United States
Review and Preview
Jul 03, 2006

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

The Treasury market posted significant 3-year led gains over the past week after a sharp rally following the FOMC statement partly reversed the nearly continuous decline the market had previously suffered since the June 14 release of the May CPI report. Indeed, through Wednesday, Treasuries had sold off in 10 of 11 straight trading sessions (with only a slight bounce Tuesday) and fed funds futures even longer, leaving the market positioned for a much more hawkish statement than the Fed delivered. Substantively, the FOMC’s statement accompanying its 25 bp hike in the fed funds target to 5.25% was little changed from May, continuing to point to upside inflation risks but leaving future rate moves data dependent, certainly a more balanced message than had been priced into the futures market coming into the meeting, which had reflected a slight risk of a 50 bp hike Thursday and a roughly 80% chance of another hike in August. Coming out of the week, odds of a hike on August 8 had been scaled back to only a bit more than an even chance.

We expect the key data over the next five weeks -- starting with the employment and ISM reports in the upcoming week and continuing with the CPI report on July 19 -- to support a move to 5.50% on August 8. Still the numbers will have to come in to the upside to support an August move, so the current market pricing seems a lot more reasonable than the 80% chance priced in pre-FOMC. The rally in futures beyond that, with the market now seeing no risk of a move beyond 5.50% and still seeing a shift towards an easing bias after November, seems far less reasonable to us given the early signs of a reacceleration in growth in June that we expect to see confirmed in the key early June numbers in the upcoming holiday-shortened week, with focus on Friday’s employment report where we look for a solid 190,000 gain in payrolls.

Benchmark Treasury yields fell 7 to 11 bp the past week, led by the 3-year, which saw its yield drop 11 bp to 5.13%, outperforming an 8 bp rally in the old 2-year to 5.18% and a 9 bp gain in the old 5-year to 5.11%. The new 2-year and 5-year both saw very weak demand from final investors on Tuesday and Wednesday but ended up well in the black at week-end. The new 2-year was auctioned Tuesday at 5.24% and rallied to close Friday at 5.15%, while the new 5-year was auctioned at 5.20% Wednesday and ended the week at 5.10%. The initial reaction to the FOMC statement Thursday afternoon was a huge gap steeper in the curve, but this was partly reversed as gains shifted out the curve in Friday’s rally, with the 10-year yield ending down 9 bp on the week at 5.14% and the long bond rallying 7 bp to 5.19%, leaving 2’s-10’s still inverted after a brief disinversion Thursday even with the 2.5 bp roll into the new 2-year.

The less hawkish than the market expected FOMC statement led to an increase in market-based measures of inflation expectations. TIPS slightly outperformed on the week, a very unusual occurrence during a significant market rally, slightly lifting breakeven inflation spreads.

And by our calculation, the 5-year/5-year forward TIPS breakeven inflation spread, which the Fed has identified as the key gauge of market-based inflation expectations, rose 4 bp to 2.60%, nearly completing a reversal of the 11 bp decline to 2.50% that was seen in the aftermath of Chairman Bernanke’s hawkish remarks after the employment report. This is still below the peak near 2.75% hit May 12, but up about 20 bp year-to-date. Gasoline-sensitive consumer inflation expectations have continued to moderate, however. The University of Michigan’s survey showed 1-year ahead median inflation expectations falling to 3.3% for all of June from the early month reading of 3.4% and 4.0% in May and the 5-year median expectations declining to 2.9% for all of June from 3.0% early in the month and 3.2% in May.

The FOMC statement didn’t contain anything we found surprising, but for a market that had sold off almost continuously for two weeks and moved to price a risk of a 50 bp move at this meeting and an 80% chance of a hike in August, it obviously proved a lot more even-handed than expected. The forward looking language contained in the statement was rearranged but essentially repeated from May. This time the key statement read “The extent and timing of any additional firming that may be needed to address these [inflation] risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.” On May 10 this section read “The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.” Pretty much the same thing

-- as in May, further rate action remains data dependent, and while the statement claimed that data dependency refers to both “inflation and economic growth,” it would seem from all recent Fed rhetoric, especially the hawkish response to the weak May employment report, that the incoming inflation figures are much more important. Who knows, though?

The Fed has certainly failed miserably to convey in a way investors have been able to understand what they mean by data dependency. What data matter and to what degree? In dramatic contradiction of market perceptions at the time, the employment report obviously didn’t matter at all a month ago. Apparently all that really mattered coming into this meeting were inflation expectations and the 3-month and 6-month growth rates of core CPI. Is that all that matters still? Is the employment report on Friday again irrelevant to the outcome of the upcoming FOMC meeting? At this point, who knows? Hopefully Chairman Bernanke will explain what the Fed is watching most closely and help investors better anticipate its response function to incoming news when he presents his semi-annual monetary policy testimony on July 19.

Near and medium-term Fed expectations in the futures market were sharply scaled back after the FOMC meeting. The August fed funds contract rallied 5 bp on the week to 5.365%, cutting the odds of another rate hike at the August 8 meeting to about 55% from around 80%. The peak rate November contract surged 8.5 bp to 5.48%, so the market no longer sees any risk of a move beyond 5.50%. We continue to look for another 25 bp rate hike at the August 8 FOMC meeting and, based on our expectations for a modest reacceleration in second half growth and a continued gradual drift higher in core inflation through early 2007, we see the risks rising of a further hike beyond that. The medium-term eurodollar futures market rallied in a parallel manner -- the white (Sep 06 to Jun 07), red (Sep 07 to Jun 08), and green (Sep 08 to Jun 09) contracts all gained around 10 bp. The max one-year inverted Dec 06 to Dec 07 spread flattened a half bp to -14 bp, with the former gaining 10 bp to 5.595% and the latter rallying 10.5 bp to 5.455%. The inversion in the fed funds futures market begins after November and in the eurodollar market after December, which, in our view, is too early to begin pricing in rate cuts. The Fed could be on hold with a tightening bias for a long time after August.

Economic data released the past week showed better than expected growth and marginally better than expected inflation. The second quarter slowdown now looks like it will be less significant than previously believed -- building in upside in home sales and consumer spending and the positive mix shift in the Q1 GDP revision (more final sales and lower inventories than we had anticipated), we upped our forecast of Q2 growth to +3.0% from +2.5%.

The home sales numbers for May surprised to the upside, but still couldn’t keep up with surging inventories. New home sales jumped 4.6% in May to a 1.234 million unit annual pace, bringing the rise over the past three months to 18.8%, almost fully reversing a 17.6% plunge in January and February to leave sales at their best level of the year, contrasting sharply with recent weakness in the homebuilders’ survey. The gain in sales in May led to the first decline in inventories (-0.7%) in over a year, but still left the stock of unsold new homes up 24% year/year.

Meanwhile, existing home sales dipped 1.2% in May to 6.67 million units.

Existing home sales have been gradually moderating, but the year-to-date sales pace would still be the second strongest ever if sustained. As with new homes, inventories of existing homes for sale continued to surge, rising 41% year/year. Eventually this surge in inventories -- and we don’t think it is likely to ease any time soon, since the current home sales pace does not seem remotely sustainable to us -- should start to put significant downward pressure on home price gains. The stronger than expected May home sales results led us to significantly boost our Q2 forecast for the brokers’ commission component of residential investment, leading us to up our GDP estimate a tenth.

Real GDP growth in the first quarter was revised up to +5.6% -- the second strongest quarter so far in the expansion -- from the +5.3% preliminary reading and +4.8% advance estimate. Most of the upward revision resulted from a slower pace of import growth (+10.7% v.   +12.8%). Overall final sales were adjusted up nearly a half point to +5.9%, boosted by strength in consumption (+5.1%), business fixed investment (+14.2%), and government spending (+4.8%), and a modest gain in residential investment (+3.3%). Inventory accumulation (+$29.5B v. +$32.3B) was adjusted down a bit, pointing to somewhat stronger growth in Q2. Incorporating these results, we upped our forecast for the Q2 inventory contribution to GDP growth by two tenths. Meanwhile, after tax corporate profits surged 13.8% (non-annualized) sequentially in Q1 for a 30.5% year/year gain.

Adding another couple tenths to our Q2 GDP forecast was a stronger path for consumption emerging from the personal income and spending report for May. Real PCE in May gained 0.1% in May but positive revisions to prior months led us to up our estimate for Q2 consumption to +2.3% from +1.9%. While this would represent a significant pullback from the 5.1% surge recorded in Q1, it would still be a fairly impressive show of resilience given the hit to consumer spending power and sentiment that the March/April spike in gasoline prices caused. And things are looking up for consumers heading into the second half. Both of the key monthly consumer sentiment measures for June, along with the weekly ABC/Washington Post poll, showed significant improvement, likely supported by the combination of stable gasoline prices since the end of April and, based on the very positive recent trend in jobless claims, an improving labor market. The Conference Board’s index of consumer confidence rose a point in June to 105.7 from an upwardly revised May reading, while, buoyed by the recent stability in gasoline prices, the University of Michigan’s index was revised up to 84.9 for all of June from the early month reading of 82.4 and May’s 79.1. Upside in the Conference Board poll was more than accounted for by a gain in the expectations gauge, led by decreased pessimism about jobs -- 15.6% of respondents expected more jobs in six months, up from 14.8%, while 17.0% expected fewer, down from 18.0%.

While the growth numbers released the past week were positive, the inflation figures were marginally better than expected. The core PCE price index rose 0.2% in May. This was as expected, but to two decimals (+0.22%), the result was a bit better than we were anticipating, allowing the year/year rate to hold unchanged at +2.1%, just slightly above the Fed's de facto 1% to 2% target. Just as for the CPI, however, the modest elevation in the annual inflation rate looks a lot more troublesome when viewed over shorter time frames -- the 3-month annualized gain was +3.2% in May and the six-month growth rate +2.5%.

These will soon start showing through in an acceleration in the annual pace. In June 2005, the monthly change in the core PCE was only +0.05%, so the year/year pace will likely accelerate to +2.3% in the next report -- which will be released a week before the next FOMC meeting.

The upcoming holiday shortened week -- early close Monday (with undoubtedly very light turnout at workplaces across the country) and full close Tuesday -- sees a number of key economic data releases, which along with the CPI report on July 19, will go a long way in helping firm up market expectations for whether the Fed will hike rates again in August or pause. We expect robust results from the key numbers in the coming week to help support the case for an August move to 5.50%.

Releases due out include ISM, construction spending, and motor vehicle sales Monday, factory orders Wednesday, chain store sales Thursday, and the employment report Friday:

 

* We expect the June ISM to rise to 56.0. Most of the regional surveys that have been released to this point have shown surprising upticks in June. Indeed, the Empire barometer rose two points on an ISM-weighted basis, while the Philly Fed gauge showed an even sharper advance. Note that we are heavily discounting the results from the Chicago region because they have been so inconsistent with the national ISM in recent months. The bottom line is that we look for the ISM to recoup about half of the slippage seen in May. Meanwhile, the price gauge is expected to show a slight dip after the big run-up posted in recent months.

* We forecast a 0.5% gain in May construction spending. The surprising jump in housing starts, together with a solid rise in hours worked in the construction component of the labor market data, points to a rebound in spending following the unusual dip recorded in April. Going forward, we expect ongoing momentum in the nonres and public categories to help offset a slowing in residential.

* Industry reports point to a modest rebound in June motor vehicle sales to a 16.5 million units annual pace following the disappointing results seen in May (when sales came in at a 16.0 million unit pace). Some automakers have already begun to step up incentive offerings in response to the latest cooling in sales, and more promotional activity is anticipated as the month draws to a close. Still, the impact of these actions probably won’t be fully felt until July.

* We look for a 0.2% decline in May factory orders, as a slight decline in the durable goods component is expected to lead to a dip in overall bookings. Meanwhile, shipments are expected to be up 1.5% which would represent one of the sharpest advances seen in the past year or so.

Finally, inventories should post a somewhat smaller gain than seen in recent months.

* We forecast a 190,000 gain in June nonfarm payrolls. A number of factors point to a rebound in job growth this month. First, unemployment claims have dipped of late, with the 4-week average slipping to its lowest reading since late-February. Second, we see signs that at least some of the subpar rise in May payrolls was attributable to bad weather in parts of the country. Third, the household survey’s tally of employment has shown impressive gains in recent months. Fourth, an unusually wide gap has developed between the trend in payroll growth and withheld tax receipts. While the tax data are inherently noisy, a divergence of this magnitude might eventually get reconciled via a pick-up in the job tally. The bottom line is that we look for a solid gain in payroll employment this month. However, the unemployment rate, which just barely rounded down to 4.6% in May, should tick back up to 4.7%. And, average hourly earnings are expected to flatten out following some unusual gyrations in recent months.

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Global
A Global Heat Map for Inflation
Jul 03, 2006

Eric Chaney (Paris)

Is the world entering an inflation cycle?  Although not convinced, the markets are nevertheless nervous and would welcome more guidance from central banks about the reality of the threat, and their commitment to price stability.  I will focus on the former issue.  In a previous piece, I looked at the average manufacturing operating rate in the G10 (G7, Sweden, Korea and Taiwan) and found that changes in operating (or capacity utilisation) rates were reasonably good predictors of changes in core inflation on a global basis.  My conclusion was that cyclical inflation was likely to rise further by 0.2-0.4 percentage points in the next 12 months in the industrialised world (see How Much Inflation Is in the Pipeline? June 20, 2006).  Today, I will look at the contributions of individual countries to the global picture.  There are interesting findings for investors in this inquiry, although probably not on the geographical distribution of inflation.

The hot, the warm and the cold

In order to make operating rates comparable, I have normalised the data so that, for each country, the long-term average operating rate as well as its variance are equal to the parameters of the US series.  Since operating rates are the result of subjective measures by companies, rather than objective ones, normalisation is necessary and does not alter the original information.  On the basis of the latest available data (1Q06), we split our sample of the largest industrialised countries into three groups, depending on operating levels.  The ‘hot’ group includes Korea, the UK, Taiwan and Sweden: all have operating rates exceeding one standard deviation above the long-term average.  Canada, Italy, Germany, the US and Japan (temperatures in declining order) form the ‘warm’ group, while France is the only country operating below average.  Call it ‘cold’.

A parameter for stabilisation policies

Should we conclude that, for instance, inflation is more likely to accelerate in Korea than in France?  Not necessarily.  First, prices of manufactured products are largely (although not only) set on the global market place, rather than in local markets, since manufactured goods are typically internationally traded.  Second, as mentioned above, changes in operating rates are more relevant than levels.  Hence, the interest of the hot/warm/cold breakdown is elsewhere: It tells us where, in a perfect world, stabilisation policies should be the most stringent.  Since UK data on operating rates are less reliable than others — the quarterly CBI survey is only reporting the proportion of companies ‘working above capacity’ — I will not comment on this particular economy.  Hence, Korea, Taiwan and Sweden are the clearest cases of economies operating at heating levels and thus where stabilisation policies seem the most wanted.  Conversely, I find it interesting that in the US and Japan, operating rates are still very reasonable, implying that tough stabilisation policies are not topical there, at least from this angle.  To some extent, the latest FOMC statement may reflect this situation.

 

Euro area: tepid rather than warm, so far

As far as the three largest EMU countries are concerned, the average operating rate is only 0.3 standard deviations above the long-term average, a measure I would call tepid rather than warm.  In this regard, stabilisation policies do not seem necessary.  This is an important finding:  because fiscal policies are structurally restrictive in the euro-3 club, a point confirmed by last week’s Italian mini-budget and the first hints at 2007 budgets in Germany and France, monetary policy does not have to enter into the restrictive zone, which we see above 3.5%.  Of course, nothing is frozen and second quarter data may show that operating rates have increased significantly since the measure taken at end of the first quarter.  Given the strength reported by manufacturers in June monthly surveys, I would not exclude a significant shift upward since then.

Watch the dynamics

The other important dimension related to operating rates is the dynamics.  Depending on the relative speeds of capacity building and actual production, operating rates are rising or declining.  Taking the latest changes over four quarters, the global heating map looks different from the one derived from levels.  This time, Germany, the UK (again) and Taiwan stand out as the countries where operating rates are rising at the fastest speed.  In reality, the underlying pictures are very different in Germany and the UK: While manufacturing capacity is expanding in the former (+1.3%Y on our measure), it is rapidly shrinking in the UK (-2.8%Y on our measure, with the caveats indicated before).  In the latter, tensions are rising because disinvestment in manufacturing is running ahead of actual production — an extreme case of capital discipline.  The US, France, Korea and Italy are in the middle of the map, with significant rises in operating rates, a possible forerunner of inflation inasmuch as local factors may play a role here.  In sharp contrast with Germany, capacity is currently declining in France and Italy.  Hence, the rise in operating rates is a strong incentive for companies to invest in order to meet demand.  In these countries, domestic demand growth is likely to be more driven by corporate investment going forward, in my view.  Last, in Japan and Sweden, rates have barely increased and, Canada even posted a sharp decline.  This is important: stabilisation policies should not be as tough as the level of operating rates would suggest (or should be relatively short-lived); this is particularly the case in Sweden, where capacity is growing fast (2.5%Y), probably too fast.

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Asia/Pacific
Commodity Speculation Forces Monetary Tightening
Jul 03, 2006

Andy Xie (Hong Kong)

*High commodity prices are causing demand destruction. A significant downturn in Chinese demand for hard commodities suggests that demand is reacting to unsustainably high prices.  As the property cycle turns down globally, demand for hard commodities should weaken further.

*Commodity prices reflect liquidity rather than demand. Commodity prices react sharply to the policy outlook for major central banks, indicating that liquidity rather than demand drives commodity prices.  Hence, demand weakness is insufficient to bring down prices in the short term.

*Oil prices should lag demand even more. Oil exporters have become enormously rich from high oil prices in the past three years and are in a strong position to cut production to sustain high prices.  It may take a global recession to bring down oil prices.

*Property downturn may exacerbate inflation. The global property boom has increased the share of corporate earnings in GDP, which has allowed businesses to hold price increases despite rising costs.  As the property cycle turns down, businesses may have to raise prices more.

*High commodity prices force central banks to tighten. Global inflation is reaching ten-year highs and is likely to move higher in the coming months.  Commodity prices are a major factor. As weak demand is insufficient to bring down commodity prices, central banks have to tighten aggressively to contain inflation even as the global economy cools.  Financial speculation makes it difficult for central banks to achieve a soft landing for the global economy.

Global inflation is close to a ten-year high and is likely to rise further into 2007.  The culprit is the unsustainably high level of liquidity, whose inflationary effect has been held back by deflation shocks (e.g., the emerging market crises, China’s SoE reform and Japan’s banking reform) in the past.  As deflation shocks have ended, the current level of money supply is not consistent with price stability, in my view.

Commodity inflation is a major channel for excess liquidity to turn into inflation.  Even though high prices are destroying demand, prices remain very high despite the recent decline and tend to surge whenever the expectation for rate hikes by central banks diminishes.  This suggests that central banks have to tighten more than what the real economy requires in order to contain inflation.

Central bank signaling has been driving financial markets lately.  Their ambivalence towards inflation only incites more financial speculation and, hence, more inflation, which makes a soft-landing more difficult to achieve, in my view.  In the end, the reality of high and rising inflation will catch up with central banks, and I believe that the more dovish they are now, the more they will have to raise their interest rates later.

High commodity prices are destroying demand

Evidence is mounting that high commodity prices are destroying demand.  The IEA estimates that global crude demand is rising at 1.24 mb/d, much lower than its forecast of 1.5 mb/d at the beginning of the year.  Further, OECD crude stock is at a 20-year high or 54 days of demand coverage.  These data suggest that crude demand has cooled and supply is more plentiful compared to 2005 or 2004.  Nevertheless, Brent crude still averaged US$65.2/bbl in the first half of 2006, up 34% and 94%, respectively, from the same period in 2005 and 2004.

Demand destruction is even more apparent in base metals.  China’s imports of base metals have declined sharply this year.  Despite the recent correction, metal prices remain extremely high: compared to average prices in 2005, copper is currently 92% higher, aluminum 29%, nickel 45% and zinc 119%.  While the commodity bulls usually cite strong demand and tight supply as reasons for the high prices, it is obvious to me that financial investment has driven up these prices.

Dovish central banks encourage speculation

The reaction to the Fed’s statement last week is a good example that commodity prices are far more sensitive to liquidity indicators than real demand.  As the Fed sounded more dovish than the market expected, commodity prices rebounded sharply from the recent decline.

The commodity bubble is a knife hanging over the heads of dovish central bankers, in my view, because it encourages more speculation, which in turn causes more inflation, and I believe that the reality will catch up with the central banks that sound dovish today.  The commodity bubble is one manifestation of the inflationary pressure from the very high monetary stock in the global economy.  The inflationary effect of the abundant money supply was suppressed by global deflation shocks.  Instead, the liquidity caused asset inflation.  As deflation shocks end, asset inflation is causing consumer price inflation.

Central banks have tightened substantially already, and this is now causing the global property cycle to turn down.   Central banks are worried about the effect of this downturn on demand and do not want to tighten much more to risk a recession.  However, the current level of tightening is not sufficient to stop commodity speculation, in my view.  This essentially puts central bankers in a box — if they focus on achieving a soft landing, they run the risk of letting inflation get out of control.

The risk of a global hard landing rises

Central bankers may not be focusing enough on the big picture, but instead could be becoming too ‘data dependent’.  The big picture is that they have pumped too much money into the global economy.  As deflation shocks suppressed the inflationary effect of this, money supply stimulated demand growth through asset inflation.  Global conditions seemed ideal — too much money but no inflation — over the past few years. 

However, the inflationary pressure was simply warehoused in asset markets; as deflation shocks end, their inflationary effect pours into the real economy.  The right policy for price stability is to target asset prices, in particular commodity prices, in my view.  If central banks react to consumer prices, they merely delay containing the inflationary pressure from asset inflation and make inflation more intractable.  Inflation would peak out much higher than in a forward-looking policy approach.  When upward inflationary pressure is delayed, central banks could well overreact and cause a global hard landing.

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Thailand
Current Account Deficit Surged Further
Jul 03, 2006

Deyi Tan (Singapore)





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Hong Kong
Sufficient Liquidity Insulates Bank Rates from Fed Hike
Jul 03, 2006

Denise Yam (Asia)

17th official rate hike.   The June 28-29 FOMC meeting concluded with a 17th consecutive 25bp hike in interest rates, which the HKMA followed this morning with the Discount Window Base Rate (DWBR).  The fed funds rate now stands at 5.25%, and the DWBR is at 6.75%.

Currency optimism and sufficient liquidity in banking system keep HK$ strong and HIBOR low.   Expectations for further appreciation in the renminbi and the cyclical correction in the US$ have kept the HK$ strong and interbank rates at a discount to LIBOR.  The 3-month HIBOR-LIBOR discount has averaged around 80bp in recent weeks.

Lending and deposit rates stay put.   Hong Kong banks’ lending and deposit rates are priced primarily on HIBOR.  Amid softness in HIBOR recently, Hong Kong banks decided not to raise deposit and lending rates in response to the latest policy rate hike.  Loose liquidity can be seen in the pricing of mortgage loans in recent months.  The majority of the loans have been offered at more than 2.5% below the prime lending rate, against a common range of prime minus 2-2.5% in late 2005.

Tightening monetary conditions in 2006.   We model our HK$ interest rate forecasts in terms of spreads over US$ counterparts.  Our US team sees the Fed hiking rates once more in 3Q06 to 5.5% in this cycle, and the US$ prime rate reaching 8.5%.  With liquidity conditions tightening at the global level as other major central banks join the hiking spree, we expect the HIBOR-LIBOR spread to narrow.  We see 3-month HIBOR reaching 5.6% and the prime lending rate (HSBC) reaching 8.5% by year-end.

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