Saturday, October 08, 2005

Harry Schultz and Stephen Roach

The legendary Harry Schultz on the gold market:

"gold mkt is now in a different kind of phase, not just another leg up. It's serious now. This is where the insiders gradually load up. U can quote me on that if u like."

MARKET TALK: Asian CBs Should Hold More Gold - MS
Oct 07, 2005 - 09:51:06 HKT
Dow Jones Newswires

Asian central banks should hold more gold, writes Morgan Stanley's global head of FX research Stephen Jen; says gold good "neutraliser" vs FX risks, especially important for central banks in region that have large FX reserves (for example, Japan, China, Korea and Taiwan); estimates correlation coefficients between gold prices and JPY, GBP close to zero (means gold prices not sensitive, so gold excellent hedge vs JPY, GBP volatility); adds for EUR and USD, gold pretty good hedge (coefficients at 0.38 for EUR and 0.26 for USD). (RNH)

Morgan Stanley

Global: Transition Curse
Stephen Roach (from Zurich)

The end of an era is nearly at hand. After nearly 18 1/2 years on the job, Alan Greenspan is required under law to step down at the end of his full term as Fed governor on January 31, 2006. Akin to the election of a new pope, the changing of the guard at the Fed is a rare and important event for the US and world financial system. In the past 27 years, it has happened only three times. In each of those instances, the transition did not go well -- financial markets quickly seized up, eager to test the mettle of the new central banker. My suspicion is that the curse of the Fed transition is likely to be in play again -- with potentially profound implications for increasingly vulnerable financial markets.

Historically, the Fed has always been a chairman-dominated institution. Yes, policy is made by committee -- a seven-person Board of Governors, joined by a rotating group of five of the 12 District Bank presidents (that always includes the representative from New York). While each member of the Federal Open Market Committee has one vote, the Chairman’s vote has always carried the greatest weight in the deliberations of the modern-day Fed. As such, it should not be surprising that financial markets take the transition to a new Fed Chairman as a very serious event. This one person has long been emblematic of the character of the institution.

The history of recent Fed leadership transitions does not read well in the financial markets. The last one occurred in August 1987, when Alan Greenspan assumed the reins of power. A little more than two months later, the US stock market crashed. Paul Volcker became Chairman in August 1979 -- a transition that that was quickly followed by a wrenching sell-off in the bond market. And the US dollar was in serious trouble from the very start of G. William Miller’s brief term as Fed chairman, which commenced in March 1978.

It’s not that new Fed chairman typically fail to meet the immediate test of financial markets. In each of these instances, the incoming central banker inherited very tough macro conditions. The Greenspan transition occurred when the US stock market was already sharply overvalued. At the same time, the US and Germany were at odds on the interest rate coordination needed to stabilize a then very weak dollar. The crack in the US stock market was very much an outgrowth of the long simmering interplay between the dollar, interest rates, and unstable conditions in equity markets. Similarly, Paul Volcker came to power in an era of raging double-digit inflation -- 13% annualized increases in consumer prices. At the time, there was no political will to turn the monetary screws tight enough to tame inflation. Volcker was quick to challenge that perception, and the bond market caught on quickly to the wrenching monetary tightening that was about to unfold. For G. William Miller, it was indoctrination under fire. As the US trade balance deteriorated, inflation went from bad to worse, and the US currency reeled in response -- ultimately forcing the Carter Administration to announce a formal dollar support program in late 1978.

These conditions certainly didn’t make life easy in the early days of the last three Fed chairmen. Financial markets were stretched and vulnerable at these delicate moments of leadership transition. Investors had developed a sense of security in the incumbent Fed chairman and were uncertain as to how his successor would fare. The leadership transition at America’s central bank played on the "confidence factor" that always underpins financial markets. Going from the known to the unknown is invariably unsettling -- even under the best of circumstances. Unfortunately, the circumstance surrounding the last three Fed transitions were far from ideal.

Alas, that is very much the case today. Saddled with a record current account deficit, the US is more dependent than ever on the confidence of foreign investors to fund ongoing economic growth. When Greenspan hands over the reins to his successor in early 2006, the current account deficit will be at least 6.5% of GDP. That’s more than four times the average external shortfall of 1.5% that prevailed during the three most recent transition points -- 1978, 1979, and 1987. Moreover, in a post-Katrina, energy-shocked climate, there is good reason to expect additional reductions in personal and government saving in the months ahead -- actually, deeper dis-saving (deficits) on both counts. As a result, already-depressed national saving should move even lower, prompting further deterioration in America’s already massive current account deficit. In other words, America’s dependence on the "kindness of strangers" is likely to increase significantly at precisely the point of an historically-delicate transition to a new a new Fed chairman.

And that, I’m afraid, brings me to the most controversial point of all -- the selection process, itself. With the consent of the US Senate, the choice of selecting a new Fed chairman falls to the President. Generalizing on the basis of George W. Bush’s most recent senior appointments, I suspect the President will look for three key traits in a new Fed chairman -- familiarity, loyalty, and a pro-growth bias. This is not meant to be critical. It is a carefully determined observation based on the President’s record. In the case of a Fed Chairman, those criteria imply that President Bush will probably not select the next Paul Volcker -- a tough, independent policy maker who might be predisposed toward "tight money." While this is inconsistent with the President’s statement on this matter at a recent press conference, in the end, I still believe George W. Bush will opt for a trusted team player who shares the goals and objectives of his political agenda.

This could well pose a serious problem for US financial markets. With America’s external financing critically dependent on the foreign confidence factor, any doubts over central bank independence will not go over well. That’s especially the case for a US economy beset with record imbalances, a potential inflation scare, and bubble-like conditions in asset markets. Foreign investors have been extraordinarily generous in the terms they have offered for funding America’s external deficit. In part, that generosity may reflect the "Greenspan factor" -- the confidence that investors have in Alan Greenspan’s adroit management of periodic international financial crises. With the Greenspan factor about to be taken out of the confidence equation, any fears of an "easy money" Fed could well prompt foreign investors to exact concessions in those financing terms in the form of a weaker dollar and higher real interest rates.

As I look to January 31, 2006, those are precisely the risks I see in the immediate phase of the post-Greenspan era. The rocky financial market history of recent Fed chairmen transitions is a warning, in and of itself. America’s heightened vulnerability to the foreign confidence factor amplifies those risks. And President Bush’s appointment record points to a candidate who could seriously compound the perception problem. This is potentially a very tough combination. It leads me to believe that the curse of the Fed transition is about to strike again.

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