US
Risks to the Bond Call
Aug 21, 2006

Richard Berner (New York)

We are moderately bearish on US bonds at current yield levels because they seem to reflect the view that US inflation has peaked, that growth will continue to slow, and that volatility will remain at current low levels.  In other words, relative to our stance that 10-year yields should trade in a range with 5% at the bottom, there’s now a lot of bond-friendly news in the price.  To be sure, if valid, the triple combination of assumptions that constitute the current consensus should reduce real yields, inflation compensation, and the risk premiums associated with each.  Likewise, the combination, if it occurs, should alter the trajectory of monetary policy that drives short-term rates and the level of nominal long-term yields associated with them. 

In contrast, we are unconvinced that any of these three factors will unfold just as the market is now pricing them, let alone that all three will materialize together.  Moreover, if term premiums have declined from where they were in May and June, that should make financial conditions easier, and the Fed more, not less likely to tighten policy.  Finally, US fixed income markets seem to be ignoring the consequences of strong growth in overseas domestic demand for US output.  Although transatlantic and transpacific yield spreads likely will continue to narrow in that context, diminished availability of global saving could also put a floor under US yields.  But with the market moving against us, it’s imperative to examine the risks that we’re wrong.

Parsing yields into real and nominal components can be helpful to diagnose whether market pricing seems sensible.  In that regard, the fact that real yields have paced the recent rally is logical, given fears about growth.  Judging by the TIPS market, on-the-run, real risk-free yields along the maturity spectrum stand at about 2.25%, down about 40 bp from their peaks at the end of June but slightly above their average of the past three years. 

Specifically, it’s not surprising that real yields have slipped from their highs, given the recent run of soft economic data, the pessimism in consumer and business conditions surveys, and the dramatic production cuts announced by a major motor vehicle manufacturer for the fourth quarter (see, for example, “A Deeper Slump: In Business Conditions or in Business Confidence?” Global Economic Forum, August 18, 2006 ).  All these seem to portend that US growth could slip well below the 3.6% seen over the past year and also under its trend rate of 3¼-3½%.  Indeed, those who are extremely bearish on US growth, like my colleague Gerard Minack, argue that they remain bullish on bonds precisely because they think real yields have further to fall.  Historical TIPS market comparisons may not provide accurate guidance, however, because TIPS were relatively new and less liquid during the last recession, so TIPS yields (at constant maturity) then were some 75-100 bp higher than they are today.  Still, if views about growth continue to fade, real yields could slide with them.

Calibrating inflation compensation from breakeven inflation (BEI) calculations in the TIPS market is also problematic in historical context.  But at roughly 2.6%, neither the 10-year BEI nor the distant forward (5-year, 5-year forward) BEI seems out of line with a realistic medium-term view of where inflation is headed.  Of course, getting to such an inflation rate would require a big deceleration from today: The framers of TIPS used the overall CPI-W to calculate BEIs, and courtesy of a 20.5% increase in energy quotes, that metric indicated inflation ran at 4.3% over the past year.  But if global growth cools and supply shocks don’t materially affect energy supply, energy prices could fall for the first time in 5 years and headline inflation by that measure could fall below 2½% next year.  Still-lower inflation and inflation expectations could bring down BEIs and thus nominal yields.

In my opinion, those are potentially powerful fundamental forces shaping yields, and if all this fell into place, they could be consistent with a monetary policy that turns back to neutral or even accommodation next year, as the Eurodollar curve is starting to price in.  But even if they do, there are two other important yield determinants that could work in the opposite direction.

First, volatility and thus apparently term premiums have sunk significantly since their peaks in May and June.  Measured by the VIX index, equity market volatility has fallen by half in the past two months, and measured by the investment-grade credit default swap market, the cost of default protection has fallen by 6 bp over the same period.  Three-month forward premiums for two-year swaption volatility have drifted lower, and risk appetite seems to have returned in full force to just about every asset class.  While we don’t have recent model-based data for term premiums, we presume that such premiums in the bond market — reflecting the volatility of both growth and inflation — have also drifted lower, despite the clear message from Fed officials that their next policy move is unclear.   In my view, that decline, along with the rise in risky asset prices, makes financial conditions more stimulative, not less so, and ought to make the Fed more inclined to firm monetary policy again (see “The Term Premium Case for Higher Yields,” Global Economic Forum, January 20, 2006).

In addition, market participants may be ignoring the consequences of strong overseas growth for the US economy and for the global balance between saving and investment.  We’re betting that strong global growth, paced by improving overseas domestic demand, will sustainably boost US net exports for the first time in two decades and will contribute to improved US job and income gains.  Moreover, we still think that strong pent-up demand will fuel stepped-up US capital spending.   All three will help promote a moderate second-half acceleration in US economic activity (see “Betting on Global Growth,” Global Economic Forum, August 14, 2006).  And the strength in overseas domestic demand implies that saving abroad — that might have in the past kept global real yields low — will now be better balanced by rising investment and consumption outlays.  So while US-overseas yield spreads likely will continue to narrow in that context, the change in internal and external imbalances could also put a floor under US yields.

Partly as a consequence, we also think that risks to both US growth and inflation lie above what is in the price and that the monetary policy implications are less bond-friendly than what is now priced in to the yield curve.  The auto production cuts will trim about 0.2 percentage point from fourth-quarter growth.  But wholesale gasoline prices have plunged by 30 cents in the past two weeks and augur a 15-20 cent decline in prices at the pump and a parallel $20-25 billion boost for consumer discretionary spending power.  Together with the improvement in net exports, stronger defense and investment outlays, and a boost from inventory accumulation, we still think 3-3½% growth in the second half of this year is a realistic possibility.

Likewise, we think it is premature to judge that the recently better consumer inflation news marks a fundamental downshift in inflation.  Measured by the University of Michigan canvass, consumer 5-10-year inflation expectations edged back up to 3.1% in early August, and it appears from commentary that the rebound involved more than just higher gasoline quotes.  Slack in product markets continues to ebb.  And July’s moderation in core inflation owed importantly to seasonal markdowns in apparel quotes; August’s inflation readings thus may not be so benign. 

Ten-year yields are below what we think is a realistic trading range, with 5% as a floor.  The recent rally seems to have changed sentiment in US fixed-income markets, forcing bears to cover their shorts.  With the market now priced to bond-friendly news, signs that growth is stronger, inflation is higher, or volatility is rising will promote higher yields.

Notwithstanding our relative optimism on US growth, however, the near-term news could be more bond-friendly than we’ve expected.  The slide in housing activity continues, and incoming data for factory orders and retailing may be weak.  But with a lot of good news for bond bulls in the price, it won’t take much adverse inflation or stronger growth readings to promote a reversal in bond yields.

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US
Review and Preview
Aug 21, 2006

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

Treasuries posted sharp gains across the board in the latest week that sent yields to four-month lows, as some moderation in core inflation readings – which, in our view, was driven by special factors and thus likely to prove temporary – prompted a wave of short covering and led investors to significantly scale back near-term Fed expectations so as to price in the likelihood that there will be no more rate hikes and also, for no obvious reason, to sharply increase the amount of easing expected next year from this lower expected peak in the funds target.

 

Indeed, the eurodollar futures market is moving to price the likelihood of a 4.75% year-end 2007 funds target. While the inflation results were the dominant market focus on the week, growth data were mixed, portraying an increasingly familiar dichotomy between strength in factory sector output, seen in both a robust industrial production report for July outside of a pullback in the volatile motor vehicle sector and upside in the early regional manufacturing surveys for August that pointed to a strong ISM, and weakness in the housing market, seen in a modest further pullback in housing starts in July and a continued collapse in the homebuilders’ survey for August. But the market did not pay much attention to these data, nor did it take much notice of some really ugly inflation expectations readings in the University of Michigan survey that have to be of considerable concern to the Fed. And this survey based breakdown in inflation psychology was accompanied by somewhat surprising stickiness in the Fed’s favorite market-based measure, as the 5-year/5-year forward TIPS breakeven inflation rate barely budged from its recent elevated level as a sharp decline in the 5-year breakeven outpaced a smaller drop in the 10-year spread. After some, we expect, temporary moderation in core inflation driven by big quirky moves in particular categories (autos in PPI, clothes in CPI) that seem very unlikely to be repeated, and a deterioration in inflation expectations, it certainly seems too early to be calling the all clear on inflation risks and assuming the Fed will soon be reversing course to cut rates.

 

Benchmark Treasury yields plunged 9 to 13 bp over the past week, reaching their lowest levels since April. There was a decent flattening move in 2’s-3’s, with the 2-year yield down 9 bp to 4.87% and the 3-year yield down 12 bp to 4.80%, as the eurodollar curve inversion cranked to yet another series of new lows, but otherwise the curve didn’t do much, with the 5-year yield down 12 bp to 4.78%, the 10-year 13 bp to 4.835%, and the 30-year 12 bp to 4.97%. And after having moved back towards pricing in one more rate hike before year-end after the strong retail sales report (with some further follow-up Monday), Fed pricing swung decisively in the dovish direction in both the near- and especially medium-term. The November fed funds contract rallied 3 bp to 5.325%, cutting the odds of a rate hike by the October FOMC meeting to 30%, while the peak rate January contract gained 4 bp to 5.34%, putting the odds at about two-thirds that the Fed is done for good at 5.25%. Despite this easing back in expected near-term hiking, the amount of easing expected next year continued to surge to new highs. The Dec 06 to Dec 07 eurodollar spread plummeted 12 bp to -43.5 bp, with the former rallying

4 bp to 5.44% and the latter surging 16 bp to 5.005%, essentially pricing in the likelihood of a 4.75% funds target at the end of next year. The biggest eurodollar futures gains were actually posted by the 2008 contracts, which rallied an average of 18 bp, with the low rate March and June 2008 contracts reaching 4.98%.

 

Moderation in the core PPI Tuesday and core CPI Wednesday drove the bulk of the week’s bond market gains. In both cases, large, quirky, and, we think, very likely one-time declines in one component fully explained the moderation – the motor vehicles category for PPI and apparel for CPI. The producer price index rose 0.1% in July, as a 1.3% jump in energy prices led by electricity offset a 0.3% drop in the core, the largest in three years. All of the downside in the core was attributable to the extremely volatile and, as far as we can tell, on a month-to-month basis essentially random motor vehicle components, with cars down 0.8% and light trucks plunging 3.1%. With the huge month-to-month gyrations that have plagued car and truck prices in the PPI for several years now, it wouldn’t be at all surprising to see them surge next month and sharply boost the August core PPI. Given the unreliability of the PPI motor vehicle measures on a short-term basis, in our view the focus in the PPI report should be on the core ex motor vehicles when they act up, which rose 0.1% in July, as expected. News at earlier stages of production showed a continuing buildup of pipeline inflation pressures. The core intermediate goods index jumped 0.7% from a 7.9% year/year rise, with upside in July concentrated in chemicals.   The core crude gauge rose 1.3% for a 34.4% year/year spike, with July gains led by a surge in wastepaper.

 

Following up the superficially positive core PPI result, the market reacted just as exuberantly to a slight moderation in the core CPI, which was also fully accounted for by an unusual move in one particular category. The consumer price index rose 0.4% in July (leading to a slight moderation in the annual rate to +4.1%), boosted by a sharp rise in gasoline prices. The core slowed to +0.2% after the prior string of four straight +0.3% readings, with the moderation entirely a result of a 1.2% decline in apparel prices, the largest in eight years. In our view, this was largely a seasonal quirk – clothing prices held firm in May (+0.2%) and June (0.0%), so when summer clearance prices were finally instituted in July, the downward comparison was unusually large. Excluding this big, very likely temporary, plunge in clothes prices, the core would have risen 0.3%, with upside again led by the key owners’ equivalent rent category (+0.4%). If apparel prices merely flatten out in August (or perhaps even see some upside as we transition from summer clearance to back to school), we’ll be right back to printing +0.3% core readings unless there is a significant change in trend in the other key categories, of which there was no sign in the July results. Even with the moderation in the core in July, the year/year pace ticked up again to +2.7% from +2.6%. With the core having only risen 0.1% last August and September, there is a good chance the core inflation rate will rise to +2.9% in August (note that the August CPI report will be released just a few days ahead of the September FOMC meeting) and will break +3% in September for the first time in over a decade.

 

These likely temporary moderations in core inflation readings were accompanied by some ugly signs on inflation expectations in the University of Michigan survey. The one-year ahead median inflation expectation spiked a full percentage point to +4.2%. Outside of the aftermath of Katrina last year when gasoline prices went completely crazy for a short time, this was the high since 1990. Much more worrisome from the Fed’s perspective was that the 5-year ahead median inflation forecast rose to +3.1% from +2.9%, just below the +3.2% peak hit in May and previously last October after Katrina. Perhaps the $3 a gallon level on gasoline is a key psychological level, since a relatively modest run-up in prices that broke through this level in early August certainly appeared to have had an outsized impact. The text of the report, however, suggested that more than gasoline is driving the deterioration in inflation psychology. The report noted that rising inflation was the single most mentioned item when respondents were asked to discuss recent changes in the economic situation. But when directly asked for a prediction on gasoline prices going forward, respondents only predicted a small further increase relative to prior estimates.

 

Still, if retail gasoline prices fall sharply going forward in line with the recent plunge in wholesale prices, inflation expectations certainly seem likely to recede. But it remains to be seen how entrenched this elevation in longer-term inflation psychology will prove in the face of a retracement in gas prices. The outcome on longer-term inflation expectations in the Michigan survey was generally in line with recent results in market-based measures. TIPS breakeven inflation spreads receded significantly in the latest week as the nominal market rallied sharply and energy prices plunged. But the 5-year breakeven (down 11 bp on the week to 2.55%) fell significantly more than the 10-year (down 6 bp to 2.58%), leaving the 5-year/5-year forward inflation forecast, which the Fed has indicated is its preferred market-based measure of inflation expectations, little changed at an elevated 2.62%. Similar to the Michigan survey for 5-year ahead inflation expectations, this is just slightly below May peak of 2.7% after having risen significantly over the past couple months. If going forward we see a continued trend higher in the core inflation rate at the same time we are seeing uncomfortably high and rising inflation expectations, we seriously doubt the Fed would be inclined to suddenly do an about face and start cutting rates even if there were a sustained growth slowdown.

 

Inflation numbers dominated market attention the past week, and investors largely ignored some mixed signs on growth – strength in the factory sector and weakness in the housing market, an increasingly familiar combination. Industrial production rose 0.4% in July, boosted by a 2.0% hot weather induced surge in utility output, while the key manufacturing gauge slowed to +0.1%. The sluggish manufacturing growth was entirely a result of a 5.4% plunge in motor vehicle output, as assemblies fell off significantly late in the month. The latest assembly schedules point to a significant rebound in August. Outside of the volatile motor vehicles sector, factory output surged 0.7%, led by machinery, aircraft, apparel, high tech products, rubber and plastics, and wood products. The overall capacity utilization rate rose a tenth to 82.4%, a more than six-year high and 1.7pp above the average of the past thirty years, while the manufacturing rate dipped a tenth to 81.0%, 1.5pp above the long-term average. The key early regional manufacturing surveys suggested that robust manufacturing growth extended into August.

While the volatile headline sentiment measures posted mixed results, both the Empire State and Philly Fed manufacturing surveys showed solid improvement on an underlying basis. ISM-comparable weighted averages of the key activity measures rebased to a 50-breakeven scale showed the Empire State rising to 55.0 from 53.6 and the Philly Fed to 56.4 from 53.9. We look for the national ISM to tick up a bit further to 55.0 in August after gaining a point in July to 54.7.

 

On the other side, housing continues to tank. Housing starts fell 2.5% in July to 1.795 million units annualized, a nearly two-year low, as surging inventories of unsold homes have led builders to scale back significantly. Single family (-2.3% to 1.452 million) and multi-family (-3.4% to 343,000) starts saw about equal sized declines, with the former hitting a three-year low, while the latter has been volatile but basically unchanged for a number of years. Since the unusually warm weather in January led to a temporary jump to the cycle high, there has now been a cumulative 21% drop in starts. We’re assuming about another 8% downside through year-end, which would leave starts for the year as a whole down roughly 10%. Certainly the homebuilders’ survey pointed to more weakness ahead. The National Association of Homebuilders’ Housing Market Index remained in freefall in August, dropping another 7 points to 32 (on a 50-breakven scale), the lowest reading since early 1991 and down from a cycle peak of 72 hit in June of last year. All three components – present sales (36 v. 43), expected future sales (40 v. 46), and prospective buyers traffic (21 v. 27) – were down sharply. The text of the report noted “rising sales cancellations and substantial growth in inventories of both new and existing homes” as potential buyers take a “wait-and-see attitude” and “investors/speculators” flee the market.

 

So at this point there seems to be a bit of a tug-of-war in the growth outlook between a robust factory sector, supported by upside in domestic investment, surging exports, and very low economy-wide inventories, and a tanking housing market. Fortunately, investment, exports, and inventories are a far larger share of the economy than residential construction.

 

The economic data calendar is quite light in the coming week, with home sales and durable goods the only key reports. On the supply front, the Treasury will announce 2-year and 5-year notes Thursday for auction the following Tuesday and Wednesday. We look for a $1 billion cut in each to $21 billion and $13 billion, respectively. The Kansas City Fed’s annual conference in Jackson Hole, Wyoming (this year on the topic “The New Economic Geography” – whatever that means) begins at the end of the week, and Fed Chairman Bernanke will give opening remarks Friday morning. Data releases due out include existing home sales Tuesday and durable goods and new home sales Thursday:

 

* We forecast existing home sales in July dipped to a 6.60 million unit annual rate. The pending home sales index has displayed surprising resilience during the past couple of months. So we look for only a very slight dip (-0.3%) in July resales.

 

* We expect July durable goods orders to fall 1.0%, a partial retracement of the 2.9% spike in bookings recorded in June. Indeed, it appears that more than half of the June gain was attributable to an unusually elevated volume of orders for military ships and tanks, which should be unwound in July. Meanwhile, the key core category – nondefense capital goods excluding aircraft – is expected to post another modest gain (+0.5%).

 

* We expect July new home sales to fall to a 1.05 million unit annual rate. In June, sales of newly constructed residences showed an outright decline for the first time in four months. Given the recent deterioration in the homebuilders’ sentiment survey, we expect to see an even larger drop in July (-7%). Moreover, it’s worth noting that the new home sale series likely continues to overstate the pace of activity because it is based on contract signings that might subsequently be cancelled before the deal closes.

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Turkey
Against Animal Spirits
Aug 21, 2006

Serhan Cevik (from Istanbul)

Turkey did not deserve to become the worst-performing country in the global volatility storm. Even before the latest wave of risk reduction, we argued that investors would draw a distinction between countries behaving responsibly and others with inadequate records (see Positive Discrimination, March, 2006). Unfortunately, we underestimated the strength of animal spirits in financial markets. Despite the obvious signs of fundamental improvements, the majority of market participants embraced short-sighted strategies overlooking structural gains. As a consequence of treating the Turkish economy like a house of cards, the lira lost almost one-third of its value and the average t-bill rate increased by 1,000bp in the midst of the shock. Of course, management failures, starting with the disappointing process of appointing the new central bank governor, delayed the policy response, distorted market expectations even more, and forced the Central Bank of Turkey to raise short-term rates by 400bp. Then, just as the volatility storm started easing, the central bank has adopted a hawkish stance as if nothing but market expectations matter for inflation dynamics and initiated a new tightening campaign. We believe that was a mistake, and will keep haunting the authorities in the future.

Short-sighted expectations overlook macroeconomic fundamentals. Inflation expectations for the end of 2006 and one-year ahead stand at 10.6% and 8.0%, respectively. Since these are notably above the corresponding targets of 5% and 4%, the central bank has informed us about the need for further tightening of monetary conditions. But is it really necessary to raise interest rates even more in the coming days? We think not. First, inflation expectations are adaptive and biased, and thus not a reliable gauge for monetary policy (see The Notorious Chicken-and-Egg Problem, August 14, 2006). Second, the recent increase in inflation was a direct result of the lira’s weakness and will gradually be corrected as exchange-rate dynamics normalise. And finally, the state of the economy even before the volatility shock and restrictive financial conditions afterwards do not justify more rate hikes. In our opinion, Turkey’s vulnerability stems from its own success in normalising macroeconomic conditions that has attracted foreign investors and convinced residents to de-dollarise financial holdings. Therefore, the country needs a proactive approach to managing liquidity conditions, not higher interest rates.

Supply-side shocks, not a demand bubble, led to the rise in inflation. After reaching its lowest reading (7.1%) in over three decades, the annual inflation rate started drifting higher for reasons that are still open to intense debate. In our opinion, the increase in inflation, at least until the recent volatility shock that abruptly weakened the lira, was a result of supply-side shocks like higher commodity and unprocessed food prices, not a domestic demand bubble. Given Turkey’s excessive dependence on energy imports, the worst oil shock in decades has fuelled cost-driven inflation pressures, while similar supply-side factors pushed the annual rate of increase in unprocessed food prices from 2.1% in July 2005 to 21.8% this year. And lately, the lira’s sharp depreciation magnified such adversities and distorted pricing decisions across the economy. However, we should not confuse short-term volatility stemming from supply shocks with the consequences of overheating. In our view, today’s problem is temporary, and secular forces that lowered inflation from the verge of hyperinflation to the single-digit territory remain intact.

Turkey had no ‘excess’ demand problem, and now faces downside risks in domestic demand. Although the longest stretch of economic expansion in Turkey’s history convinced some observers that the economy was overheating, that was, in our view, just an illusion. The astounding recovery in consumer spending has lagged far behind the increase in the potential level of output. In other words, thanks to strong investment growth and productivity gains, the Turkish economy continues to operate with an output gap, which may still underestimate the effective slack in the economy. This is why we also focus on the labour share of national income and the ‘demand’ gap in analysing inflation dynamics. The share of value-added (net of indirect taxes) accruing to workers stood at 26.6% of GDP last year — 410bp lower than the 1999 reading (see Marx’s Ghost, July 17, 2006). The latest data suggest that there are no inflationary pressures coming from the labour market and that restrictive financial conditions have already brought a moderation in private consumption.

Being cautious does not mean an ‘excess’ tightening of the monetary policy stance. Risks stemming from the global commodity bubble and financial volatility are not over and inflation will remain high in the near future. However, despite recent fluctuations, the balance between aggregate demand and potential supply still points to a non-inflationary growth trajectory, especially considering the lag between policy actions and effects on the economy. This is why an excessive focus on expectations risks becoming a source of moral hazard in liquidity preferences. After all, as Alan Blinder said, “traders in financial markets — even those for long-term instruments — often behave as if they have ludicrously short time horizons, whereas maintaining a long time horizon is the essence of proper central banking”.

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China
Another Rate Hike; Many More to Come
Aug 21, 2006

Andy Xie (Hong Kong) and Denise Yam (Hong Kong)

*China raises interest rate to reaffirm tightening policy. China raised lending and deposit rates by 27bp for most categories last Friday.  This is the right move and long overdue.  China’s interest rates are too low for the current growth environment.  As administrative tightening has failed, interest rate policy has to take the central role in regulating the economy.

*Interest rates likely to rise by 135-162bp before end-2007. We believe that China will raise rates one more time before end-2006 and another three to four times in 2007, at 27bp each.  Subsequently, interest rates will remain below neutral.  China’s rate cycle may peak only in 2008.

*The economy remains overheated for the foreseeable future. China’s tightening is too slow to cool the overheated economy.  In particular, the property overheating may be expanding.  China’s deposit rates are probably 300bp below neutral.  The property market should normalize when interest rates are neutral.

Summary and conclusions

China raised deposit and lending rates last Friday as another step in its two-year-long tightening campaign to rein in an overheated economy.  The recent data continue to paint an economy with runaway fixed asset investment, particularly in the property sector.  China’s tightening bias is likely to remain for the near future, in our view.

We believe that China will raise interest rates one more time by about 27bp before year-end and another three to four times by an equal magnitude in 2007.  Even with these rate hikes, the country’s interest rates would still be below neutral.  China’s neutral deposit rates are above 5%.

The latest rate hike does not imply that China is prepared to do enough to solve the overheating problem.  In the past two years of tightening, the government has displayed a pattern of tolerating overheating at a certain level.  Tightening moves tend to come when overheating accelerates, which may derail the economy imminently.

The country’s overheating is likely to end not through government policy, but through the disappearance of excess liquidity due to the following: (1) Exports decline, decreasing excess liquidity; or (2) Fixed investment accelerates to absorb all the excess liquidity.  A US consumption recession might trigger the former.  The current investment trend might make the latter come true in 2008.

A small step toward monetary normalization

China raised deposit and lending rates by about 27bp last Friday.  The pattern of the rate hikes is to encourage long-term deposits and discourage corporate credit demand.  The central bank increased the lower limit of the mortgage rate to 85% from 90% of the regulatory rate, essentially keeping the mortgage rate the same.

This is the third rate hike in the two years of the tightening campaign.  The first increase was in October 2004, when the central bank raised both lending and deposit rates by 27bp.  The second hike was in April 2006, when the central bank kept deposit rates the same and raised lending rates by about 18bp.

The rate increases so far are minuscule compared with the country’s growth rate and the extent of overheating.  China reported an 11% GDP growth rate for 1H06.  After the last hike, however, the one-year deposit rate is only 2.52%, and 2.202% after the 20% interest income tax.  The exceptionally low deposit rates are a key factor in China’s property overheating, which is the main driver of fixed investment overheating.

The neutral level of China’s deposit rates is over 5% for the whole curve.  At the current pace of tightening, it may take another two years before China’s monetary policy reaches the neutral level.

The national consensus that the economy is overheating has existed for two-and-a-half years.  The government has taken many steps that sounded tough at the time but turned out to be insufficient.  The right interpretation of the tightening failures is critical to our forecast of the future.

There are essentially two interpretations.  First, the central government is orthodox and does not want overheating.  The measures have failed due to the resistance of local governments (see Development Model and Tightening Challenges, August 8, 2006).

Second, the central government sees more benefit than harm from the overheating and, hence, does not want to tighten.  The tightening measures are to reassure the market that China will have its economy under control – i.e., the tightening is a public relations campaign (see Regional Disparity Constrains Macro Management, August 14, 2006).

To seek an understanding of the government’s intention is probably too simplistic an approach.  China is not monolithic any more, and many forces are at work for or against tightening.  One thing clear is that the government is not running its macro economy in an anticipatory manner.  Instead, its decisions are based on the balance of various interests.  As the government controls the financial system, the fixed investment half of GDP and key industries, China’s economy effectively evolves according to the balance of political interests.

The outcome of this political process is sporadic tightening moves that aim to postpone the final frenzy in a financial mania – i.e., China’s measures are to prolong, not to stop, overheating.  ‘Make the good times last’ is probably the best description of China’s policy so far.

This outcome makes sense in China’s political economy.  Most government officials expect to be in their current positions for the next two to three years.  Hence, if the economy booms for this period and busts afterwards, it is consistent with their interests.  But, if the mania surges to trigger a crash, it is not consistent with their interests.

Overheating Lasts as Long as Excess Liquidity Remains

If our understanding of China’s overheating process is correct, overheating will last as long as excess liquidity is available.  In the meantime, there will be tightening measures from time to time.  They serve to cap rather than cool overheating.

China’s excess liquidity is due to (1) strong exports, (2) currency appreciation expectations, and (3) a rising share of government and state-owned enterprise (SOE) income in the economy.  There are macro and micro solutions to rid China of excess liquidity. 

The best approach is to increase the household income share of the economy by raising wages, distributing shares of income-earning SOEs to households and shifting government expenditures to social areas like healthcare and education to decrease the household financial burden.  This approach would sustain China’s high growth in a high interest rate environment, which would be very good for China and the world economies.  It is least likely to be adopted, however, as it decreases the power of government officials.

Increasing the production cost of exports is an alternative.  It could be done by removing export subsidies or appreciating the currency.  We favor the first approach.  Removing VAT rebates and profit tax exemptions would be equivalent to about 10% currency appreciation.

Although measures to deal with China’s excess liquidity are available and China is better off in the long run by taking them, decisive actions to deal with excess liquidity are unlikely.  The political process is such that China’s overheating ends when excess liquidity vanishes without policy interventions.

China’s excess liquidity is roughly from the balance of fixed investment and exports.  The most likely ending for excess liquidity is from an export slowdown.  China’s exports rose by 25.1% in 1H06 compared with 32.6% in 1H05.  While there is a slowdown, exports are still rising at a pace similar to that of fixed investment.  Hence, excess liquidity is not diminishing.

The export slowdown will truly arrive when American consumers stop the borrow-and-spend binge.  At some point, this will happen, but we don’t know when.  There are no convincing data to show that US consumption has slowed.

An alternative scenario is that the fixed investment surges ahead of exports.  This is now a distinct possibility.  Property sales exceeded property investment for the first time in 1H06.  This implies that the financial policy has far less effect on the economy in future.  Property investment could surge in the coming months with tightening lending policy.

The central government has tightened land policy.  Hence, property investment is rising much less than sales.  As deposit rates are still too low to discourage property purchases, this could lead to a massive price bubble in 2007 – i.e., China’s property market in 2007 could resemble Hong Kong’s in 1997.

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