issuance comfortably and more than counteracted the small reduction in demand from foreign central banks. However, when the official quantitative easing measures stop, it will be up to the banks to take up the reins and buy government bonds in order to improve their liquidity ‘buffers’.

History lessons

We continue to refer to the early 1990s as a template for the current environment. Back then, there was a post-recession environment in which interest rates were kept low for a prolonged period and the emphasis was on fiscal tightening further down the road. The three years from 1990 to 1993 amounted to one of the best periods for bond investors as bond yields fell and investors made 36.5% by investing in the US government bond markets. Unfortunately, in 1994 bond markets grew increasingly concerned that central banks were going to be too slow to raise rates and that inflation would rise substantially as a result. Bond markets bore the brunt of these worries.

With interest rates in the West set to remain at their extreme lows for an extended period, their currencies will continue to be used as the funding currencies for ‘carry trades’. This combined with the growth of the ‘pro-risk trade’ and general rise in interest rates in other countries is likely to lead to a global shift towards commodity-based and Asianlinked currencies.

Currency markets, therefore, should present significant opportunities over the coming months as diverging economic prospects and abundant liquidity drive respective currency valuations apart. Over the medium term, currencies which are supported by sound economic fundamentals, and which are well placed to benefit from an Asia-led economic recovery and a rise in commodity prices (such as the Australian dollar and the Norwegian krone) look attractive. Selective Asian currencies themselves (the renminbi and the South Korean won included) can also be expected to appreciate as part of a continued global economic realignment over the medium term.

Bond yield volatility could be an increasing feature over the next 12 months as investors grapple with large amounts of supply and the possible exit strategies of authorities. Those bond markets that are supported by continued low interest rates and fiscal austerity should benefit from such an environment.