Financial markets have produced some unexpected developments so far in 2005.The IMF also sees support for the dollar from the American Jobs Creation Act.
First, despite a growing US current account deficit, the dollar has appreciated this year as market participants have turned their focus toward relative growth and interest rate differentials in favor of the United States.
Second, despite a yearlong tightening of short-term rates by the U.S. Federal
Reserve and an earlier round of rate tightening by the Bank of England, yields at the long end of the curve in mature markets have actually fallen in the last several months. While this reflects in part expectations of more moderate growth and contained inflation, it is also part of a shift in the long-term preferences of institutional investors toward fixed-income instruments.
These developments have been accompanied by an ongoing search for yield that has driven spreads on corporate and emerging market bonds to very low levels. These low spreads and the low and flat mature market yield curves have provided incentives to financial market participants to move out the credit spectrum toward riskier and more complex investments, involving "relative value" trades using credit derivatives.
What are the main risks ahead?
First, given the ongoing shift in institutional demand for longer duration bonds, a flat yield curve and low long-term rates may persist. This will continue to provide incentives for "relative value" trades and prove a more difficult environment for financial intermediary earnings.
Second, leveraged bets - especially in complex derivatives markets - could be unwound in a disorderly fashion. While this could conceivably lead to credit market volatility, strong balance sheets and risk management practices of banks would likely confine dislocations to individual investors, including hedge funds. In fact, occasional market "corrections," so long as they remain confined, should reduce investors' complacency and contribute to the stability of the global financial system. Improved fundamentals in many emerging market countries and continued strategic allocations by institutional investors may help to cushion these markets against the risk of mature credit market volatility. Emerging market countries therefore continue to enjoy favorable financing prospects for the time being.
Third, while the US current account deficit represents a growing long-term vulnerability, so far there have been ample capital flows to accommodate the US current account deficit.
The measure, passed in 2004 (but only fully clarified in January 2005), allows US companies to repatriate profits previously held abroad at a 5.25 percent tax rate rather than the 35 percent that would otherwise prevail. To meet the provisions of the act, companies must outline how the funds will be used in a plan that requires executive approvals. The tax advantages of repatriation may lead to substantial flows, to be reported as negative direct investment abroad, and may have become significant starting in the second quarter of 2005.Not that I like the advice of the IMF for developing countries, but this makes sense.