After the Wealth Binge
Jul 31, 2006
Stephen S. Roach (New York)
The modern-day US economy has just gone through its most extraordinary period of wealth creation on record. First equities, then housing -- over the past decade American households have added to net worth as never before. That binge is over. With the property market now cooling and equities settling in for an era of single-digit returns, wealth creation is likely to be subdued, for the foreseeable future. There can be no mistaking the profound implications of this development for the American consumer, the global economy, and world financial markets.
1997 was a year of great symbolic importance for the US economy. It was the first time in 30 years that household sector net worth moved back above its longer-term trend. And, of course, it was only the beginning of what we now know to have been the greatest surge of US wealth creation in the post-World War II era. There have been two major legs to this explosive surge in net worth. Reflecting a powerful equity bubble, real household sector net worth surged nearly 28% above trend by early 2000. That was followed by a 16% pull-back in the aftermath of a wrenching post-equity bubble shakeout. But then, courtesy of the property bubble, a second leg kicked in -- taking real household sector net worth up about 23% above trend as of early 2006. From bubble to bubble, US wealth creation broke the mold of anything seen in the past. Trend growth in real household sector net worth has averaged 5.5% since 1995 -- more than 50% faster than average gains of about 3.5% over the prior 40 years. This wealth binge has reshaped the macro performance of the US and global economy over the past decade. First and foremost, it has fed a record American consumption boom. Initially driven by the largely psychological wealth effects of the equity bubble but then supported increasingly by the tangible proceeds of equity extraction from the property bubble, the US consumption share gapped up to a record 71% of GDP in early 2002 -- well above the 67% norm of the prior 25 years. Significantly, this consumption binge occurred in a climate of relatively weak income generation; over the 1995 to 2005 period, growth in real consumer expenditures outstripped gains in real disposable income by an average of 0.5 percentage point per year. This mismatch between income generation and consumption lies at the heart of the vanishing personal saving rate. When the surge in wealth creation began in early 1995, the personal saving rate stood at 5.7%. This same metric plunged into negative territory in 2005 -- the first sub-zero reading since 1933 -- and stood at a modern-era low of -1.5% as of the second quarter of 2006. The rest of the story unfolds all too neatly. Reflecting the confluence of a negative personal saving rate and the government’s chronically large structural budget deficits, America’s overall domestic saving position also has plunged to record lows -- a net national saving rate that averaged just 0.3% of national income in the four quarters ending 1Q06. Lacking in domestic saving, the United States then must import surplus saving from abroad in order to keep growing -- and run massive current account and trade deficits to attract the foreign capital. In a weak climate of domestic income growth, that means the excesses of US consumption are being supported increasingly by foreign income generation. In other words, America’s wealth binge lies at the heart of the global imbalances that now pose such a serious threat to the stability of the world economy. A slight digression is in order at this point. It has become fashionable in this era of froth to dismiss the US personal saving rate and current account deficit as nothing more than statistical anomalies -- poorly measured and out of step with new developments in the financial economy. My advice: Don’t fall for these wild-eyed claims. They are just as misleading as the New Paradigm hype that filled your inboxes in the late 1990s. Trends in the government’s official estimate of the personal saving rate actually do a fine job in measuring disparities between growth rates of personal income and spending. A negative saving rate does not necessarily mean that consumers have stopped saving; in the current climate, it simply implies that households have shifted the source of such saving from their paychecks to appreciation of their assets. I think that’s a perfectly reasonable way of interpreting the recent plunge in income-based measures of US saving. Similarly, if the current account deficit is such a figment of our imagination, why is the US running such a massive trade deficit? Why are foreign capital inflows still surging into dollar-denominated assets? The answer to both questions goes right to the core of a wealth-dependent society -- a veritable lack of income-based saving. So much for what has happened. It is the prognosis that now matters most. I do not think there is any doubt that the US housing cycle is now turning. The questions pertain more to scope, speed, duration, and depth of the coming adjustments. In an era of financial-market deregulation -- especially since deposit ceilings in mortgage lending institutions were eliminated by the early 1980s -- residential property cycles have taken on a life of their own. As a result, both the uplegs and the downlegs have lasted far longer than standard business cycles. The data flow has certainly shifted to the downside -- namely, mounting inventories of unsold homes, declining mortgage loan applications, rising financing costs, and anecdotal reports from builders and realtors. A housing downturn will have obvious and important implications for US GDP growth. The direct effects are straightforward: Over the past three years, 2003-05, residential construction activity has boosted real GDP growth by about 0.5 percentage point per year. In data just released for 2Q06, the sector was estimated to have reduced annualized GDP growth by 0.4 percentage point. To the extent the decline in new building activity remains orderly, reductions could continue at the second quarter pace. Relative to the heady gains during the final stages of the boom, that means the contribution of residential construction activity could swing from +0.5% to -0.5% -- imparting about a one percentage point drag on overall real GDP growth for at least the next couple of years. The indirect effects are likely to be of greater consequence. In this case, it’s back to the saga of the wealth-dependent American consumer. And here it is very important to underscore the dramatic shift in the composition of the wealth effect that has occurred in the past six years. The first leg of the wealth binge was all about the stock market bubble; the equity share surged to a record 35% of total household sector assets by the end of 1999 -- essentially double the portion of 1991. Reflecting the equity tilt to wealth creation, the residential property share of household assets fell to a postwar low of 24% in 1999. The tables turned during the second leg of the wealth binge -- the equity share collapsed by 15 percentage points during the post-bubble shakeout while the real estate portion regained lost ground and then surged to a new high. As a result, by the end of 2005, the market value of household sector residential property was nearly 50% higher than equity holdings. For wealth-dependent American consumers, that takes us to the main event: Barring a spontaneous and sustained resurgence of labor income generation -- something I think is unlikely for as long as globalization and the global labor arbitrage persist -- the state of the US property market could well hold the key to the consumption outlook. Conventional wisdom has it that macro calls are hard to make in America’s diverse and highly fragmented property markets. “Local markets are subject to local conditions” became the mantra of real estate brokers and bubble-blowing central bankers, alike, over the past several years. In the early days of this housing bubble, that may have been an accurate assessment of market conditions. Not any longer. This bubble has gone to excess both in terms of scope and rate of expansion. As of the first quarter of 2006, the detail behind the widely followed OFHEO home price index revealed that in fully 53 metropolitan areas, house price inflation was still running at 20% or higher on a year-over-year basis. Nor are these areas America’s tiniest hamlets; making the list are places such as Phoenix, Miami, Los Angeles, and Washington, DC. Back-of-the-envelope calculations suggest that these 53 local markets collectively account for at least 50% of the total value of the nation’s housing stock. Looking out over the next year, I fully expect the house price comparisons in most of the hottest metropolitan areas to be flat at best -- and, quite conceivably, negative in many cases. That spells curtains for the heady pace of property-driven wealth creation that has powered the American consumer -- and the global economy -- in recent years. No, this does not represent another change in my thinking. The capitulation of the wealth-dependent American consumer has long been a central element of any realistic global rebalancing scenario. If once-frothy asset markets can no longer be counted on to backstop the American consumer, a reordering of saving priorities is both necessary and likely. Absent the support of asset markets, rational households will have little choice other than to return to income-based saving strategies. The looming retirement of some 77 million baby boomers only underscores the imperatives of such a shift in the mix of saving. The result should be an upward adjustment to personal and national saving and a concomitant reduction in the demand for foreign saving -- thereby tempering America’s need to run a massive current account deficit. Without such adjustments, you can forget about global rebalancing. The trick will be to pull this off without a hard landing. Here’s where my newfound optimism comes into play. As long as G-7 finance ministers, the IMF, and the world’s major central banks remain committed to a rebalancing policy agenda, the odds favor more orderly adjustments in the US and global economy. A withdrawal of excess liquidity by bubble-prone central banks is a key element of this rebalancing agenda. The good news is that this process now appears to be getting under way. The bad news is that the authorities may have waited too long to begin the heavy lifting -- leaving a still highly unbalanced world all too vulnerable to any number of exogenous shocks (see my 28 July dispatch, “The Pitfalls of Ceteris Paribus”). Either way, there is no escaping the endgame. The wealth binge must be brought to an end if an unbalanced global economy is ever going to end up on safer footing. I think that is exactly what is now under way.
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Tough Call for the Fed
Jul 31, 2006
Richard Berner (New York)
The news that slower growth arrived in the second quarter is being greeted with a mixture of relief and foreboding. Many, including Fed officials, assume that slower US growth is here to stay and that it will quickly cap the cyclical rise in inflation. Those who are relieved assume that while growth won’t seriously falter, the Fed has reached the end of its tightening campaign and, in time-honored fashion, will at some point back away from monetary restraint — which could be good news for risky assets. In contrast, those who are pessimistic assume that the spring slowdown is the harbinger of something worse — possibly including a recession — that will force significant declines in interest rates and in risky asset prices. I am far less sure that a lasting slowdown has arrived and am confident that the economy’s resilience will help it weather shocks that might otherwise threaten a downturn. Indeed, we had been anticipating a spring deceleration for some time, so the only issue was how dramatic it would be. More important, we continue to think that, while the forces depressing growth are unmistakable and a slowdown is coming, there are other factors sustaining still-hearty growth for now. One key reason: Courtesy of the annual recasting of the national income and product accounts for the past three years, the improvement in consumer income prospects that we thought was underway is now evident, lending strong support to consumer outlays. Nonetheless, the Fed’s job just got tougher, considering the range of possible outcomes ahead. Even if we are wrong and the economy fails to re-accelerate in the second half of 2006, the annual retrospective on the national accounts also implies that inflation fundamentals are slightly worse than we thought. Thus, while I think that the rise in inflation is cyclical, inflation risks are still moving higher. And while officials could still decide to pause at the FOMC meeting next week, in my view it’s premature to think that the Fed is finished tightening, much less that easing will soon be on the way. Here is why and a consideration of the risks. First, it is important to diagnose the deceleration in economic activity that has just occurred. In my opinion, declining housing affordability, higher energy quotes, and the payback from a strong first quarter all depressed second-quarter growth. Courtesy of soaring home prices and rising interest rates, the slide in affordability has promoted a year-long decline in demand, and builders are now scrambling to cut housing construction to align it with sales and trim unwanted inventories. That scramble will probably intensify in coming months. The surge in gasoline and other energy prices drained some $65 billion (0.7% of disposable income) from consumer purchasing power over the second quarter. That hit to income alone would have been enough to cut spending growth in half following the 4.8% first-quarter spending surge. In addition, however, exceptionally warm January weather and the rebound in activity following last year’s hurricanes exaggerated growth in the winter at spring’s expense. Spring declines in business equipment and federal government spending — in turn representing paybacks from exceptional first-quarter strength — magnified the second-quarter deceleration. The upshot: There are fundamental reasons why growth slowed sharply in the spring. But there are also enough distortions in the data to question whether this deceleration is at least partly the product of a confluence of special factors or the start of a more lasting slowdown. The answer, as I see it: Our case for moderately stronger second-half growth — which is now way out of consensus — is still intact. Most important, the strong gains in wage and salary income implied by booming tax collections are now more evident in the recasting of the official data. Despite surging energy quotes, real wage and salary income rose by 3.4% over the past year — a six-year high and eclipsing the growth in spending for the first time in six years. With the growth in non-wage income also strong, even modest relief from energy price increases should unleash stronger growth in consumer spending and increased thrift. What’s more, pent-up demand for capital spending is still likely to boost capex. In fact, it is probably even stronger in light of annual revisions that trimmed the growth of such outlays from a previously-estimated 8.3% to 6.4% over the 13 quarters ended in the first quarter of 2006. As a consequence, the ratio of equipment and software outlays to depreciation — a key metric for judging such demand — is now 1100 basis points lower than previously thought. Although recent capex orders haven’t been strong, unfilled orders for such goods have surged 15% annualized in the first half of this year, practically assuring a rebound. In addition, strong gains in overseas demand likely will sustain hearty export outlays, and the anomalous spring declines in federal government spending are unlikely to be repeated. Inflation fundamentals, meanwhile, have deteriorated slightly, with compensation accelerating and the trend in productivity growth possibly lower than previously thought. The good news on the inflation front is that both surveyed and market-based inflation expectations have receded from their peaks. Five-to-ten year inflation expectations stood at 2.9% in July, according to the University of Michigan canvass, or 30 bp below their May peak. And 5-year forward 5-year breakeven inflation as measured in the TIPs market stands at 260 bp, or 13 bp below the peak in May. Both those developments in my view point to a peaking in inflation sometime next year. The bad news comes from the revisions to price, income and GDP data. Core inflation measured by the personal consumption price index was revised higher in 2003 and 2005, so that monetary policy has been more accommodative than previously thought. And we estimate that such inflation likely rose to 2.4% in June, close to the upper end of the Fed’s just-released central tendency for all of 2006. In addition, much faster compensation gains imply that unit labor costs probably reached a six-year high of 3½% in the second quarter, or more than 200 bp higher than previously thought. While I think the trend in productivity growth is 2½-2¾%, the downward revisions to real growth in GDP over the past three years, averaging 0.3%, and the reduction in laborsaving investment growth over the same period hint at possible downside risk to that trend. To be sure, I believe that the inflation process starts with inflation expectations, not with labor costs. Accelerating labor costs in the past have typically been a late-cycle development, reinforcing and strengthening the incipient rise in inflation. Unfortunately, and notwithstanding the many secular, global disinflationary forces that now exist, in today’s context of firmer product and labor markets, these forces have the potential to reinforce the ongoing rise in inflation in time-honored cyclical fashion. Neither bond- nor equity-market participants seem prepared for the implications of these developments. Both seem to be celebrating the end of Fed tightening prematurely, but for very different reasons. Bond-market participants appear to be anticipating that poor economic prospects will reduce inflation and prompt Fed ease, while equity investors hope that acceptable growth and a gentle Fed will promote expanding multiples. Both cannot be right. In fact, I worry that both may be wrong, at least over the next few months. If we are right about both growth and inflation, the policy prescription is straightforward and implies that the Fed has more work ahead. Were officials to agree, no pause in tightening would be appropriate. As I see it, however, given the Fed’s more benign outlook, and with officials now — realistically — likely to tolerate inflation outside the comfort zone into 2007, the risk is that they will be playing catch-up to economic developments, and that rates will ultimately have to go even higher than we now expect.
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Review and Preview
Jul 31, 2006
Ted Wieseman (New York) and David Greenlaw (New York)
Treasuries posted significant front-end-led gains over the past week as the market moved to largely price out the possibility of a Fed rate hike on August 8 – and only about an even chance of any further hike beyond that before an expected shift to easing in early 2007. That followed a Beige Book that pointed to more widespread indications of moderating growth, and also a significantly weaker than expected 2Q GDP report. With Fed Chairman Bernanke having clearly laid out the FOMC’s expectation that slowing growth will eventually reverse the recent significant upside in underlying inflation, the market ignored some potentially worrisome underlying details on the inflation outlook in the GDP report and continued reports of scattered signs of business pricing power to pass through recent surging costs in the Beige Book. Most notable on the inflation front in the GDP report were revisions that now portray a sharp acceleration in employee compensation in recent quarters that should lead to a dramatic upward adjustment to unit labor cost growth when the Q2 figures are reported August 8, as well as a modest upward adjustment to core PCE inflation that should leave the June reading (reported Tuesday) at a higher than previously expected +2.4%. This newly depicted surge in consumers’ income, with wage and salary growth now showing a nearly 7% year/year rise in Q2, a six-year high, also provided a very positive backdrop for stronger consumer spending in the second half even as housing wealth effects fade and prompt a rise in savings. Forward looking indicators for capital spending also look quite positive after the very disappointing and surprising decline in business investment in equipment and software in Q2, with unfilled ex aircraft capital goods orders surging through the first half of the year. So while Q2 was clearly disappointing, we see good reasons to continue to look for a pickup to somewhat above trend growth in the second half – the major focus will be on Friday’s employment report for some near-term confirmation of this. With the inflation backdrop also continuing to worsen, we don’t see the Fed as out of the picture yet. Benchmark Treasury yields fell 3 to 8 bp over the past week to their lowest level since before the release of the May CPI report on June 14. The curve steepened somewhat, though the cumulative move since Chairman Bernanke’s July 19 testimony remains very small in light of the dramatic change in Fed policy expectations over this period, with 2’s-10’s rising 3 bp and 2’s-30’s 4 bp on an 8 bp drop in the old 2-year yield to 5.00%, a 5 bp rally in the 10-year yield to 4.99%, and a 3 bp dip in the long bond yield to 5.07%. The 3-year yield fell 8 bp to 4.94% and the old 5-year yield 7 bp to 4.92%. After mediocre demand from investors at the auctions, the new 2-year and 5-year issues ended well in the black, with the new 2-year closing Friday at 4.98% after being auctioned Wednesday at 5.09% and the new 5-year ending the week at 4.91% after being awarded Thursday at 4.995%. Fed expectations in the futures market were scaled back dramatically, first in response to the Beige Book Wednesday and then to a much larger extent after the weak GDP report Friday. The August fed funds contract gained 2 bp on the week to 5.31%, dropping the odds of a rate hike on August 8 to only about a one in three chance, while the peak rate November contract gained 5.5 bp to 5.365%, leaving the market just pricing in the likelihood that the Fed is already done for the cycle. Even with this lower expected peak in the funds target, the market continued to price in more rate cuts next year and sooner. The Dec 06 to Dec 07 eurodollar futures spread fell 2.5 bp to an all-time low -27 bp, with the former rallying 8.5 bp to 5.45% and the latter 11 bp to 5.18% (and thus fully pricing a cut to a 5.00% funds target by the end of next year). The bulk of this inversion is in early 2007, Dec 06 to June 07 at -17.5 bp, so a switch to rate cuts is expected early by the market. The TIPS market, particularly the long end, had a very strong week after huge investor demand at the 20-year auction. As a result, the Fed’s preferred measure of market-based inflation expectations continued inching higher – calculated from the benchmark issues, the 5-year/5-year forward breakeven inflation rate rose 7 bp on the week to 2.63%, a more than two-month high (looking at off-the-runs, the move was smaller, but still left it near the high since the end of May). Consumer inflation expectations also saw some upside, with the 5-year ahead median inflation expectation in the Michigan survey for all of July revised up a tenth to 2.9% from the early month, pre-Bernanke reading. The week’s key driver was the very disappointing second quarter GDP report. Real GDP rose a much less than expected 2.5% in Q2. The main surprises from our perspective were a smaller than expected contribution from inventories (+0.4pp), a dip in business investment in equipment and software (-1.0%) that was much weaker than seemed to be implied by shipments figures, and a drop in the recently very volatile federal government category (-3.4%). Consumption rose 2.5%, as expected, but the downside in investment (+2.7% overall thanks to a surge in the structure component), government (+0.6% overall with a boost from state and local spending), and an as expected drop in residential investment (-6.3%) led to a sluggish 1.6% rise in final domestic demand. Aside from the post-Katrina fallout in 2005Q4, this was the slowest quarter for domestic demand since 2003Q1. The report also contained negative historical revisions to growth. On a Q4/Q4 basis, there were downward revisions to GDP growth in 2005 (+3.1% v. +3.2%), 2004 (+3.4% v. +3.8%), and 2003 (+3.7%. v. +4.0%). Growth in Q2 was clearly disappointing, but we found another largely overlooked aspect of the report quite encouraging for the growth outlook and potentially quite negative for the inflation backdrop. In particular, there was a dramatic upward revision to the recent growth of total employee compensation and the key wage and salary component. We had been scratching our heads for some time trying to understand how it was possible that we could be seeing the recent off-the-charts growth in withheld income and payroll tax collections when the official data on wage and salary income growth were suggesting such modest growth in the tax base. Our speculation was that the recent growth in wages was understated in the official data and due for an upward revision (see, for example, the article “Tipping Point?” by Dick Berner from July 17) and we were gratified to see this supposition verified in Friday’s GDP report. Growth in total employee compensation was revised up to +5.5% in 2005 (on a Q4/Q4 basis) from +4.6% and in Q2 all the way up to +6.8% from just above +5% (based on monthly data for April and May). The core wage and salary income component of total compensation was revised up to +5.1% from +4.0% in 2005 and to +6.8% from less than +5% in Q2. These were the strongest rates of growth of both total compensation and wages and salaries in nearly six years, providing a very positive backdrop for both reasonably strong growth in consumer spending in the second half and also a rise in the personal savings rate as housing wealth effects fade. These revised income figures also have dramatic implications for business costs and thus potentially inflation. The latest figures for Q1 showed unit labor costs up just 0.3% year/year. However, based on the new income data, we look for a significant revision to the cost data. In fact, we expect the annual reading for Q1 to be revised all the way up to +2.2%, and we forecast that Q2 will show a further acceleration to +3.4%, reflecting both the revisions to compensation and the slowdown in output registered in Q2. This would significantly draw into question one of the arguments Fed Chairman Bernanke made in his monetary policy testimony against upside inflation risks – “Although the costs of energy and other raw materials are important, labor costs are by far the largest component of business costs. Anecdotal reports suggest that the labor market is tight in some industries and occupations and that employers are having difficulty attracting certain types of skilled workers. To date, however, moderate growth in most broad measures of nominal labor compensation and the ongoing increases in labor productivity have held down the rise in unit labor costs, reducing pressure on inflation from the cost side.” While prior spikes in unit labor costs over the course of recent years were seen as temporary because they were apparently triggered by the exercise of stock options, as tight as labor markets currently are we see no such indication that the latest move will prove short-lived. In addition to the potential future risks from upside to unit labor costs, current inflation figures are also likely to look a little worse than previously expected when the monthly breakdown of the new quarterly figures are released Tuesday. For all of 2005 (on a Q4/Q4 basis), growth in the core PCE price index was revised up slightly to +2.1% from +2.0% and growth in Q2 reached +2.3%. Previously reported monthly data showed both April and May up 2.1%, and we were looking for a move up to +2.3% in June. It will be sensitive to the exact monthly pattern of the historical revisions, but assuming the recent monthly pattern is roughly similar, we now see core inflation rising to +2.4% in June, which would already place it near the upper end of the Fed’s full year forecast of +2 1/4% to +2 1/2%. The surprising decline in business investment in equipment in software in Q2 seemed to be quite a bit weaker than implied by the capital goods shipments figures contained in the durable goods report for June released the past week. The divergence appeared to at least partly be a result of BEA’s new methodology for computer investment (now based mostly on IP figures adjusted by an unpublished BEA price series, with a much lower weight now given to shipments), as growth in real computer investment showed a huge deceleration. Whatever the reason, investment was clearly disappointing in Q2, but like the positive implications of the income figures for consumers, some underlying details of the durables goods report for June released the past week were positive on a forward looking basis. In particular, unfilled orders for nondefense capital goods ex aircraft jumped 1.4% in June and have now surged at a 15% annual rate so far this year, the strongest gain over a six-month period in over six years. We expect that the income support to consumer spending, stronger capital spending, and continued robust gains in exports based on the very positive global growth backdrop should more than offset an expected cratering in the housing market in the second half and allow growth to run near 3 1/2%. We are building a 15% annualized decline in real residential investment into our second half forecast, and reports on housing sales the past week continued to highlight the precarious state of the market as inventories of unsold homes continue to post huge increases. New home sales fell 3.0% in June to a 1.131 million unit annual rate, while sales in May were revised down sharply to 1.166 million (+0.5%) from 1.234 million (+4.6%). This still left sales in June 9% above the February trough, a large disconnect from a significant deterioration in the homebuilders’ survey over this period. Meanwhile, existing home sales continued to edge gradually lower, dipping 1.3% in June to a still-robust 6.62 million unit annual rate. Despite sales having held up relatively well so far – which we doubt is sustainable – inventories of unsold homes continued to surge, with unsold new homes up 24% year/year and existing 39%. The months supply of new homes rose to 6.1 and existing 6.8, compared with 20-year averages of 5.3 and 6.3, respectively. The upcoming week is a busy one, with a heavy calendar of key data releases and the quarterly refunding announcement Wednesday. The Fed, however, will be largely on the sidelines again after no public appearances the past week as we head into the traditional quiet period ahead of the August 8 FOMC meeting. There will be two speakers Monday – dovish San Francisco Fed President Yellen and St. Louis Fed President Poole, who told USA Today in mid-July that thinking about the possibility of an August rate hike he was “50-50 coming out of the June meeting, and that’s exactly where I am at today.” Minneapolis Fed President Stern will speak Friday on banking issues Friday and is very unlikely to say anything relevant to monetary policy so close to the FOMC meeting. At the refunding announcement, we look for a $21 billion 3-year, $13 billion 10-year (both unchanged from last time), and a $10 billion reopening of the long bond. Risks as we see them would be tilted towards slightly smaller sizes given the continued surge in tax revenues that has carried through July and continued to bias budget deficit forecasts lower, as well as the suggestion from the Treasury in the pre-refunding dealer questions that they may have some concerns about bill sector liquidity conditions and thus might be inclined to switch some issuance into that rapidly shrinking share of the market. The current auction calendar looks to have plenty of flexibility to deal with a wide range of medium-term budget outcomes, so we don’t expect to see any significant announcements in that regard on Wednesday. Main focus on the data calendar will be Friday’s employment report, inflation figures in Tuesday’s personal income and spending report, ISM Tuesday, and early indications of July consumer spending in the auto sales results Tuesday and chain store sales numbers Thursday. Other releases due out include construction spending Tuesday and factory orders Thursday: * We forecast a 0.7% increase in June personal income and a 0.5% rise in spending. Job gains were subpar once again in June, but the labor market report showed solid increases in both average hourly earnings and the workweek, implying an above-trend jump in overall income. Meanwhile, a modest rise in motor vehicle sales should lead the way on the spending side. Finally, the key core PCE price index is expected to rise 0.2% (just barely rounding down from +0.25%), with the year/year rate rising to +2.4%. * We look for a decline in the July ISM to 53.0 from 53.8. The regional surveys that have been released to this point imply some further slippage in the national ISM. However, because the Empire and Philly gauges were somewhat more elevated than the ISM in June, we don’t expect to see quite as much of a pullback. Meanwhile, the prices paid index is expected to remain quite elevated. Indeed, rising prices for industrial materials still seems to be an important headwind for the manufacturing sector. * We forecast a 0.2% dip in June construction spending. The drop in housing starts points to some further slippage in residential activity and a third straight dip in overall construction spending. However, a rebound in nonres and ongoing gains in the public category tied to large-scale infrastructure projects should provide some offset in June. * Morgan Stanley’s analysts expect July motor vehicle sales to rise to 17.0 million units annualized from 16.3 million in June. Slower than expected demand during the second quarter caused some automakers to overbuild. The associated inventory concerns led to a roll-out of new marketing campaigns and incentive offerings which appear to have triggered the best sales month since January. * We look for a 1.8% rise in overall factory orders in June, as a sharp jump in the durables component points to a solid gain in overall bookings. Meanwhile, shipments are expected to be little changed, with inventories rising 0.5%. This combination should leave the I/S ratio near its record low of 1.15. * We expect nonfarm payrolls to rise 175,000 in July. In the face of continued low readings for unemployment claims, ongoing gains in withheld tax receipts at the federal level, and a surge in employment as measured by the household survey, we remain somewhat suspicious of the moderation in employment growth evident in the payroll figures over the past three months. So, we anticipate at least a modest pickup in job gains in July. In particular, the retail sector appears overdue for some upside, and there are fairly widespread reports of strong demand for summer hires, which should be particularly evident in the leisure category. Finally, the unemployment rate is expected to hold steady at 4.6%, and average hourly earnings should moderate a bit to +0.3% following the outsized gains registered of late.
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Fairy Tales of the US Bond Market (Tale 3)
Jul 31, 2006
Joachim Fels (London) and Manoj Pradhan (London)
In the first two instalments of this tale, we presented and discussed our proprietary, model-based estimate of MS FAYRE, the fundamental fair value for the 10-year US Treasury yield. In today’s third and last instalment, we compare our results to the Fed’s separate estimates of the term premium and find some striking similarities. Our full report including charts and a technical Appendix is available on Morgan Stanley’s Client Link. Demystifying the ‘term premium’The Fed’s term premium estimate … Much has been made in recent papers and commentary about a decline in the so-called ‘term premium’ in US bond yields. Most prominently, Don Kim and Jonathan Wright (2005), two researchers at the Federal Reserve Board, estimated a decomposition of the term structure of nominal interest rates into expected future short rates and term premia. The decomposition is based on a model that almost completely abstracts from macroeconomic fundamentals. The term premium in their model is a catch-all for the compensation investors demand for the uncertain return on holding a long-term bond rather than rolling over short-term deposits for the lifetime of the bond. Kim and Wright find that much of the decline in long-term yields during the 2004/2005 conundrum episode is due to a decline in the term premium. Moreover, updated estimates of their term premium estimates available on the Fed’s website suggest that around half of the increase in bond yields since the start of this year can be attributed to a back-up in the term premium. … is highly correlated with deviations of yields from MS FAYRE! Comparing the Fed’s measure of the term premium to the residual of our fundamental fair model (that is, the deviation of actual bond yields from MS FAYRE), we are struck by the high degree of correlation between the two series. The two series usually move in the same direction and share joint peaks and troughs. Two different methods, similar results. This correlation is remarkable because the two series are produced by two very different methods. Our residual is the unexplained part of the actual bond yield after taking into account the impact of our three fundamental factors, whereas the Kim-Wright term premium is the result of a decomposition procedure that is not based on economic fundamentals. The fact that two very different theoretical and empirical approaches come to similar results suggests that the resulting estimate of the term premium and our MS FAYRE model are fairly robust. Note that while our residual is stationary over time, the Kim-White term premium slopes downward during much of the 1990s. We offer a simple explanation for this difference: One of the three fundamental factors in our model is the volatility of inflation, which we use as a proxy for the inflation risk premium. Thus, our model already incorporates and accounts for one of the factors that make up the term premium. This inflation risk premium has fallen during the 1980s and 1990s. While our estimate of MS FAYRE captures this part of the term premium and thus eliminates it from the residual, the inflation risk premium is still part of the Kim-Wright term premium and likely explains the latter’s downward slope during the 1990s. In fact, when we extract our estimate of the inflation risk premium from the Kim-Wright term premium, the residual of our MS FAYRE equation and the ‘corrected Kim-Wright term premium’ become almost identical. Bottom line and health warningOur main conclusions … We use a simple, three-factor fundamental model of bond yields to estimate MS FAYRE, the fundamental fair value for 10-year US Treasury yields. The three factors are the real fed funds rate, inflation expectations and inflation volatility. Cross-checking our model against the Fed’s measure of the term premium suggests that our estimates are robust. Bond yields have deviated from MS FAYRE by as much as 100bp on several occasions during the past 25 years. Such extreme deviations have typically been corrected by major bond market sell-offs or rallies. The same happened with last year’s interest rate conundrum, which was not atypical in the historical context. Following this year’s bond sell-off, 10-year yields trade relatively close to the present MS FAYRE of 5.3%. Thus, bonds are in the neutral zone from a pure valuation point of view. … and the health warning. Note that MS FAYRE should not be used to forecast the near-term direction of bond yields, which can be driven by many other factors. However, it can be a useful valuation tool for medium- and longer-term-oriented investors, especially when it signals major deviations from fair value. Stay tuned!
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'Cause I Told You So
Jul 31, 2006
Elga Bartsch (London)
Anything other than a 25bp interest rate hike by the ECB at the upcoming Governing Council meeting on August 3 would be a major surprise to the ECB watching community. The main reason for financial markets to price in a further gradual tightening of a quarter point with almost complete certainty this coming week is that ECB President Trichet told us so in the previous ECB press conference in early July. Back then Trichet stated that the ECB Council would “exercise strong vigilance” regarding the upside risks to price stability, which historically has been used to telegraph an imminent refi rate hike. The chances of a larger move of 50bp are remote at this stage, in our view. This is due to the uncertainty regarding the continuation of the current upswing over the medium term and due to what seems to be a rift within the Council regarding how much monetary policy action is warranted. Since the July meeting, when the ECB Council agreed that it would most likely raise rates again in early August and therefore instead of holding a teleconference decided to meet in person and schedule an extra press briefing, economic activity and inflation data have, on balance, surprised on the upside. For starters, business sentiment has held up better than expected in many euro area countries. In some countries, business sentiment even improved unexpectedly in July. Moreover, the details of the surveys paint a very robust picture of euro area GDP growth as the economy enters the third quarter (see Business Cycle Watch: Not Yet Landing, July 28, 2006). Also, labour market conditions continue to improve and consumers, at least in Germany and France, have become more confident in recent weeks. Thus far, there’s little indication that events in the Middle East are starting to take a toll on euro area confidence indicators. Only the German ZEW investor survey showed a noticeable downgrade in analysts’ business expectations in the wake of the recent events. With ZEW business expectations now below the long-term average, analysts are clearly much more bearish than company captains on the prospects for the German economy. Meanwhile, consumer price inflation might not have eased as expected in July from the 2.5%Y recorded in June. Together, the rise in German HICP inflation to 2.1%Y, a stable 4%Y reading in Spain and an Italian clip, which showed a slight moderation to 2.3%Y, suggest that an unchanged reading of 2.5%Y is now equally as likely as a decline to 2.4%Y when the flash estimate of EMU HICP is reported this coming week. Near term, the renewed rise in crude oil prices and, to some extent, in fresh food prices causes the risks to near-term projections to tilt to the upside. Back in 2003, hot and dry summer weather added about 1.5% to food prices over the summer and autumn, thus temporarily adding up to two-tenths to headline inflation. Break-even inflation rates, measuring inflation expectations embedded in the inflation-linked bond market, have eased slightly since early July. Falling from 2.25% to 2.19%, market-based inflation expectations for the average inflation rate over the next ten years remain noticeably above the ECB’s 2% ceiling. At long last, monetary developments show tentative signs of somewhat slower dynamics in money supply and credit growth. The slowdown was visible not only in headline M3 money supply growth, which slowed from 8.8%Y in May to 8.5% in June, but also — and more so — in narrow money supply growth (M1), which fell from 10.2%Y in May to 9.3%Y in June. The slowdown in money supply growth is largely driven by a moderation in private sector loan growth. While still being considerably above the reference value, the moderation should help to assure the ECB Council that its tightening campaign is starting to take effect. That said, liquidity in the euro area still remains ample. On balance, monetary developments therefore still likely add to the upside risks to price stability. As usual, it probably won’t be the ECB interest rate decision that could potentially move financial markets this coming week (see C. Brand, D. Buncic and J. Turunen, The Impact of ECB Monetary Policy and Communication on the Yield Curve, ECB Working Paper No. 567, July 2006). If anything, it would likely be the press briefing with ECB President Trichet that could potentially turn out to be a market-moving event. Here, observers will be keen to gauge the timing of the next ECB interest rate hike. Thus far, the ECB always reverted back to “monitoring upside risks to price stability closely” after an upward adjustment in rates. While it would be premature, in our view, to expect any hints that the ECB is getting closer to the end of its tightening campaign, we would watch out for any commentary indicating how the ECB Council is concerned about recent events in the Middle East and their repercussions on the euro area growth and inflation outlook. But, all in all, we would deem the risks to GDP and inflation forecasts — including our own above-consensus estimates — to be on the upside for this year.
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Sayonara to the Old Data
Jul 31, 2006
Takehiro Sato (Tokyo)
Both the June nationwide and the mid-July Tokyo metropolitan core CPI, at +0.6% and +0.4% YoY, respectively, meshed with the market consensus. The standout points this time, however, were (1) the Tokyo metropolitan core CPI, which settled despite a blitz of price hikes in July for gasoline, tobacco, and tissue paper; and (2) the US-style Tokyo metropolitan core, which posted identical growth MoM and was still +0.1% YoY, which implies that the wholesale prices hikes for some consumable items seem to have been absorbed at the final retail sales stage. For the next CPI release, covering the July nationwide and August Tokyo metropolitan data, we think the 5-year CPI benchmark revisions to be made as follows will suppress core CPI growth by about 0.2-0.3ppt at a conservative clip. In short, we think price growth is peaking in F1H06. The wildcards in this scenario are crude oil prices and dollar/yen rates, however. Unexpectedly large impact from CPI revisionsThe Ministry of Internal Affairs and Communications (MIC) is due to undertake its five-yearly revision of the CPI benchmark with nationwide data for July and Tokyo data for August due out on August 25. When the benchmark was last reset in August 2001 (from 1995 to 2000), a significant gap of -0.31ppt opened up between the before and after core inflation rates. So we have examined the prospective impact of the revisions in August. Ultimately, judging from the (1) substitution effect (impact on prices from the shift in consumption categories: +0.09ppt), (2) quality shift + new product impact (impact from replacing new products where prices have fallen sharply: -0.05ppt); (3) impact from imputed rents revision (-0.14ppt), and (4) impact of benchmark resetting (about -0.1ppt from altered levels for the various components arising with the shift from 2000 to 2005 as the benchmark year), we estimate the likely before-and-after gap in the core CPI inflation rate at about -0.2ppt . We have also set conservative estimates above for the downward impact on prices, because we must consider the admittedly hard-to-quantify impact of (5) the outlet effect (consumers shifting purchases to superstores) and (6) charge sample revisions (reflecting the latest discounts in mobile phone charges, for example). As such, we assign a -0.3ppt impact from the benchmark revisions. In light of this, we look for the core inflation rate prior to adjusting for the benchmark revisions to come in at +0.6% YoY in July-September, +0.5% in October-December and +0.3% in January-March 2007. After adjusting for the benchmark revisions, we look for respective growth of +0.3%, +0.2% and +0.0%, which suggests that price growth is peaking during the first half of F2006. Our forecasts for average growth in F2006 is +0.5% YoY (about +0.2% after factoring for the revisions), further below the BoJ’s outlook of 0.6% YoY growth. Basically, the impact should not be that visible if price growth was relatively strong like in other developed countries, but when the inflation rate is as low as it is in Japan at the moment, the effects are likely to become impossible to dismiss out of hand. It may be that once the effects of these revisions in the price data have actually started to emerge, they start to have some influence on future monetary policy, as examined below. Policy outlookAlthough the BoJ lifted ZIRP on July 14 as expected, we maintain our basic view that, once ZIRP has been lifted, the subsequent pace of interest rate growth is likely to be more measured than consensus forecasts. Indeed, we think the market consensus has moved closer to our viewpoint due to the remarks and the speeches given by the governor and the deputy governor. Therefore, we envision a rate hike timetable for 2006-07 of basically two half-year intervals, with one in the Jan-Mar 2007 quarter and again in the Jul-Sept 2007 quarter (+50bp). Our reasons for anticipating just three rounds of rate increases including July’s ZIRP lifting are that, first, we assume productivity will continue to improve and we therefore have a more cautious view on the outlook for prices than either the market consensus or the BoJ’s forecasts. Second, we expect a heavier focus on the relationship with fiscal policy in implementation of monetary policy after the new Cabinet gets going in late September, or perhaps after the Upper House elections in summer 2007. Third, we allow for the prospect that US monetary policy will start easing from the October-December quarter of 2007. As for the productivity issue, we are optimistic that the Japanese economy will continue along a path of improved productivity while restraining price pressure, given that: (1) the mass retirement of senior workers ahead will realign the labour force, making for a more efficient labour market, (2) fixed capital expenditure continues to grow, and (3) large-scale surplus remains in production resources in regional economies (for instance, the job offers-applicants ratio in June stood at 1.92x in Aichi Prefecture but 0.62x in Hokkaido). In other words, we are sceptical of the BoJ’s view of a runaway economy brought by rising prices from higher unit labour costs. Actually, the Monthly Labour Survey shows that nominal wage growth is less than +1% YoY, and real wages adjusted for growth in consumer goods prices are trending either flat or down slightly. Nevertheless, the BoJ does have some tailwinds: (1) an ultra-weak yen on a real effective base, and (2) the possibility that monetary tightening will be delayed due to a recovery in tax revenues. As a result, we see a likelihood that rate hikes will not end in 2007, but extend into 2008. Therefore, under the current phase of fiscal tightening, we think that Japan’s policy rate is unlikely to reach the level of neutral interest rates (i.e., 2.5-3%, assuming that the current potential growth rate is 1.5-2% and a 1% inflation target); however, we believe that it may move to mid-1% in the run-up to the next fully fledged phase of fiscal tightening in F2009.
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