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Rising Libor is the story of the year, not Fed, says Morgan Stanley
RISING private borrowing rates is the bigger concern right now, not a more hawkish than earlier anticipated US Federal Reserve, Morgan Stanley chief strategist for Asia and Emerging Markets Jonathan Garner said.
The three-month US dollar London interbank offered rate, or Libor, which is one of the benchmarks for setting borrowing rates worldwide, has been on the rise since Feb 7, reaching 2.25 per cent, the highest since 2008. Meanwhile, its gap over similar-maturity risk-free rates, known as the Libor-OIS spread, has more than doubled since the end of January to 55 basis points, a level unseen since 2009.
"That's a key reason why markets have struggled. The acceleration in the private borrowing market is the story of the year, not the Fed," Mr Garner told BloombergQuint in an interview.
Here are edited excerpts of the interview:
Q: How high is the possibility that US Federal Reserve Governor Jerome Powell may be more hawkish than what the Street is estimating?
A: What's interesting is that the private or dollar-Libor markets have already moved far more aggressively than Fed funds. If you look at six months Libor, it looks 2.38 per cent, whereas the Fed is likely to raise the Fed funds rate by quarter of a point to 1.75 per cent. This determines that corporate costs are experiencing a very significant increase in interest rates.
So, unless the Fed is super dovish, I think we are looking at significant tightening of monetary policy in the US. In addition, China is tightening monetary policy at the same time and this joint timing is a key reason why we are so cautious on markets here.
Q: Will there be three hikes, or will they give any kind of indications that there could be a fourth one too? Are the markets already pricing that in?
A: It will be three or four. As I tried to indicate that it's not really that Fed is in the driver's seat in relation to corporate funding. The dollar-Libor markets, where corporates borrow, have already moved 2.38 per cent for six-month funds. That's the key reason why the markets are struggling because of the acceleration of tightening of private markets. So dollar-Libor market is the story of the year and not the Fed.
Q: If that is the case, what is your forecast for the global equities in that context?
A: Our thesis for the year was a rougher ride, and we had a number of things that we were concerned about. The reduction of Fed's balance sheet and the fiscal easing in the US is one of the reasons why the private money markets are getting so tight. There is some evidence that the treasury bill issuance by the US government is grading up private borrowings to some extent.
At the same time, we have exceptionally high valuations for non-financial part for global equities and over optimistic earnings expectations in my coverage, certainly in Japan and in North Asia in particular. So, this sets us up for a market which we are sure reached its high this year in the euphoria of the third week of January. For the rest of the year, it will be a tough market. It's been two months since the market peaked in January. So, our thesis which was very counter-consensus in January, is becoming more well understood and accepted in the market right now.
Q: Last week, data suggested that global investors put in the highest amount in global equity in long time, nearly US$43 billion, which was pulled out from the money markets. That seems to suggest that in certain pockets of markets there is risk and you are sounding very bearish.
A: Global equities are experiencing fund inflows but they have been somewhat choppy. In my area of expertise in Asian emerging markets, we saw in the third week of January, an all-time high dollar inflow which was about US$8 billion.
You are referring to total universal flows which were skewed towards the US markets. When you see foreign fund inflows, it's typically characteristics of the market top. Retail investors are allocating money to the market. But it's institutional investors, our evidence says, who are reducing risk in equities and moving to shorter dated bonds.
The flattening of the yield curve, the fact that the dollar-Libor rates are going up, 3-5 year maturity yields have stopped going up, it is kind of indicative of the kind of the end of cycle that we are getting. So, I will not put the retail inflows into a bucket of something which one needs to be concerned about. In 2016, there were very large retail investors outflows. So, that's characteristics of the market trough and was on that occasion.
Q: What about the commodity and currency story? Will the supposed bottoming out of the dollar prove to be a cap on commodity prices, particularly crude?
A: We don't think that the dollar is going to be as weak this year as last year. Some emerging market currencies, including the Indian rupee, are expected to witness their parity to weaken up some more against the dollar going forward.
The dollar-Libor markets have moved up a lot. It's got much higher interest rates. If you land into dollar market now as compared to this time a year ago, then interest rates are increasing on a daily basis right now. So, the competition related to relative money market rates is picking up which should stabilise the dollar.
Q: What about commodities? Do you think crude has hit the areas where we could say that it's a near-term top? What about the other commodities?
A: We are more bullish on crude than we are on metals and mining. So, we think that Brent price average is US$75 per barrel this year and it's a story of relatively tight global supply and continue to strengthen in demand in China and India. That keeps the market relatively tight. Due to the slowdown in the Chinese property market, we expect iron ore to soften and iron ore has been weak for last two days.
Q: What's you view on emerging markets and India in particular? Is the spate of good news which buoyed investor sentiment in India coming to an end?
A: We entitled our mid-November year ahead piece A Rougher Ride. Our view was perfectly clear then. Markets moved beyond our base case targets, overshot them significantly in January. Right now, it has come back in some cases pretty well to our target, which you see in Hang Seng and MSCI EM Index, we are almost at our year-end targets.
In the near term, particularly with the trade protectionism coming out of the US, there is possibility that we undershoot to downside. These are continually under review. But I don't see any good news on the horizon for the moment for markets. BLOOMBERG