FX CONCEPTS FX CONCEPTS

GLOBAL MACRO RESEARCH GLOBAL MACRO RESEARCH

CURRENCIES INTEREST RATES EQUITIES COMMODITIES
To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; research@fx-concepts.com


MARKET INSIGHT REPORT
Rates Cant Go Up
By John R. Taylor, Jr.
Chief Investment Officer
_____________________________________________________________________________
The interest rate decline over the last thirty years created both the economic growth we
all enjoyed and the climb in asset prices that benefited wealthier individuals. We were
not smarter than other generations, we were luckier nothing more but now this multi-
decade wind at our back must come to an end. Unfortunately, there is no alternative, as
rates cant go any or not much lower and asset prices will therefore stall in their
decades-long upmove as well. The drop in rates from the teens in most countries
allowed everyone to borrow more, for a lower cost, over indulging ourselves in more
luxurious housing, personal adornment, and travel. At the same time rates dropped we
bid up the prices on assets and services housing booms and equity rallies followed the
bond rally in every country. As citizens, we voted for our governments to increase
spending on social programs and pension benefits while telling them to cut taxes. We
allowed them to fund the difference with increased debt, even with creative off-balance
sheet structures, which are only just coming to light. This whole process seemed
painless and it felt like a win-win situation, but it never was. The decline of rates from
the nosebleed levels of 30 years ago means most of us and most of our governments
can still support our interest payments, as we pay no more today than we paid in 1980.
Borrow $100 billion today at 2% and the annual interest cost is less than it was to borrow
$20 billion at 15% back then. With some adjustments, ratios like this are seen through
the entire developed world. For a while it seemed governments could follow this path
forever, but interest rates can only go so low. And, the lower rates are, the higher the
risk. In our simplistic example above, a doubling in rates from 2% to 4% would explode
almost every countrys budget. For individuals who are on average paying a lower
percentage of their income on interest payments today than they were in 1980, despite a
many-fold inflation-adjusted level of debt, increases in mortgage rates have become
more painful as rates go down and house prices go up. In the UK, where the average
home costs about 5.1x the median wage, a 1% increase in mortgage rates would cut
roughly 7% of after-tax, after-mortgage income. Considering average wages have been
stagnant for the past five years, this would have a drastic impact on consumer welfare.

As almost every country and many individuals still run deficits or support their balance
sheet with questionable assets (like houses, bonds, and equities), a rise in interest rates
is an anathema to governments not only because of the impact on consumer spending
and individual finances but also because they are a disaster for asset prices. Equities
are famously valued with a dividend-discount model or more simplistically in comparison
to the 10-year government bond, so a rough rule of thumb is that any increase in rates
will drive asset prices down. The hoped-for loophole to this rule is that the asset could be
assumed to generate more revenue if the higher rates (driving value down) coincided
with higher growth (pushing future flows higher). The problem with this is mathematical.
At very low levels a small increase in rates has a large percentage impact in the discount
rate (rates going from 1% to 2% is a 50% increase), while a small increase in growth
(implied this increase in rates) will not impact the future actual level of cash flows in that
logarithmic fashion. The lower rates go, the worse the comparison, so any hint at higher
rates becomes negative. Compare the US and Europe to Japan over the last 20 years
and Japan looks better. It started with more assets, was more conservatively funded,
and its people less indebted and more liquid. Buying long-dated bonds at low rates paid
off in Japan for years. Higher rates cannot be allowed. We cannot afford it!
FX CONCEPTS FX CONCEPTS
GLOBAL MACRO RESEARCH GLOBAL MACRO RESEARCH
CURRENCIES INTEREST RATES EQUITIES COMMODITIES
To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; research@fx-concepts.com


CURRENCY - Asia Long-Term View

Abe Is Running Out of Time
By John R. Taylor, Jr.
_____________________________________________________________________________

We do hope the numbers begin to improve in
Japan, but there arent many more data points that
Abe can ignore before he loses the backing of
world economic opinion and his countrys political
elite. Wednesdays report on Q2 growth, where it
only declined by 6.8%, better than the forecasted
average at -7.0%, could not be seen as a positive
as first quarter growth declined for an originally
reported 6.8% positive to a 6.1% positive. As we
see it the net outcome is -0.7% for the half-year
rather than the forecasted -0.2%. The
expectations for the current quarter are more
positive, but we see few signs there will be a significant uptick in capital expenditures or
any other key input to growth.

The cycles for the USD/JPY are positive for the next five months with the normal
ups and downs in between. This view would normally imply a risk-on attitude in the
global economy and an effort from the Abe team to stimulate the economy once again.
We hope is the outcome, but we are not optimistic. As the yen is a counter-cyclical
currency, it would normally strengthen if the euro were to weaken and the equity markets
were to be under pressure. As that is our most likely outlook, we would usually need to
see Abe turn on the BOJ printing presses again for our forecast to prove correct.
However, the 1997 example shows us something very different. As we discussed last
week, during the period between the middle of 1997 and the fall of 1998, the Japanese
economy did very poorly because the government did not respond with sufficient
stimulus to offset the dramatic slide in economic output that followed the consumption
tax hike of April 1997. During that period, the Nikkei equity index made a significant new
low, the JGB yield dropped from about 2.8% to the 0.80% area, and the USD/JPY rose
over 30% as Japan was in such dramatic trouble. As our cycles very often point the way
even when it is hard to construct the fundamental situation that might drive the market in
their direction, we will follow the cyclical lead but keep a close eye on the surrounding
fundamentals.

Our near-term view has become more positive on the USD/JPY as the low that occurred
on August 8 at the 101.50 level could very easily have been aggressive enough to
establish the dollar low. The short cycles tend to see dollar weakness into the first
half of next week, but if the USD/JPY can hold the brown upchannel lines around
101.70 to 101.90 then the upmove into the week of September 1 is more likely to
be aggressive going to the 103.40 level by that time the box is marked with the red
#1. This much strength would further mean the dollar will have a more aggressive
uptrend into the first half of October as well, reaching over 105.50 by then the #1
again. If the dollar drops down below the August 8 low now the lower probability
then the upmove will continue to the flatter green channel, only reaching the 103.80 to
104.20 level in the first half of October.