What Message from the Euro Yield Curve?
November 16, 2006
By Joachim Fels
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 US and the euro area have tended to be followed by recessions about a year later, and the yield curve has typically outperformed any other recession indicator. But many observers claim that, for various reasons, the yield curve has lost its predictive power and, in fact, buoyant markets for risky assets suggest that investors are unimpressed. Yet, knowing from my own experience as an economic crystal ball gazer about the profession’s very limited ability to forecast GDP a year or so ahead, I think investors shouldn’t dismiss the early warning signals from the yield curve too lightly. A few points are worth noting.
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 US were correctly signalled by the flattening and inversion of the US curve late last year. Then, as now, when I pointed out the signal from the yield curve (see The Recession of 2007, November 17, 2005), many pundits dismissed it as irrelevant. As in the US, however, a recession signal in the euro area requires a significant inversion of the spread between 10-year rates and 3-month rates (see F. Moneta, Does the Yield Spread Predict Recessions in the Euro Area? ECB Working Paper No. 294, December 2003). So far, 3-month euro rates still trade some 20bp below 10-year yields, implying that the curve is not predicting a recession yet.
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.
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Patience Is a Virtue (Part II)
November 16, 2006
By Takehiro Sato
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 US economic cycle since the bursting of the IT bubble, it should take about the same amount of time as it did in the US. The US economy bottomed out in early 2002 and wages began to rise just this year. This suggests that the labor distribution rate in Japan is not likely to rise until F3/08 at the earliest, and only then if a knock-on effect from increased hiring does in fact finally translate into higher wages. In such a case, we would expect nominal wages to run more or less flat during the forecast period and for real wages to continue to decline during this time. Accordingly, we maintain our cautious stance regarding consumer spending.
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.
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.
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Patience Is a Virtue (Part I)
November 16, 2006
By Takehiro Sato
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 US or China, (2) geo-political developments, and (3) an unexpectedly sharp rise in wages resulting in a deterioration in productivity. But our main stance remains the same: we are bullish on the economy and cautious on prices. Our forecast for growth in the economy continues to be higher than the consensus, while our forecast for prices is a little lower than the consensus, which has also declined quite a bit.
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 US looks set to peak out, while the labor distribution rate is ready to climb. Looking at the US economy over the past five years, as the corporate distribution rate has risen, it is capex and higher housing assets that have provided the main support for the economy. But, going forward, we expect these roles to be reversed. While the corporate distribution rate is set to decline and the housing asset effect is not likely to provide much help, expanded employment and rising wages are set to take over as the key supports for consumption. The recent retreat in gasoline prices should offset the negative asset effect of the slide in housing prices.
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 US economy slowed in the July-September quarter of this year, growth in the Japanese economy was driven to a surprising degree by overseas demand.
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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 Taiwan have been supported by loose monetary conditions, made possible by the accommodative stance of the Central Bank of China, the current account surplus and sustained foreign interest in Taiwan’s financial assets.
Balance of payments trends clearly demonstrate Taiwan’s increasing dependence on external demand and foreign portfolio investment. The persistently large current account surplus, which we forecast at 6% of GDP in 2006, reflects the output gap amid structural weakness in domestic consumption and investment. In the financial account, Taiwan has been a consistent net exporter of direct investment capital, totaling US$10.7 billion since 2004 and US$20.7 billion since 2001. Portfolio flows, on the other hand, are characterized by local investors investing increasingly abroad but partially cushioned by foreign investments in Taiwan equities. Foreign portfolio inflows totaled as much as US$13 billion in 4Q05, buoyed partly by the MSCI re-weighting, but these have been offset by accelerated outbound investments by locals since 2004, leaving the overall financial account barely in balance since 2004.
The overall balance of payments surplus since 2001 has contributed a great deal to the easy monetary conditions in Taiwan and the recovery in asset prices, as shown in the close relationship with narrow money growth. Although YoY growth has retreated from the peak in 2Q04, ample liquidity in the banking system has kept interest rates low. Rates are low even at the long end, with the 10-year government bond yield hovering around 2% at present, keeping financial assets afloat even amid a weak domestic economy: domestic demand growth dipped to 0.2% YoY in real terms in 1H06, from 1.5% in 2005 and 6.3% in 2004.
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 US housing market has not yet been accompanied by any noticeable economic slowdown; upside surprises to inflation continue to haunt the industrialized world, heightening risks of further tightening by leading central banks. In the much-feared scenario of global stagflation, investment fund flows to emerging markets would be unlikely to avoid an adverse turnaround.
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 Taiwan could possibly endure a significant reversal of flows before liquidity is affected. Moreover, the US$260 billion-strong foreign exchange reserves provide an additional shock absorber.
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 Taiwan government and mainland China were to intensify, the likely collapse in consumer and business confidence could coincide with slower export growth next year and push the economy into recession. A bullish scenario, whereby local investor capital returns to Taiwan would require a breakthrough in cross-strait relations such as significant liberalization in direct trade, transport and investment flows. Asset — especially property — prices could stage an impressive rally, powering a strong recovery in consumption and investment, more than offsetting the export slowdown. GDP growth could surge above 6% in this scenario.
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 Taiwan, or even reverse the flows. Improved economic fundamentals upon the removal of political uncertainty would also secure and sustain foreign investor interest in Taiwan assets. Until such a scenario is in place, Taiwan remains vulnerable to a turnaround in the foreign capital inflows that have provided considerable support to the economy over the past few years.
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