Friday, February 5, 2010

Investment Perspectives — Global February 4, 2010

Global Interest Rate Strategy Eye of the Tiger

An unwind of market risk offers an opportunity to put
more on, in our view. In the Chinese zodiac, February 2010
marks the year of the tiger and denotes a period of great
change. The change we see ahead is one of a significant rise
in rates and steepening of yield curves. We urge investors to
look into the eye of the tiger as yields fall and position for just
such a market move. The risk of tighter policies in China and
other Asia-Pacific (AXJ) nations, considered to be the engines
of global growth, has caused many investors to reduce risk.
Sovereign risk events in Greece and the unknown variables
surrounding tighter banking regulations in the US have
caused a further unwind of risk; opposite to what we saw in
the last several months of 2009. While the tail risks have
increased, fundamentally we do not believe that prospects for
global recovery have changed. As a result, we see this
unwind of risk as an opportunity to add to our core views for
higher rates and steeper curves.

US Economics Mind the Gap: Even Record Slack Won’t Crush Inflation

Three sources of uncertainty.
There’s broad agreement
that inflation and pricing power diminish as slack in the economy
rises. Yet there’s still uncertainty around three issues:
(1) Inflation measurement: Measures of “core” inflation are
diverging. (2) Modeling the key inflation determinants: There
is uncertainty over how to measure both inflation expectations
and slack in the economy, and how to gauge their relationships
with inflation. (3) How the Fed’s response will shape the
outlook. Many officials take comfort from today’s relatively
well-anchored inflation expectations. But today’s wellbehaved
readings could change if investors believe that the
Fed — for whatever reason — has overstayed its welcome.

Measurement uncertainty. There is, to start, uncertainty
over the “right” measure of underlying or core inflation. The
two popular measures of core inflation diverged over 2009:
Measured by the CPI, core inflation was stable, but it declined
by 30 bp measured by the personal consumption price index
(PCEPI). While the differences mainly result from different
ways of measuring some prices, they may create uncertainty
over the direction of inflation

Model uncertainty. There’s even less certainty about key
inflation determinants and the model that links them to inflation.
Over the 30 years since the Fed held a first conference
on inflation modeling, the workhorse “markup over cost”
model has proven increasingly less reliable, courtesy of good
monetary policy, globalization, and changes in firm pricing
behavior. Indeed, our analysis suggests that firms now price
“to market,” setting prices based on conditions of demand and
supply in global product markets, rather than marking up over
costs. Both models do include three key elements, however:
a measure of inflation expectations, a gauge of slack in the
economy, and factors that “pass through” to underlying inflation,
like changes in energy or import prices. But it appears
that the slack-inflation relationship has loosened over the past
several years, and that the pass-through has also diminished.
The flattening of the so-called “Phillips curve” may mean that
as slack increases, inflation falls less today than it did in the
past. The price-to-market model may also help explain this
phenomenon, as companies absorb costs, including currency
swings, more readily into margins.

source morgan stanley

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