United States
Bernanke?s Roadmap for Monetary Policy
Feb 13, 2006

Richard Berner (New York)

In his public debut as Fed Chairman, Ben Bernanke this week will likely outline both a forecast for the economy and a roadmap for monetary policy consistent with the Federal Open Market Committee’s (FOMC) current view: The expansion is solid, there are upside risks to inflation, and thus the Fed still has more work to do.  To be sure, as has a chorus of Fed officials over the past two months, Bernanke will probably stress that the policy path is now more uncertain, being highly conditional on the outlook and the data shaping it.  But he will also continue the risk-management approach to policy that is by now standard procedure for all central bankers, laying out the risks in both directions.  And as an advocate of forward-looking guidance, he will probably indicate that significant additional policy firming is unlikely.

All that sounds barely different from what might have been expected at this juncture from former Fed Chairman Alan Greenspan were he still in office.   That’s no accident; nominee Bernanke at his confirmation hearings stressed “continuity with the policies and policy strategies of the Greenspan Fed” in at least three respects: Maintaining low and stable inflation and maximum sustainable employment as equal goals (the Fed’s “dual mandate”); balancing a consistent policy strategy with flexibility and judgment; and “letting the public in on the policy conversation” as a means to condition expectations and improve policy effectiveness. 

Of course, Chairman Bernanke’s views on the nuances of those strategies do differ from Greenspan’s and, more important, from those of some current FOMC members (see “Greenspan’s Legacies; Bernanke’s Challenges,” Investment Perspectives, February 2, 2006).  Bernanke favors an explicit numerical inflation objective and believes that appropriate inflation targeting would improve policy outcomes.  He favors more frequent and timely publication of policymakers’ economic forecasts.  And he strongly believes that policymakers should “give careful, fact-based, and analytical explanations of their actions to the public.”  Yet, while that last quote likely describes his first monetary policy testimony to a tee, Bernanke also thinks that the Chairman should speak for the Committee as a whole.  As a result, he is unlikely to use this occasion to prosecute the inflation-targeting debate or impose his own spin on the immediate conduct of monetary policy.

Nonetheless, in acknowledging the key risks to the outlook and for monetary policy, Bernanke may have a slightly different take from that of other Committee members or of market participants.   He famously believes that a “global saving glut” has kept US interest rates low, but now that the yield curve has inverted beyond two years, it will be important to know whether he believes that it augurs trouble for the economy or not.  Judging by a paper he wrote with his then colleague Alan Blinder, he would argue that in isolation the yield curve isn’t a good predictor of future growth (see "The Federal Funds Rate and the Channels of Monetary Transmission", American Economic Review, vol. 82, no. 4, September 1992, pp. 901-921). 

Bernanke’s appraisal of the downside risks to growth will also be critical for assessing the outlook.  Two sources of risk are at the forefront of market concern. First, given the widespread perception that slowing housing wealth and mortgage equity withdrawal threaten economic growth, how big are the risks from a rapid adjustment in home prices?  While the economy has held up well so far in the face of surging energy quotes, how resilient would it be should they climb further?  In my view, the surprise this year will be that housing wealth decelerates and, courtesy of rising income, pent-up demand for capital spending, and stronger global growth, the economy will actually accelerate (see “Betting on Sustainable Growth,” Investment Perspectives, February 9, 2006).  Contrariwise, if supply curbs significantly boost energy quotes again, I think that could harm US growth (see “Oil Prices: Tight Markets + Geopolitics = Upside Risks,” Investment Perspectives, January 19, 2006).

Despite the intense focus on those threats to economic activity, Bernanke may also point to near-term upside risks both for growth and inflation.  With energy quotes breaking to 9-month lows despite the return of seasonable weather and geopolitical tensions, the evident support for growth from favorable financial conditions, and the recent run of favorable indicators outside of housing, economic strength could persist beyond the widely-expected first-quarter economic snapback.  And courtesy of dwindling economic slack and the potential for firms to pass costs through to prices more quickly and significantly, and with core inflation running near the top of the new Fed Chairman’s “comfort zone,” he will likely echo the FOMC’s stated near-term inflation concerns.

Against that backdrop, Bernanke is unlikely to offer market participants guidance about future monetary policy — either dovish or hawkish — that will significantly affect the shape of the yield curve.   As I see it, today’s inverted yield curve likely is the product of several forces.  Among them: A telegraphed monetary policy that has depressed term premiums; a perceived, pension-driven demand for duration; and a global search for yield.  In my opinion, it also reflects the view that the Fed will tighten monetary policy twice more and subsequently do an about-face and begin an easing process later this year and into 2007. 

I disagree.  Monetary policy is unlikely to ease until inflation risks subside.  If a declining term premium — rather than the weighted sum of expected future changes in short-term interest rates — has recently contributed both to lower long-term yields and to a flatter yield curve, both imply faster, not slower, future growth, exactly the opposite of the traditional interpretation.  And if the term premium has declined permanently for whatever reason, making the current structure of interest rates more stimulative than otherwise, then the Fed will have to raise short-term rates by more than otherwise to achieve its goals, and rising term premiums probably will resteepen the curve later this year.

Despite the intense focus on the new Chairman’s every word, on balance, Ben Bernanke’s debut is unlikely to be a market-moving event.  To be sure, the outlook is more uncertain, market participants aren’t familiar with his take as Fed Chair on near-term outlook or policy risks, and they are unsure how the Bernanke Fed will evolve.  But Chairman Bernanke likely will emphasize his desire to continue the FOMC’s current policy approach, viewing the outlook as solid with potential inflation pressures.  He will speak for the Committee, echoing its current stance, rather than introducing new debates.  Given that the Fed has extended the late-March FOMC meeting to a second day, those discussions can wait six more weeks. 

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US
Review and Preview
Feb 13, 2006

Ted Wieseman (New York) and David Greenlaw (New York)

After considerable gyrations nearly every day — extreme volatility for a week with almost no fundamental news to drive trading, including an almost completely empty economic calendar — the Treasury curve ended slightly flatter the past week on a like-for-like basis. But the week-end results were certainly far more eye-popping when just looking at the roll into the new benchmark issues after the refunding, with the very rich and very heavily demanded new 30-year bond — which closed the week inverted to every Treasury coupon or bill with a maturity of more than three months — drawing most of the market’s focus in an otherwise very quiet period for news. The refunding taken as a whole was a bit of a mixed affair, starting off with a weak 3-year leg that was followed by an about average 10-year auction. But it was the shockingly strong results for the bond, both in terms of the near record high demand from final investors and the extremely aggressive yields at which they bid, that ultimately dominated investor attention and made the refunding as a whole seem a resounding success regardless of what came before it.

Certainly how this apparently sizable demand for duration manifests itself in the market will remain a key trading theme going forward. But in the coming week at least, a shift back towards a more fundamental and less technical focus seems likely as we look forward to Fed Chairman Bernanke’s first semi-annual Monetary Policy Testimony, as well as a round of economic data that we expect to be market negative — we forecast strong consumer demand, rising capacity utilization, and accelerating underlying inflation in the week’s key reports.

Benchmark Treasury yields, looking at the old issues for comparison, rose 5 to 11 bp over the past week, sending the curve to new lows on a weekly closing basis (though a bit off the cycle lows hit Thursday in the aftermath of the bond auction). The 3-year extended its recent sorry performance on the curve, with the yield on the old issue up 11 bp to 4.655%, underperforming a 9 bp rise in the 2-year yield — which continues to set new cycle highs on a nearly daily basis — to 4.68% and an 8 bp increase in the 5-year yield to 4.58%. The old 10-year yield rose 9 bp to 4.62% and the old long bond yield 5 bp to 4.68%. Even setting aside the fireworks created by the bond auction, it was a very busy week for the curve. Pre-auction, 2s-30s moved through an average daily range of nearly 7 bp from Monday through Thursday, closing at 4.6 bp at the end of the prior week, then 0.8 bp Monday, 5.5 bp Tuesday, 4.6 bp Wednesday, and -0.8 bp Thursday, before settling down a bit Friday, when the whole market came under comparatively curve neutral selling pressure (apparently simply driven by some corporate rate lock selling into a market that had just gotten way too bulled up by the bond auction) to end at 0.4 bp Friday.

Regarding the new issues, all three ended the week in the red thanks to Friday’s sell-off — the 3-year closed at 4.65% after being auctioned at 4.595% Tuesday, the 10-year at 4.58% after being awarded at 4.54% Wednesday, and the 30-year at 4.545% after being awarded at 4.53% Thursday (though not before surging to as strong as 4.46% early on Friday). Despite there being essentially no fundamental news to drive it, the futures market continued its relentless recent trend towards pricing in a more aggressive near-term Fed. The April fed funds contract lost 1 bp to 4.73%, so a March rate hike to 4.75% can be considered fully priced in, we believe. And the July contract lost 7 bp to 4.965%, so a hike to 5% in May or June (most likely May) is also considered by the market to be a near certainty, in our view. Rate cuts are no longer considered a reasonable outcome in Q3, as the June 06 to Sep 06 spread moved back into slightly positive territory, rising 2 bp on the week to +2 bp. On the other hand, the trend that had been underway the prior week towards pricing out the rate cuts in the mid-06 to mid-07 timeframe reversed. The Sep 06 to Sep 07 eurodollar spread flattened 2.5 bp on the week to -17 bp, reversing course after having previously moved from a low of -20 bp on January 20 to a recent high of -11.5 bp on February 2.

The week’s big event, of course, was the triumphant return of the 30-year bond at Thursday’s auction, the first bond auction since August 2001. The security, already expensive looking when issued, which was trading about 12 basis points rich to the prior long bond (February 2031 maturity) just ahead of the auction, still managed to pass through expectations thanks to extraordinarily high demand from final investors relative to prior norms. The $14 billion new issue was awarded at 4.53%, 4 basis points stronger than pre-auction levels, which left it, at least in the initial post-auction shake-out so far, inverted to every other benchmark coupon — the 2-year, 3-year, 5-year, and 10-year — and even to the fed funds target for a time, as its yield traded as low as 4.46% Friday morning before Friday’s big sell-off took hold (which was roughly a curve neutral event, particularly in relation to the wild curve gyrations seen earlier in the week). Any doubts about whether there was really enough underlying demand for duration by investors to absorb such a large issue (at least considered on a duration weighted basis) at such an expensive level were certainly assuaged by the extraordinarily strong demand from final investors at the auction relative to prior norms. The detailed bidding statistics provided by the Treasury showed that primary dealers were apparently scared off by the richness of the security, bidding a mere $16 billion for the $14 billion issue. In contrast, ‘indirect bidders,’ a category that includes bids placed by primary dealers on behalf of customers and the New York Fed on behalf of central banks (note, though, that at least historically, central banks have not been meaningful participants in long-end auctions in contrast to their predominance at short maturities) bid a considerable $11 billion, 80% more than they bid for the $13 billion 10-year auction a day before. Of the competitively-awarded amount, indirect bidders received 65.4%, a share that has only been exceeded once at any coupon auction in the three years these data have been published. Primary dealers received 34%, which compares with an average of 68% at the new issue 30-year auctions from 1998 through 2001.

Treasury has always been very clear that it does not try to “time the market” in making financing decisions. But the debt managers operate under a mandate to seek the lowest-cost funding of the debt over time, balanced against a desire to maintain flexibility and contain rollover risk. If the initially strong demand for the new 30-year were to intensify in the months ahead, and it appeared that the sort of structural curve inversion seen in the U.K. were occurring here, the debt managers might consider making a shift to relatively greater long bond issuance in 2007 when they announce their plans in August. Note though, that Treasury has been quite clear that there will be no change to the previously announced plans for 2006 — a new issue in February reopened in August with a total size of $20 to $30 billion.

It was a light week for economic data, with the most noteworthy release being the trade report. The trade deficit widened to $65.7 billion in December from $64.7 billion in November, with both exports (+2.1%) and imports (+1.9%) posting surprisingly sharp gains. The $2.3 billion gain in exports, which brought the annualized rise over the past three months to +24%, came despite the expected normalization in aircraft (-$1.1B) after a post-strike surge. Offsetting this was broadly based upside in key categories, including industrial materials, ex aircraft capital goods, autos, and consumer goods. The $3.3 billion import gains came despite a sizable price related pullback in petroleum products (-$1.1 billion). This was offset by a surge in consumer goods and solid gains in ex-oil industrial materials, capital goods, and autos.

The trade results were marginally worse than BEA assumed in preparing the advance estimate of Q4 GDP, but this was more than offset by upside in wholesale inventories, which rose 1.0% in December on top of an upwardly revised 0.5% gain in November. Combined with previously reported data on construction spending, manufacturing inventories, and capital goods shipments, we currently see Q4 GDP being revised up to +1.5% from +1.1%. And we continue to forecast a 5.5% rise in Q1.

New Fed Chairman Ben Bernanke will present the semi-annual Monetary Policy Report to Congress on Wednesday and Thursday. We suspect that Bernanke will clearly stress the more data dependent nature of future policy decisions now that the real fed funds rate has reached what’s probably close to an approximately “neutral” long-term level, while also suggesting a tightening bias by indicating that the main risk to the outlook remains higher inflation, particularly after the “possible increases in resource utilization” recently warned of by the FOMC continued in the recent employment report. This is liable to be a politically tough debut for the Chairman, as he may be challenged by members of Congress who perceive him as leaning towards higher rates in response to a falling unemployment rate.

While the main focus will be on Chairman Bernanke’s testimony, there are also several key data releases in the coming week. We look for market negative results, with upside in consumer demand, in “resource utilization,” and in inflation.   Investors will also be watching the early regional manufacturing surveys for initial thoughts on the upcoming ISM survey and the weekly jobless claims report to see how much impact the recent turn to more normal weather after the warmest January on record impacts the recent run of extremely strong claims numbers. Key data releases include retail sales and business inventories Tuesday, IP and the Empire State manufacturing survey Wednesday, housing starts and the Philly Fed survey Thursday, and the PPI and Michigan consumer sentiment index Friday:

* We forecast a 1.1% gain in overall retail sales and a 0.8% rise ex autos. Motor vehicle sales came in much better than anticipated in January. So even though much of the upside was apparently tied to fleet sales, we look for a solid 2% gain in the auto dealer component of retail sales. Similarly, the monthly chain store results for January showed a good deal more strength than implied by the weekly reports, pointing to solid gains in categories such as general merchandise and apparel. Finally, we expect to see a price-related rebound in the gas station sector.

* We look for a 0.3% gain in overall industrial production, with a sharp expected gain in manufacturing output (+0.8%), driven, in large part, by a rebound in motor vehicle assemblies. Based on the hours worked figures contained in the labor market report we also look for solid gains in sectors such as fabricated metals, electrical equipment, and textiles.

Indeed, the key manufacturing component is expected to register a sharp 0.8% gain. However, unusually warm weather across much of the nation should lead to a plunge in the utility category, which will hold down overall IP. Finally, the utilization rate is expected to hit another new cycle high.

* We forecast January housing starts of 2.05 million. Favorable weather conditions across much of the nation during the month of January are expected to have helped support home building. Indeed, hours worked in the construction sector rose more than 2% in January according to the labor market report. Also, it’s worth noting that the homebuilder survey showed significant deterioration in November and December before stabilizing in January. So, even though the pace of starts may continue to edge lower on an underlying basis, we look for about a 6% gain in January.

* We look for a 0.5% gain in the overall producer price index in January and a 0.4% rise ex food and energy. The renewed rise in energy prices should more than offset a slight decline in quotes for food items, helping to push up the headline PPI in January. Otherwise, we expect a modest rebound in motor vehicle prices — which have posted outright declines for three straight months — to contribute to some upside in the core. Moreover, it appears that the seasonal adjustment factors do not fully account for the typical start of the year price hikes that tend to be implemented, since the core PPI has registered some noticeable upside in January of each of the past few years.

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Currencies
On the Timing of the NZD Trade
Feb 13, 2006

Stephen L. Jen (London) and Luca Bindelli (London)

NZD/USD trade could be as tricky as EUR/JPY trade

The economic fundamentals for NZD/USD and NZD/JPY to trade substantially lower are very compelling. However, investors will need to be patient, and watchful of factors that are likely to determine the timing of this almost inevitable depreciation in NZD.  Specifically, we believe the likely triggers for a move from NZD are mainly driven by ‘nominal’ factors coming from the supply of capital flowing into New Zealand, rather than the economic fundamentals in New Zealand. Still, commodity prices are likely to play a central role.

NZD Should Be Lower

First, NZD/USD is overvalued by around 15 percent, according to our fair value framework.   Second, NZD is particularly volatile. If NZD does start to move south, it is likely to undershoot its fair value.  Third, the New Zealand economy is decelerating.  Not only have net exports become a detractor to growth since 2003, but domestic demand has also begun to decelerate.   Fourth, New Zealand’s C/A deficit has breached 8% of GDP, and its net foreign indebtedness is 81% of GDP.   Fifth, large volumes of Eurokiwi and Uridashi bonds are scheduled to mature in the next two years.

But When Will NZD Trade Lower?

It is one thing to have a ‘real fundamentals’ based medium-term view on NZD/USD, but other factors may interfere with this logical trade. Getting the timing right is the key. We need to be sensitive to factors that may keep NZD elevated. 

•            Thought 1.  The ECB and the BoJ may be key.  

The prospective termination of quantitative easing (QE) should have minimal effect on the JPY and the broad monetary aggregates, in our view. As the BoJ is likely to opt for a gradual approach, there is always a risk that some investors try to buy JPY on this event.   A fall in USD/JPY could potentially shake the psychology of Japanese investors and influence NZD. Similarly, Eurokiwi bonds have been popular with European investors.  But if the ECB has indeed embarked on a protracted tightening campaign, Eurokiwi’s popularity may be affected. A very gradual tightening from both the ECB and the BoJ may slow NZD depreciation. 

•            Thought 2.  NZ’s credit demand.  The key ‘funding countries’ are on a recovery path while NZ itself is at a more mature stage of its business cycle.  Credit demand in NZ, if the forecasts are correct, should abate, rendering the supply-demand balance in the offshore NZD market ambiguous.  In other words, heavy Eurokiwi and Uridashi redemptions in the coming year or so are due to large issuances in the past two years, these scheduled maturities themselves do not pose a problem for NZD – as whether more or less new Eurokiwi and Uridashi will be issued will be a function of the market’s fundamentals. 

•            Thought 3.  Global fixation on nominal yield differentials.  We have pointed out in the past that the G10 space is still very much dominated by the search for nominal cash yields. The same argument applies to NZD/USD.  We believe a fundamental shift in investor sentiment away from ‘nominal’ variables to ‘real’ variables will simultaneously drive down EUR/JPY and NZD/USD.  A sharp fall in NZD/USD is unlikely as long as investors remain in love with cash yields. 

•           Thought 4.  NZ inflation remains high.  Productive resources in NZ remain stretched.  Inflation reached 3.4 percent in Q3, and expected inflation near the top of the RBNZ’s target range of 1–3%. However, a prospective fall in NZD would be inflationary.  If NZD falls far enough, RBNZ could actually be compelled to raise rates, in theory, notwithstanding the recent comments from Governor Bollard.  In other words, the fact that NZ is still operating close to its capacity suggests that NZD could not fall too far too fast.

•           Thought 5.  Commodity prices remain high.  Our calculations show that a 1% increase in the Commodity Research Bureau’s spot commodity price is associated with an increase of 1.03% in NZD/JPY and a 1.30% in NZD/USD. Also, we have estimated modified version of the Uncovered Interest rate Parity (UIP) relation integrating a commodity price driven risk premium measure. Our modified UIP performs quite well, especially for the NZD/USD. This is strongly supportive of the fact that investors account indeed for commodity prices variations in their strategies. Based on our evidence, it is possible that a commodity price driven risk premium is priced in the Kiwi crosses. If global demand remains robust, particularly if demand from China stays supported, it may be difficult for NZD to sell off.

Bottom Line

The argument that NZD should weaken makes sense from a real fundamentals perspective. This view is reflected in our medium-term forecasts. However, investors should be careful not to be too eager about this trade right now. The key is to get the timing right.

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Global
Energy Security
Feb 13, 2006

Eric Chaney (from Paris)

Over the weekend, G8 finance ministers are meeting in Moscow.  Oil and energy issues are at the top of their agenda.  This is quite topical: recent events have shown that we cannot take for granted that our houses will be correctly heated next winter, that power supply will not be rationed or that petrol stations will be open.  To name but a few examples: when hurricane Katrina devastated some of the largest US refineries, European and Asian refiners were unable to compensate for the loss of supply, thus, there were shortages; when Gasprom, Europe’s biggest natural gas supplier, stopped gas supplies to Ukraine, the gas pressure fell in Poland, Germany, Italy and many other European countries; when Iran decided to resume its nuclear fuel programme, markets shivered at the idea that the global oil supply could be reduced by 3 million barrels per day (3.8% of global production), as was the case already in 1979-1980.  Such a loss would probably send the price of crude oil well above US$100/bbl.

The safe access to energy sources at reasonable prices is a necessary condition for economic prosperity; however, it should by no means be taken for granted.  Moreover, this is a not concern for rich countries only.  In reality, energy is more critical for developing economies, which need to grow faster than mature ones in order to raise standards of living, and are more sensitive to price volatility than rich countries, because they have less wealth.

The world is, again, struggling to secure energy supply.  This has happened many times in the past: historians think that some of the worst periods in Asian and European histories were caused by the depletion of what was then a major source of energy: wood.  This time, we are talking about the world, not a particular region.  This time, a massive energy shortage would result in hundreds of millions of deaths, mostly in poor countries.  So what can we do?

The riskiest of all sources of energy is oil, for reasons both geological — we are quickly depleting a finite resource — and political — 60% of the world reserves are in the Middle East.  So let’s use less oil.  The most abundant source is coal, so let’s use coal.  The cleanest and most powerful source of power could be controlled nuclear fusion, so let’s invest more in physics.  And so on and so forth.

Unfortunately, things are not that easy in the real world.  Driving big cars seems to be a part of the American way of life.  Coal-rich China could fully switch to coal instead of oil, gas or nuclear power, but then, global warming would dramatically accelerate, not to mention acid rain.  Funding research for new and clean sources of energy could mean a cut back in spending on other areas like welfare benefits.

Strong political will, supported by conscious public opinion, is a necessary condition to pursue sound energy policies, but it is not sufficient.  Market forces, which result from the confrontation of millions of rational (if correctly informed) individual decisions, should be used, I think.  I will take two (and a half) examples.

Why is each American burning 3.2 tonnes of oil every year while their European counterpart is using only 1.5 (based on 2004 data for the USA and the EU-25)?  Why are cars used in Europe more fuel efficient than those used in the US?  Because gasoline is heavily taxed in Europe, not in the US.  Price signals always work; it is just a question of level.  By taxing oil products, the US government would hit three birds with one stone: it would reduce dependency on oil, trim the budget deficit and stimulate R&D for more fuel-efficient vehicles.  In short, raise gasoline prices, let market forces do their job, and you will be surprised how nicely it works.

Is coal the solution?  Contrary to oil, coal is widely spread over the globe: 33% of known reserves are in the Asia-Pacific area, 32% in Europe and Eurasia and 30% in the American continent, according to BP statistics.  By contrast, 62% of oil reserves are in the Middle East.  However, coal has well-known drawbacks, such as carbon dioxide and sulphur emissions.  A market-based solution was invented a long-time ago in the US, where companies may trade rights to use a limited quantity of polluting inputs, so that their cost structure reflects the true cost of pollution.  Paradoxically, the European Union, which is often reluctant to embrace market-based practices, has made trading of carbon emission rights compulsory, following the Kyoto protocol.  The lower the total quota of carbon and sulphur, the higher the price of emission rights: there is no better incentive to use coal more efficiently and to invest in “clean coal” technologies.  Since pollution is becoming a major concern in China, a market-based carbon trading system would not only be consistent with the broad goals of the Chinese leadership, i.e. turning a command economy into a modern market economy, it would also help the global economy to use coal more efficiently and reduce its dependence on oil.

In the end, technological innovation is our best friend, as has been the case since the Neolithic Revolution.  In theory at least, energy is much more abundant than air or water: it is trapped in every single particle.  However, making it available for human needs is a daunting challenge, which only massive investment in science and technology can meet.  Financial markets can help by funding research in new and promising technologies.  However, without clear signals from policy makers that more taxpayers’ money will go to fundamental research and less to unproductive spending, such as the generous welfare programmes Europe is addicted to, this time the markets will not do the job.

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UK
Mortgage pricing - an offset to monetary policy
Feb 13, 2006

David Miles (London) and Melanie Baker (London)

At the start of November 2003, the base rate in the UK was 3.5% and the typical rate charged on a short-term (2-year) fixed rate mortgage was around 5%.  In February 2006, the base rate is 4.5%, but the typical interest rate on a 2-year fixed rate mortgage is only around 4.75%.  So, over a period when the short term level of interest rates has risen by 100 basis points (bp), the typical interest rate on a 2-year fixed rate mortgage (as well as on a 5- and 10-year fixed mortgage) has fallen. 

Given the significance of mortgage debt in the UK, and the key role of changes in the cost of that debt in the overall transmission mechanism of monetary policy, these pricing developments are of macroeconomic significance.  Over the past couple of years, a substantial part of the usual impact of monetary policy tightening has been offset by shifts in the shape of the yield curve and by changes in the pattern of pricing of mortgages.

Developments in Mortgage Pricing

Three forces have been behind the unusual evolution of mortgage pricing.   First, the UK yield curve has become inverted pretty much along its full length.  Second, the average mark-up of fixed rates on mortgages over swap rates has fallen somewhat.  Based on quoted rates on 2, 5 and 10-year fixed rate mortgages in February 2006 we estimate the typical margin over swap rates is now around 20 bp.   The spreads over swap rates back in November 2003 were closer to 40 bp.  Third, there has been a marked decline in the aggressiveness of initial discounts on many variable rate mortgages. 

The combination of changes in the spread of different mortgage rates over the cost of funds and the inversion of the yield curve has very significantly altered the mortgage rates charged on variable and fixed rate mortgages.   In November 2003, the average rate on 5-year fixed rate mortgages was around 160 bp above the average initial rate on a typical discounted variable rate mortgage.   Today that gap is 20 bp.

The one aspect of mortgage pricing that has not changed is the typical margin of lender’s standard variable rates (SVR) over LIBOR.   This is almost identical today to November 2003 — 166 bp now versus 169 bp then.   But while this spread has not changed, the proportion of mortgages that pay SVR has almost certainly continued to fall steadily.   Indeed, one of the reasons why the scale of initial discounts on variable rate mortgages is less aggressive today than in 2003 is that the ability, and perhaps also the inclination, of lenders to cross subsidise has fallen.  The greater amount of information about switching mortgages that is now available may also have contributed to lower initial discounts.

Arguably, we now have a less distorted structure of pricing of mortgages in the UK than a few years ago, with less variation in the spread between the cost of funds and the interest rate charged on mortgages of different types.   This development, along with the inversion of the UK yield curve, has brought the cost of fixed rate mortgages down relative to the initial cost of typical variable rate mortgages.   As a result, the proportion of fixed rate mortgages in new lending has risen significantly in the past eighteen months.

Monetary Policy Implications

Based on recent history we would anticipate an average cost of mortgage debt some 50 bp above where it actually is — the average mortgage margin (the spread between the average effective mortgage rate and the base rate) between January 1999 and January 2004 was around 130 bp… about 50 bp above today’s margin.  To put the point another way, about one half of the impact of the 100 bp increase in base rate since November 2003 has been offset by a combination of shifts in mortgage interest rate margins and in the slope of the yield curve.

The spread between the base rate and average cost of mortgage debt may stay low, meaning the neutral base rate is likely to be higher than previously.   A significant element of the shift in the shape of the yield curve may prove persistent.  Shifts in mortgage margins over the cost of funds may prove even more persistent, since they partly reflect shifts in competitiveness, in consumer information and in the scope for cross subsidization, all of which are likely to prove permanent.  Because of this, the relation between base rate and the average cost of mortgage debt may be permanently lower.

This has an important implication for monetary policy.   It means that the average cost of household debt for a given base rate will probably be lower now than it has been in the past — perhaps by as much as 50 bp.   This means that, other things equal, the neutral level of base rate is likely to be higher than it has been even in the relatively recent past. 

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Europe
An Economic Disservice
Feb 13, 2006

Elga Bartsch (London)

Over the past week, the two largest factions in the European Parliament hammered out a compromise regarding the EU Services Directive.   By watering down the EU Commission’s proposal for the establishment of a Single European Market in services, politicians have likely done the European economy a disservice. 

In my view, hindering the extension of the country-of-origin-principle — the cornerstone of economic integration in the Europe Union — to include a large range of (non-financial) services puts the prospects of Europe’s service industry at risk.  The country-of-origin principle stipulates that a product or a service that is legally sold in one EU Member state can also be marketed in all others.  This principle, which was established by the EU Court of Justice in 1979 in its Cassis-de-Dijon verdict, is crucial because it ensures that product safety standards and service specifications cannot be used to put up non-tariff trade barriers to keep foreign competition out.  In the late 1980s, there was a similar public outcry when some felt that it was an undue risk to public health and safety for Belgian beer to be sold in Germany and for German noodles to be marketed in Italy.  Unlike in the 1980s, however, calls for protection against social dumping were successful at the current juncture. 

Instead of pushing for a more competitive market environment in Europe, policymakers responded to thinly disguised protectionism.   Abandoning the country-of-origin principle, in my view, not only limits Europe’s chances of seeing a similar productivity spurt to that of the US in the late 1990s, it also seriously undermines the prospects of European companies as exporters of services.  Continuing to confine European services companies to fragmented national markets will prevent them from fully exploiting the economies of scale present in many services.  This will make it more difficult for European services companies successfully to compete against US companies, as the latter benefit from a much bigger domestic market on which they can leverage their fixed cost base. 

The protectionist outcry in a number of countries, including Germany and France, is also based on the misconception that western European economies would find themselves swamped with cheap services from Central and Eastern Europe.  Our analysis of the trade pattern in European services trade shows that Western European countries tend to have a comparative advantage in high-value added services (see Not in Service, April 22, 2005).  In addition, academic studies of the drivers of international services trade have found that countries with less regulated markets, such as the United States or the United Kingdom, are more successful in exporting services.  They also tend to have a more favourable balance of in- and outsourcing business and ICT services compared to those countries with a stricter regulatory framework.

Furthermore, plans to make it easier to post workers abroad, often a key requirement if a company wishes to offer its services abroad, will likely be scrapped too as a result of the compromise hammered out in the European Parliament.  In addition, some Western European Member states have made it clear that despite the EU Commission’s call to promote the free movement of workers in the EU, they will likely leave existing restrictions against the free movement of workers from the Central and Eastern European accession states in place for another three years when the rules are reviewed in April.  Keeping the labour market restrictions in place, in my view, will likely have several unintended side-effects:  it will tend to force east-west migrants into the shadow economy, it will encourage them to become self-employed in Western Europe and thus operate outside the trade-union controlled wage setting mechanism, and it will further strengthen Western European companies’ incentives to relocate production eastwards.  In the long run, this week’s success in the political arena might therefore turn out to be a pyrrhic victory for protectionism. 

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Asia Pacific
A Tale of Two Cities - Hong Kong's and Singapore's Search for New Identities
Feb 13, 2006

Andy Xie (Hong Kong)

In the current emerging market (‘EM’) boom, Hong Kong and Singapore are not in the limelight.  The two city economies became rich by being the gateways to the rest of the world for their large neighbors.  However, globalization has allowed their neighbors to bypass them and access the global stage directly.  Both are trying to get back into the game but in different ways.

Hong Kong’s businesses were previously intermediaries between China and the world.  Now Hong Kong’s aim is to provide the ground for China and the world to meet directly.  While this effort has succeeded in appearing to turn Hong Kong’s stock market into China’s main board, it is too early to conclude that this business model is sufficiently high margin to support Hong Kong’s per capita income at 13 times that of China.

At the same time, Hong Kong has been tightening land supply to support property prices to stimulate consumption.  This strategy was effective after the SARS crisis.  But, some reversal in property prices is already apparent.  The hikes in the Fed funds rate have increased the cost of funds in Hong Kong through the pegged exchange rate.  The outlook for Hong Kong’s consumption is becoming increasingly uncertain.

Singapore looks to be turning into a private equity fund and is trying to own the growth in neighboring economies.  This strategy seems quite successful at the moment with the EM boom creating big paper gains for Singapore’s investments.  However, past history suggests that EM activity is very cyclical and long-term gains are difficult to achieve.  It is too early to judge the success of Singapore’s approach.  Even if the investments do work out, the returns may not be sufficient to sustain Singapore’s per capita income at 27 times that of Indonesia or 14 times that of China.

Singapore is also focusing on China’s weaknesses to create economic activities at home.  Private wealth management, healthcare, education, and casino operations are some of the areas.  I think these activities look promising for creating sufficient jobs for Singapore’s small labor force.

Singapore and Hong Kong are taking different approaches to regaining their relevance in globalization.  It is too early to say if either approach will be successful.  In the background, the enormous wage gaps between the two cities and their neighbors work as a headwind to their economies.  Their economic policies need to be very effective for living standards to be maintained.

The Lucky Twins

Hong Kong and Singapore are Asia’s lucky cities.  Their income levels are considerably higher than those of their large neighbors.  In 2005, Hong Kong’s GDP per employee was US$52,000 and Singapore’s US$54,000, not far from Japan’s US$66,500 and much higher than Korea’s US$34,000 and Taiwan’s US$30,000.  The income levels in China, India and Indonesia are less than 10% of these levels.

The cities of Hong Kong and Singapore have become rich by being the intermediaries between the world and their big neighbors (China in Hong Kong’s case and Southeast Asia for Singapore’s).  To a significant extent, the two cities have gained from inefficiencies in their giant neighbors.

In the EM boom in the 1990s, for example, Hong Kong benefited from international enthusiasm for China by offering its listed companies and properties as plays on China’s future.  Its property and stock markets boomed.  When the bubble burst, Hong Kong continued to benefit with foreign investors the losers.

Singapore benefited from the massive inflow of Indonesian money into its property market.  This source of money was partly the regurgitated foreign capital flow into Indonesia.  Another gain for Singapore was its ability to provide a base from which multinational companies could operate to manage businesses in Southeast Asia.

Hard Times since 1997

The Asian Financial Crisis in 1997/98 was the turning point for the two cities.  Since that time, GDP growth in Hong Kong has averaged 3.6% and in Singapore 3.7%.  In nominal terms, Hong Kong’s GDP regained its 1997 level only in 2005.  Furthermore, its nominal domestic demand last year was still 17.3% less than in 1997.  Nominal GDP recovered on the increase in net exports.

Singapore’s nominal GDP has performed much better, up 3.6% a year during 1997-2005.   The 12% currency depreciation against the dollar helped in boosting Singapore’s nominal GDP.

The difference in deflationary pressure between Hong Kong and Singapore is a reflection of the extent of property overvaluation when the EM bubble burst in 1997.  Hong Kong’s property prices were up by 546% over the previous ten years and Singapore’s 253%.

Hong Kong’s property prices dropped by 65% and Singapore’s by 28% between 3Q97 and 2Q03.  Even after the adjustment, Hong Kong’s property is still twice as expensive as Singapore’s on average, while the two have similar income levels.

The Fragile Recovery

Hong Kong and Singapore have experienced a sharp recovery since the end of the SARS crisis in 2003.  Hong Kong’s property prices have shot up 63% in two years.  Its real GDP rose by 15% and nominal GDP by 12% between 3Q03 and 3Q05.  Singapore’s real GDP rose by 15% and nominal GDP by 19% over 3Q03-3Q05, while its property prices remained flat during the period.

The rapid recovery after the SARS outbreak has brought hope that the two city economies are back to their old forms.  I think this is a wrong perception.  Domestic demand remains depressed in both economies.  Hong Kong’s real domestic demand was only 5.7% higher in 3Q05 than in 3Q97, while nominal domestic demand was 13% less.  Singapore’s domestic demand rose by 11% in real terms and 12.5% in nominal terms between 3Q97 and 3Q05 or one third as much as the increase in GDP.

The real reason for the recovery of both is the expansion in the current account surplus.  Hong Kong’s net exports accounted for 14.5% of GDP in 3Q05 compared with -1.5% in 3Q97.  Singapore’s net exports rose from 12.8% of GDP in 1997 to an estimated 29.5% in 2005.

The fragility of the recovery is due to its dependence on the rise in net exports, which is a form of cashing out of past investments.  This sort of cashing-out depletes the domestic capital stock and, hence, the growth potential over time.

Capital Exports Become the Key to the Future

Rising exports, or the cashing-out of past investments, is possible when capital is exported in the same amount.  There lies the key to the future of both economies, in my view.  How much they earn on their exported capital will determine if the two cities can sustain or raise their living standards.

Singapore has executed unprecedented capital redeployment, led by its government, relative to the size of its economy.  The efforts have so far been successful.  Some of its investments (e.g., the stake in China Construction Bank) have appreciated considerably in the current EM boom.  For a small economy like Singapore, the government-led approach is entirely appropriate, as long as it works.

Hong Kong’s capital exports are driven by the private sector.   Its leading businesses have been buying into some of the same businesses as Singapore.  In addition, its population has been buying into Chinese IPOs and properties.  Such investments have been profitable so far in the current EM boom.

However, asset markets in emerging economies are highly cyclical.  It is too early to judge if the current paper gains will last.  As Hong Kong and Singapore invest in their neighbors rather than at home, their living standards depend on the long-term returns on such investments.

Hong Kong’s and Singapore’s strategy contrasts with that of Korea, which is to build up its manufacturing industries that are ahead of China’s or India’s in terms of quality and branding.  Korea’s living standards depend on sustaining its edge over China and India in such areas.  The success or failure of Korea’s strategy depends on Korean businesses.  Hong Kong’s and Singapore’s strategy depends on entities over which they have no control.

Employing People

As Hong Kong and Singapore divert capital to neighboring economies, how to employ the local population becomes an issue.  Again, Singapore has a government-led strategy that tries to take advantage of China’s weaknesses.  The low level of confidence in aspects of China’s economy gives Singapore an edge in private banking and healthcare.  The possibility of obtaining a Singapore passport increases demand for Singapore-based education.  Gaming, as in many other places, is viewed as an easy source of economic activity.

The effects of Singapore’s economic adjustment are not apparent yet.  Its economic recovery so far is still based on manufacturing, not services.  This employment strategy will eventually work, I believe.  But, we cannot yet predict the wage level that such activities can support.

Hong Kong has pursued one consistent policy in recent years to boost consumption, i.e., pushing up property prices by decreasing land supply.  This policy was effective from mid-2003 to 2005 as the low Fed funds rate and strong global demand once more triggered property speculation.

However, pushing up property prices is proving to be much more difficult than previously.  First, Hong Kong’s nominal and real wages have stagnated since 1997 compared with the double-digit annual growth rate in the preceding ten years.  The diminution in income prospects, mainly because of competition from China, is likely to continue in the next ten years.

Second, the expatriate population – a major force in the high-rent market – has declined as foreign businesses send more of their employees directly to Chinese cities.  For example, since 1997 the number of Japanese nationals has fallen by 39%, British by 22%, Canadian by 20%, and American and Australian by 16%.  The diversion of the expatriate population to Chinese cities is a secular trend.

This is why Hong Kong’s property market is softening even though the Fed funds rate at 4.5% is still relatively low by historical standards.  I believe it will become harder and harder for Hong Kong to keep its property prices up.

The other relevant change in Hong Kong is the opening to mainland tourists.  This change has been quite important in creating jobs for unskilled labor.  Even though the initial effect of ‘opening up the floodgate’ has worn off, it is likely to remain a major factor in Hong Kong’s labor market.  However, this business is unlikely to support high-wage jobs.

Why Should Investors Care?

Hong Kong and Singapore have faded in the current EM boom with investors rarely talking about either.  However, the stocks linked to the two economies (excluding Chinese or foreign companies listed in these markets) still command about US$800 billion, nearly three times their GDP.  If their restructuring efforts are not successful, the stocks associated with these economies would possibly be de-rated.

The bottom line is, will Hong Kong and Singapore be able to justify wages that are 10 0r 20 times those of their immediate neighbors in the era of globalization?  If not, steady deflationary pressure will constrain wage growth, which suggests poor earnings growth for the companies operating in these economies.  Their stocks still trade at the same valuations as elsewhere.  The question may eventually be raised –should they be trading at big discounts instead?

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Japan
Aim for Growth, or for Fiscal Rebuilding?
Feb 13, 2006

Takehiro Sato (Tokyo)

Fiscal base recovery proving remarkably firm

In its recent “Structural Reform and Medium-Term Economic and Fiscal Perspectives - F2005 Revision” (Jan. 20, 2006), the Council on Economic and Fiscal Policy effectively projected a primary balance surplus in F2011, a year ahead of schedule. Since the primary balance stands at -¥11.2 trillion based on F2006 budget proposals, the consumption tax would need to be hiked by 5%-plus to meet this goal, if all else remained equal. However, if we factor in the increased burden on social welfare from the aging population and the impact of a tax hike on consumption, it seems unlikely that a simple tax hike can achieve this result.

There was some encouraging news, however. Thanks to spending cuts and better tax revenues, the primary balance deficit is expected to contract for three straight years after bottoming in F2003 at -¥19.6 trillion, recovering by +4.7 trillion in F2006 alone. The government is therefore looking for improvement equivalent to just under 5% in the consumption tax rate only for the past three years, a further testament to the potential for recovery of the fiscal base during an economic recovery phase.

Based on the figures available as of December, F2005 tax revenue was ¥26.6 trillion (+7.0% YoY) for the nine months up to and including December, thanks partly to firm corporate tax revenue. Although this looks like poor progress (56.6%) towards the government’s adjusted F2005 budget forecast of ¥47.0 trillion, it is still 2 points higher than the progress in the year-earlier period. If annual growth comes in at 7%, and assuming our F2005 nominal GDP growth estimate (+1.9%) holds true, this would mean a four-fold increase in tax revenue elasticity (not adjusted for tax system changes). Under the progressive tax system, the built-in financial stabilizing mechanism wherein the upturn in worker’s income and the decline in losses carried forward by companies causes income tax/corporate tax revenue growth to far outstrip the nominal growth rate is holding up remarkably well.

However, although the tax elasticity value has been high of late, reflecting the decline in corporate losses carried forward, going forward we don’t expect major catalysts on the order of the major banks resuming corporate tax payments after years of reporting losses, so we think 4x is unlikely. Even so, the MoF’s medium-term economic and fiscal outlook assumed tax revenue elasticity of 1.1, in marked contrast to the current level. Since the government plans on getting the primary balance into the black via a consumption tax hike, there is something to be said for using assumptions as conservative as this; it is also open to criticism for being too pessimistic, however. 

Avoiding excessive fiscal tightening would free the govt. to focus on economic growth

Recently we are noticing signs of internal division within the administration on the subject of how best to ensure a primary balance surplus, with some championing fiscal restructuring via higher taxes and lower spending, and others advocating natural revenue growth by boosting economic growth. We think this is likely partly due to the power struggle between economy minister Kaoru Yosano, an advocate of the former position and internal affairs & communications minister Heizo Tanaka, who favors the latter. Fallout from this has also resulted in a surge in debate on the relationship between the nominal growth rate and long term rates.

For advocates of the former position, long-term rates have to date been higher than the nominal growth rate, so fiscal tightening is a necessity in the interests of sustaining the financial system. For advocates of the latter position, the long-term rate can be kept safely below the nominal growth rate by sticking with the ultra-easy money policy, freeing the government to pursue economic growth more aggressively.

In our view, comparisons of the long-term rate (yield on 10 yr JGBs) and the nominal growth rate levels are largely meaningless in the first place. We think the growth rate should instead be compared to the funding cost of JGBs on a stock basis. Also, the stock-based funding cost would be barely affected even if the long-term rate rose to 2% going forward, so if the nominal growth rate gets on a 2%-or so pace going forward, the nominal growth rate may well consistently trend higher than the government’s funding costs. In this sense, we are sympathetic to the latter camp’s position.

The ‘Dormar Theorem’ is often referenced in regard to both fiscal sustainability and the above-mentioned primary balance concepts. The above political debate is essentially a debate on this theory. According to the theory, fiscal sustainability can only be guaranteed if the nominal GDP growth rate is higher than the interest rates of the debt. In other words, if the nominal growth rate is lower than the funding rates, the government debt will diverge. Although demonstrating the theory requires the nominal growth rate to exceed the funding cost for quite some time, funding costs have thankfully been on a steady downward trend since the ‘90’s. Over this period, the nominal growth rate has been far below the government’s funding cost with the exception of the bubble period. It now appears that this situation can’t last much longer, with the two rates having intersected in 2005.

In fact, it was only since 1995 that deflation was really built into the long-term rate, and the 10yr JGBs issued in F1995 with a coupon of 4%-plus have already been fully retired, so there will be no 10yr JGBs with a coupon of 3%-plus in existence from September this year. Also, even if the long end of the curve rises to some degree, since the older JGBs with a relatively high coupon will keep being redeemed, its overall funding costs will hardly rise at all (the ‘paying down of coupon payment cost’ effect). Further, as noted above, the elasticity of tax revenues is trending far higher than the government has assumed.

Since the primary balance remains in deficit, we must of course remain on guard against excessive optimism. Still, we don’t think the scenario wherein the fiscal base is rebuilt without excessive tax hikes against the backdrop of ongoing modest economic growth to be mere pie-in-the-sky. Of course, the government would have to be very careful not to ease up on spending cuts and to prevent a risk premium in regard to the fiscal deficit. Also, it will be important to keep the economy simmering by maintaining its monetary easing policy to leverage asset prices. Only after implementing such policies can it safely consider raising the consumption tax, we think.

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