Morgan Stanley Global Economic Forum

They've outdone themselves with a lengthy year end report covering, well, the whole world. Thanks to Brad Setser's and Brad DeLong's blogs for the pointer.

Given the cautionary perspective of Stephen Roach (Morgan Stanley) and other well-known economists, I am amazed that (a) implied vol is at a multi-year low and (b) long bond yields are so low. The latter can perhaps be explained by foreign central bank buying (and hedge funds plying the carry trade), but why are equity markets so sanguine about the coming year? Perhaps there are structural forces at work there as well? Will realized vol in the coming year be much higher than the market is currently predicting?

Roach: Finally, the US also needs a further weakening of the dollar, in my view. On a broad trade-weighted basis, the dollar’s real effective exchange rate is down about 15% from its early 2002 peak. This is a relatively small decline for a US with a current account deficit that is expected to rise to at least 6.5% of GDP over the next year. Back in the latter half of the 1980s, when the current account deficit peaked at 3.5%, the broad dollar index fell about 30% in real terms. In other words, America today has a current-account problem that is almost twice as bad as it was in the 1980s but a dollar that has fallen only about half as much. For that simple reason, alone, I would argue that the dollar has at least another 15% to go on the downside. While a weaker dollar will not alleviate America’s imbalances, it could well trigger the interest rate adjustments that might — especially since the current-account conundrum means that marginal changes in US rates are increasingly in the hands of America’s overseas creditors.

A spike in interest rates would definitely cause an equities crash. Roach should put his money where his mouth is and buy SP puts - or at least advise his clients to!