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Global
What Message from the Euro Yield Curve? November 16, 2006 By Joachim Fels | London Taking the yield curve seriously. For the first time in more than six years, euro area 10-year bond yields fell below 2-year yields last week, even though only slightly and temporarily so. Historically, pronounced yield curve inversions in the First, the euro yield curve is not flashing a recession signal yet, but it does suggest that a significant growth slowdown may lay ahead in about a year’s time. The slight inversion in the euro yield curve in summer of 2000 — the only previous occasion since the start of the euro — was, in fact, followed by a near stagnation of the euro economy during the final three quarters of 2001. Also, recall that the recent two quarters of below-trend growth in the Monetary policy in the driver’s seat. Second, it’s worth recalling the reason why the yield curve has traditionally been a good indicator of future growth. Monetary policy is usually a powerful driver of cyclical growth, and monetary tightening tends to lead to a flattening or even inversion of the yield curve. Thus, taking seriously a signal from the yield curve, as I do, is the same as taking seriously the impact of monetary tightening. In fact, since ECB President Jean-Claude Trichet pre-announced the beginning of the ECB tightening cycle almost exactly a year ago, the refi rate has risen by 125bp, the 2-year yield by some 80bp and 10-year yields by some 20bp (the latter with significant gyrations along the way). ECB about to turn restrictive. Third, the message from the yield curve — that monetary policy is no longer stimulative — is exactly in line with the message from comparing the current refi rate with our estimate of the natural, or neutral rate. Our model puts the latter at 3.25-3.5%, assuming inflation of some 2% in the foreseeable future (see The Natural ECB, October 3, 2006). Thus, the ECB has returned to neutrality and looks set to move into slightly restrictive territory if it hikes twice more, as the money market foresees. Exhibit 1 serves to illustrate that the yield curve and our natural interest rate analysis send similar messages: the slope of the curve is closely correlated with the interest rate gap, defined as the difference between actual short-term interest rates and our estimate of the natural rate of interest. Not everything is gloomy, but … Finally, two factors suggest that the anticipated slowdown is unlikely to morph into a recession. First, interest rates along the curve are now some 150bp lower than they were the last time the curve was as flat as it is now (2-year and 10-year yields traded around 5.25% in August 2000, against 3.70% now). Second, the flattening of the curve in recent months has been largely driven by falling long rates, while rates at shorter maturities have risen only slightly further. As the latter most likely reflects lower global yields and liability-driven purchases, it has likely led to a decline in the term premium, rather than expectations of economic slowdown or even recession. Still, compared with a year ago, rates are higher across the maturity spectrum and monetary policy is no longer expansionary. This, together with slower global growth and the upcoming fiscal tightening in the euro area, leads me to think that euro area growth will disappoint next year, especially if the still-hawkish ECB keeps tightening.
Japan
Patience Is a Virtue (Part II) November 16, 2006 By Takehiro Sato | Tokyo The wage conundrum The fact that wage growth has been sluggish despite a tight labor market is one of the surprises of the Japanese economy this year. Year-over-year growth in real wages has been running in negative territory for the past five months now. We believe that the weakness in wages is due to four factors: (1) Increased use of part-time staff and temporary workers from outside employment agencies: All labor statistics point to a decline in part-time workers under the formal definition, but a rise in contracted part-time employees, and this keeps average wages in check. (2) Cost structure changes in response to retirement of older employees: As baby boomers retire, they are replaced by younger employees at lower wages. (3) Low mobility of human capital: Movement of human capital is limited, so companies have a hard time attracting people in certain regions even if they raise wages. (4) Statistical bias in sample: MHLW’s Monthly Labor Survey changes the sample basket every January and July, and gaps arising from this are adjusted when the statistics are compiled. However, there is a possibility that gaps may not be fully corrected. As a result of these factors, wage growth is likely to remain sluggish relative to the tighter labor market. Trying to predict when wages will rise and what the catalyst will be is a difficult task, but if the Japanese economy has been running about a year behind the Stable prices on increased productivity As noted, we think it is very likely that significant upside in wages will be limited by continued high growth in labor productivity. The active capital spending that is set to support this growth in productivity will be the key to future price stability, in our view. On this point, our view is optimistic, in contrast to the consensus. This does not mean, however, that we look for extreme price stability to pave the way for a reversal in the deflationary trend. If the two key determinants of prices are (1) the output gap, and (2) the real wage gap, then the output gap is a function of the gap between potential GDP and actual GDP, and there is a positive correlation with the core CPI inflation rate. The real wage gap then reflects the rate of deviation between nominal and real wage labor productivity. As there is little downside for wages, assuming that the speed of actual wage correction is not as great as that of labor productivity, changes in corporate margins would put pressure on prices in the following ways. 1) Case of real wage gap > 0: Real wages > productivity, so margin pressure →pressure to pass on by raising in prices →rise in inflation rate. 2) Case of real wage gap < 0: Real wages < productivity, so expanded margins →increased capacity to lower prices →decline in inflation rate. In this case, there would be a positive correlation between the real wage gap and the core CPI inflation rate, but since wages would provide a cushion, the correlation between the two would be weaker than in the case of the GDP gap. So, regardless of whether or not real wages persistently outstripped growth in labor productivity, the impact of wages on prices would not be great, with supply/demand in the goods and services markets being the main determinant instead. This view is consistent with actual circumstances. In this respect, the BoJ may underestimate the potential impact of productivity deterioration (= higher unit labor costs) on prices, and by extension the impact of the quiet productivity revolution in the Japanese economy as a whole. In bottom-up terms, the general decline in cell phone rates and rates for other utilities in response to deregulation were not one-time events. Rather, they were the culmination of years of reform measures in both the public and private sectors, and gradual productivity improvements at quasi-public corporations, and are likely to continue going forward. Based on this view, we expect core CPI growth of +0.2% YoY in F3/07 (+0.1% in 2006) and +0.2% in CF3/08 (+0.2% in 2007). We expect the GDP deflator in F3/07 (and in 2006) to continue to run negative. In addition to a weak domestic demand deflator, the import deflator is leveling off at high levels due to oil prices. Based on our global economics team’s projections for oil prices and the yen-dollar rate, we expect an improvement in the domestic demand deflator and a rapid decline in the import deflator to prompt the GDP deflator to turn positive in the April-June 2007 quarter and ultimately drive a stronger improvement than we had previously assumed. This timing for the turnaround in the GDP deflator is one quarter later than we had forecast before, but this is due purely to a technical factor as changes in the basis for CPI statistics prompted fairly significant downward revisions, particularly of the personal consumption deflator. Corporate earnings maintain double-digit growth On the macro side, improvement in the GDP deflator means a rise in nominal wages per unit of productivity. The question is how to apportion this between the corporate and household sectors. As noted, we do not expect a significant rise in unit labor costs going forward, and we are optimistic about continued improvement in unit profits, so we think that there is a good chance that GDP deflator upside could lead to better-than-expected corporate earnings. As a result of the above, our top-down corporate earnings forecast for F3/07 (Corporate Statistics (Houki) basis, capital over JPY1 billion) is +10% YoY. In F3/08, however, we expect to see a slowing in growth. Although operating profits are likely to remain strong, we expect an increased depreciation expense in response to a rise in capital stock to slow the rate of growth to about +10%, which is likely to be moderate for a buoyant sales growth. Even so, this would still mark a fifth consecutive year of record corporate profits. Policy implications In terms of government fiscal policy, regardless of the results of upper house elections to be held in summer 2007, we think there is an increased likelihood that the widely expected hike in the consumption tax will be postponed until 2010 or 2011. If the general elections were to be held in summer 2009, it is unrealistic to expect the sales tax hike to be implemented in 2009, especially given that the new cabinet is clearly focused on making growth a priority. In terms of financial policy, we maintain our projection for a rate hike in the January-March F3/08 quarter — more specifically at the January meeting (January 17-18) — despite the stronger-than-expected headline in Jul-Sep GDP. This is for two reasons. (1) In text from the November 7 speeches and the following comments in the Q&A session, the BoJ governor placed greater emphasis on conditions for raising rates, the “second perspectives” of current policy framework (considering the risk, albeit a small one, of significant fallout on the economy and prices in the future), than the BoJ officially did in the Outlook Report. (2) If the BoJ can set a precedent of raising rates once every six months, in January and July, or three months after release of its Outlook Report, this would serve to stabilize both expectations in the market and, by extension, long-term interest rates. In such a setup, even though some leading economic indices have weakened, it seems plausible that comments supporting a hike in interest rates would be made sometime at year-end through the beginning of the new year. Although there is a decent possibility that the core CPI inflation rate becomes significantly lower than the bank’s operating scenario due to the decline in oil prices, the BoJ does not place that much emphasis on current core CPI. More important is the bank’s (not our) outlook for forward headline CPI.
Japan
Patience Is a Virtue (Part I) November 16, 2006 By Takehiro Sato | Tokyo Contrast between strong corporate sector and weak household sector As shown in preliminary Jul-Sep GDP numbers, the contrast between the corporate sector and the household sector has intensified, and this gap is not likely to close for some time. We assume that it will take a year or more for a positive growth cycle to develop, as momentum on the corporate front gradually spreads to the consumer and household level. Thus, while lack of support from consumer spending is likely to result in a slowing through F3/08, we expect growth in corporate spending to allow for continued gradual growth in the economy overall. Thus, we look for improved productivity to contribute to ultra-stable prices going forward. Reflecting this outlook, we have trimmed our real growth forecast to +2.5% in F3/07 (+2.8% in C2006; it remains unchanged on a calendar year base) and +2.3% in F3/08 (+2.3% in C2007). For the GDP deflator, we lowered our F3/07 forecast to -0.8% (-1.0% in 2006) to reflect a change in the CPI revision, and raised our F3/08 forecast to +3.1% (+2.6% in 2007) to reflect a cut in our assumption for import oil prices. Normalization (a switch in the nominal-real reversal) in GDP data might be delayed another quarter until Apr-Jun 2007 as a result. We also adjusted our nominal growth forecasts, lowering our F3/07 outlook to +1.7% (+1.9% in 2006) and raising our F3/08 projection to +3.1% (+2.6% in 2007). We expect core CPI inflation to remain stable at a low +0.2% in F3/07 and F3/08. With the labor distribution rate remaining stable at a low level, the outlook for an improvement in the GDP deflator reflects a greater-than-expected improvement in corporate earnings. Key risk factors include (1) economic slowdown in the Oct-Dec economic conditions and outlook going forward Following a strong expansion that lasted through the January-March quarter, the Japanese economy, buffeted by adverse weather conditions, hit an air pocket in the first half of F3/07. Even now, personal income and consumption data are still a bit weak, while other recent data, including METI’s manufacturing production forecast survey, point to a pause in momentum in the economy as the corporate sector works to draw down inventories, particularly of IT products goods. Consumption took a hit in the period from spring through summer due to adverse weather conditions, while the same factor has helped to drive a mild recovery since the beginning of autumn. The rise in inventories of IT products also may not be as serious as it looks at first glance, as it appears that this was due in large part to postponed PC purchases by consumers waiting for release of a new OS and delayed shipments of new game consoles. Clearly, there are a number of similarities between the current situation and the bursting of the IT bubble in 2000 and the lull in the economy from summer of 2004, but there are also key structural differences. The labor market is now very tight, prices and asset values are in recovery, and the financial system is much healthier than before. The Japanese economy is more resilient than it used to be and the risk of some sort of outside shock sending it into a deep tailspin is extremely limited now, in our view. As for the outlook for Japanese economy going forward from the October-December quarter, with the corporate distribution rate leveling off at a high level, corporate earnings look set to run strong while capex also remains steady. At the same time, the labor distribution rate is running low, suggesting that employment compensation growth will be limited. As a result, we look for personal consumption to grow at an annual rate of around 2%. In short, the gap between the strong corporate sector and the weak household sector is not likely to close for some time. Instead, we expect the high corporate distribution rate to support steady capital investment demand, allowing the economy, led by the corporate sector, to continue to expand gradually at a rate that exceeds the potential growth rate. This suggests that productivity will continue to see surprisingly steady growth. Looking at economic conditions overseas, although the risk of a slowdown in the US economy in response to a sharp correction in the housing market remains a key concern, growth in employment and income, the main drivers of consumption, remain strong in the US, and we believe that gains in this area may well offset fallout from the correction in the housing market. In fact, the corporate distribution rate in the It is also worth noting that the global economy is not as US-centric as it once was. Even if the US economy were to see a sharp correction, demand in Latin America is likely to remain strong thanks to high prices for resources, while hyper growth in the rest of Asia, beginning with China, can also be expected to continue. In fact, as the
Global
Monetary Conditions Vulnerable to Foreign Capital Flows November 16, 2006 By Denise Yam, CFA | Hong Kong Asset markets dependent on liquidity amid weak domestic economic fundamentals Amid sluggish domestic demand and continuous outward investment by local enterprises and individuals, asset markets in Balance of payments trends clearly demonstrate The overall balance of payments surplus since 2001 has contributed a great deal to the easy monetary conditions in Monetary conditions are vulnerable to turnaround in foreign liquidity Nevertheless, easy monetary conditions and low rates should not be assumed indefinitely. Foreign capital inflow is a crucial factor in the current delicate monetary balance. Monetary conditions and, hence, asset market performance, are extremely vulnerable to an abrupt turnaround in foreign portfolio flows. Indeed, the size of and swings in short-term capital flows have increased significantly in the past decade amid increasing global financial integration. The fluctuations are substantial relative to the more stable current account and indeed to the size of the economy as a whole. Quarter-on-quarter swings in short-term capital flows could be as great as 20% of GDP and could be extremely destabilizing for financial markets. It would be irresponsible to deny the growing risk of a contraction in global liquidity that could have a greater impact than in the past. Recent softness in the In Taiwan’s favor is the buffer of excess liquidity stored by the CBC in NCDs (negotiable CDs), which it can release to the money market to maintain accommodative conditions and low interest rates in the face of unfavorable capital flows. The outstanding stock of NCDs currently totals NT$3.57 trillion, or US$108 billion, so Will local investor funds come to the rescue? Stabilization in political sentiment is key In the face of the growing risk of tightening global liquidity and an end to foreign capital inflows, a preferable policy response would be the introduction of measures to slow the pace of capital exporting by local investors or even encourage repatriation of earlier outflows. Needless to say, the unfavorable political climate and business uncertainty prior to the drawing up of a concrete roadmap governing cross-strait exchanges are to be blamed for the persistence of the outflows. If the tension between the Nevertheless, our central case remains that the political climate will still be in gridlock in 2007. Dissatisfaction with the governing of President Chen Siu-bian continues, but limited legislative progress can be made to oust the government. Domestic consumption and investment will remain subdued while the economy encounters slower export growth amid a cooler global economy. We expect real GDP growth to slow from our estimate of 4% for 2006 to 3.5% next year. What continues to be needed above all else is a convincing and sustainable resolution in cross-strait relations that would halt capital outflows from |