Special Year End Issue: Looking to 2007


Global:
Global: Looking to 2007
Global: From Globalization to Localization
Global: Dr. Jekyll and Mr. Bond
Global: The Term Premium - A Puzzle Inside a Riddle Wrapped in an Enigma
Global: Freer Trade Matters

Currencies:
Currencies: A Retrospective on 2006: A Cyclical Dollar Downturn

The Americas:
United States: Inflation Uncertainty
United States: A Tale of Two Tiers
United States: Fiscal Outlook
United States: Business Conditions - Bouncing Along the Bottom
United States: CPI - A Shocking Development
Latin America: A Dose of Stability

Europe:
Europe: About Decoupling, Reforms and Tensions
Europe: The ECB's Balancing Act
Germany: Putting the Recovery to the Test
France: We Have a Problem, Mr(s) President
Italy: Flickers of Light
The Netherlands: Roundtrip
UK: Benign Central Case Belies the Risks
Nordics: Sweet Dreams or Nightmare?
Sweden: Hot or Not?

Emerging Europe & the Middle East:
Central Europe: Continuing Progress on the Path to Convergence
Romania: Big Picture
Turkey: The Real Stake of Turkey-EU Negotiations
Turkey: Looking Beyond the Wall of Noise
Israel: Missing Piece
South Africa: Opportunities Galore
Egypt: The Dangers of Overheating

Asia Pacific:
Asia: Asia's Decoupling Story -- The Litmus Test
Japan: Buy Mr. Abe on Dips
Japan: If Prices Were To Decline Again ...
China: Liquidity, Liquidity, Liquidity
China: Who’s Subsidizing Whom?
Korea: To Survive the Slowdown in 2007
ASEAN: Heading for a Soft Landing in 2007
India: Beyond the Cyclical Boom
Australia: The Real Slowdown Starts

Our baseline forecast points to a sustained global expansion through 2008.  After expanding at a 4.8% average pace over the 2003-06 period — the strongest four years of global growth since the early 1970s — we are forecasting a modest downshift to 4.3% in 2007.  Such an outcome would be well above the 45-year growth trend of 3.7%, suggestive of a global economy that is coming in for a classic soft landing.  Our first cut for 2008 calls for a fractional re-acceleration to 4.5% global growth. 

The global downshift in 2007 should be broad-based.    The US and Europe are expected to lead the deceleration in the developed world, and a slowing of Asia ex Japan stands out in the developing world.  In the US, we expect a housing-related “growth recession” to persist through 1Q07, with important knock-on effects for export-led economies heavily dependent on US demand — especially China, Mexico, Canada, Japan, and other Asian economies tied to China’s supply chain.  China’s progress in cooling off an overheated investment sector should provide another impetus to the coming global downshift. 

The risks are on the downside of our 2007 global soft-landing scenario.  As post-housing-bubble adjustments begin to play out in the US, the risks of spillovers to other sectors — especially personal consumption and business capital spending — are especially worrisome.  Lacking in support from private consumption, the rest of an export-dependent world could be surprisingly vulnerable to a US growth shortfall.  Pro-labor political shifts in the US, Germany, France, Italy, Spain, Japan, and possibly Australia could shift the pendulum of economic power from capital to labor — raising the risks of trade frictions and earnings pressures that could prove quite problematic for world financial markets.

This is the final issue of the Global Economic Forum for 2006. We hope that the following 36 dispatches will provide you with ample food for thought as you ponder the outlook for the world economy and financial markets in the coming year. We will resume regular publication on Tuesday, January 2, 2007.  Our very best wishes for the Holiday Season.

Morgan Stanley Global Economics Team.

On one level, there seems to be no stopping the powerful forces of globalization.  Not only has the world just completed four years of the strongest global growth since the early 1970s, but in 2006, cross-border trade as a share of world GDP pierced the 30% threshold for the first time ever -- almost three times the portion prevailing during the last global boom over 30 years ago.  What a great testament to the stunning successes of globalization!

On another level, however, there are increasingly disquieting signs.  That’s because of a striking asymmetry in the benefits of globalization.  While living standards have improved in many segments of the developing world, a new set of pressures is bearing down on the rich countries of the developed world.  Most notably, an extraordinary squeeze on labor incomes has occurred in the industrial world -- an outcome that challenges the fundamental premises of the “win-win” models of globalization. 

It is a great theory -- but it’s not working as advertised.  The first win -- that going to the developing world -- is hard to dispute.  China has led the way, with more than a quadrupling of its per capita GDP since the early 1990s.  Other developing countries have lagged the Chinese experience but have still made considerable progress in boosting living standards. 

The problem lies with the second win -- the supposed benefits accruing to the rich countries of the developed world.  And that’s where the going has gotten especially tough.  In recent years, the benefits of the second win have accrued primarily to the owners of capital at the expense of the providers of labor.  At work is a powerful asymmetry in the impacts of globalization and global competition on the world’s major industrial economies -- namely, record highs in the returns accruing to capital and record lows in the rewards going to labor.  The global labor arbitrage has put unrelenting pressure on employment and real wages in the high-cost developed world -- resulting in a compression of the labor income share down to a record low of 53.7% of industrial world national income in mid-2006.  With labor costs easily accounting for the largest portion of business expenses, this has proved to be a veritable bonanza for the return to capital -- pushing the profits share of national income in the major countries of the industrial world to historical highs of 15.6% in 2Q06. 

This asymmetry in the second win is not without very important consequences.  In days of yore -- when labor and its organized unions actually had bargaining power -- the current squeeze on labor income in the developed world would have undoubtedly resulted in some form of a “worker backlash.”  In today’s increasingly globalized world, however, workers have no such power.  But their elected political representatives most certainly do.  And there can be no mistaking the important shift that has recently occurred in the political alignment of the industrial world -- with the majority shifting from the pro-capital right to the pro-labor left.  Not only is that the case in the United States, but such a tendency is also evident in Germany, France, Italy, Spain, Japan, and possibly even Australia.

The stunning results of the recent mid-term elections in the US could well be the canary in this coalmine. A newly-elected Democratic Congress is about to find itself center stage in the battle between capital and labor.  The old Congress was quite transparent as to where it was headed in this regard -- having introduced, by our count, 27 separate pieces of legislation since early 2005 that would impose some type of punitive actions on trade with China.  The new Congress could go further -- not just on the trade frictions front but also in embracing additional elements of a pro-labor agenda.  In fact, newly elected Democratic leaders already have promised immediate passage of the first increase in the minimum wage in ten years.  In my view, these are just the early warning signs of a US Congress that is likely to be far more sympathetic to the plight of labor than it was in the past. 

Nor is America alone in tilting to the pro-labor left.  In France, the ascendancy of Ségolène Royal offers a modern-day mix of pro-labor politics with a protectionist bias.  Italy’s Prodi is also pro-labor, and in Spain, Zapatero is certainly more sympathetic to the plight of labor than Aznar was.  In Germany, Merkel has tilted increasingly toward labor after she nearly lost the election running on a pro-market reform agenda.  The new Abe government in Japan has teamed up with the center right in support of the “second chance society” -- attempting to make certain that the victims in the rough and tumble arena of global competition are given the opportunity to come back.  And in Australia, Kevin Rudd, the newly anointed opposition leader, seems set to center his platform on the struggle of the average worker.

I am not heralding the demise of globalization.  What I suspect is that a partial backtracking is probably now at hand, as a leftward tilt of the body politic in the industrial world voices a strong protest over the extraordinary disparity that has opened up between the returns to capital and the rewards of labor.  The extent of any backtracking is a verdict that lies in the hands of the politicians -- specifically, how far they are willing to go in legislating an effort to narrow this disparity. 

As the self-interests of nation-states become increasingly prominent, the pendulum of political power should swing from globalization to “localization.”  That would imply very different characteristics to the macro climate.  The most obvious -- wages could go up and corporate profits could come under pressure.  But it also seems reasonable to expect pro-labor politicians to direct regulatory scrutiny at excess returns on capital -- focusing, in particular, on the perceptions of excess returns in financial markets (i.e., hedge funds and private equity) as well as on the inequities of rewards at the upper end of the income distribution (i.e., tax cuts for wealthy citizens and the excesses of executive compensation).  Moreover, localization taken to its extreme could also spell heightened risks of protectionism -- especially if the global economy slows and unemployment starts to rise in 2007, as we anticipate.  Under those circumstances, inflation could accelerate, leading to higher interest rates, greater volatility in financial markets, and a potentially vicious unwinding of an over-extended credit cycle.  And, of course, the protectionist ramifications of localization could prove equally challenging for the beneficiaries of globalization’s first win -- dynamic new companies in the developing world and the employment growth they generate.

Don’t confuse prognosis with advocacy.  Many of these potential developments, especially a drift toward protectionism, are without any redeeming merit, in my view.  But this is what happens when trends go to extremes.  In free-market systems, the pendulum of economic power then invariably swings the other way.  An era of localization will undoubtedly have more frictions than the unfettered strain of capitalism and globalization that has been so dominant over the past decade.  The big question, in my view, pertains mainly to degree -- how far the pendulum swings from globalization to localization.  The answer rests with the body politic.  The repercussions lie in economics and financial markets.

Jekyll and Hyde  Following the ‘conundrum’ of low long-term yields during 2005 despite rising US short rates, global bond markets staged a (reverse) ‘Jekyll and Hyde’ performance during 2006, pretty much as I envisaged in my 2006 outlook piece a year ago (The Passing of the Batons, 8 December 2005).  A sell-off during the first half of the year gave way to a powerful bond rally during the second half when the Fed paused and the signs for an economic slowdown in the US started to accumulate.  As a consequence, the US 10-year Treasury yield now trades around 4.5%, only slightly higher than a year ago, but some 80 basis points below the peak of mid-2006.  However, gazing into my crystal ball, I visualize a bearish scenario for the G3 bond markets in 2007, with yields moving back to, and possibly above, the temporary highs of last summer. 

Three main drivers.   In thinking about bond markets, I continue to focus on what I consider the three main medium-term drivers of yields: (1) the economic cycle and (2) inflation expectations, which together shape expectations of future central bank policy rates; as well as (3) the global liquidity cycle, which I suspect has been a key factor influencing the recently vanishing ‘term premium’ in bond yields (see also M. Pradhan, The Term Premium: A Puzzle Inside a Riddle Wrapped in an Enigma, in this issue).  Here are my assumptions and expectations for how each of these drivers will develop in 2007. 

A global mid-cycle slowdown, but no recession.  I assume that the global economy entered a mid-cycle slowdown during the second half of this year that will become more apparent during the first half of 2007.  While this is qualitatively consistent with our global economic team’s forecast of a slowdown in global GDP growth from 5.0% this year to 4.3% (see Stephen Roach’s Global Transitions for details), I agree with Steve that the risks to this number are on the downside.  Importantly, however, I assume that the slowdown won’t lead into recession, but will give way to a second leg of this expansion, albeit milder than the first leg in recent years, starting some time during the second half of 2007.  A crucial assumption here is that the US slowdown remains temporary and largely bottled up in the housing sector, as our US economics team expects (see Richard Berner and David Greenlaw. It’s a Growth Recession, Not a Lasting Downturn, 11 December 2006).  If so, at some stage next year, investors will likely revise significantly upwards their expectations for the path of the Fed funds rate in 2008 and beyond.

… with Europe disappointing and Japan surprising.   Looking elsewhere, I envisage the euro economy disappointing the upbeat consensus expectations, but Japanese growth surprising on the upside in 2007.  Japanese monetary policy is still very accommodative and the yen is super-competitive.  Meanwhile, even though there may be a nascent pick-up in potential output growth in the euro area reflecting past corporate restructuring efforts and labour market reforms, cyclical growth is likely to be hit by the removal of monetary stimulus over the past year, fiscal tightening in Germany and Italy, and the trade-weighted appreciation of the euro.  As a consequence, while I’m outright bearish on all the G3 bond markets, I do expect euro area bonds to outperform US Treasuries and JGBs in the sell-off, reversing their underperformance of the last six months or so.

Sticky inflation.    While my view that this is a mid-cycle slowdown (though possibly a sharp one) rather than the onset of recession is in line with mainstream thinking among investors, my view on inflation isn’t.  As I see it, market- and survey-based inflation expectations are too low and are likely to be revised up in the course of next year.  The most likely trigger will be higher-than-expected actual inflation rates in the US and, possibly, Europe.  One reason is that, in my view, the US economy is experiencing a structural slowdown in productivity growth, following a ten-year acceleration in trend productivity in response to the IT revolution, as US companies have now reaped most of the productivity-enhancing benefits of this revolution.   Thus, labour costs per unit of output will rise more rapidly and potential output growth will fall.  Moreover, the rise in the profit share to multi-year highs in the US and Europe suggests that some wage pressures are likely to emerge, supported by a growing consensus in society and political circles that workers should get a “fair” (read: higher) share of national income.  Break-even inflation rates do not fully reflect these risks, and so I expect inflation linkers to outperform nominal bonds in 2007.

Tighter global liquidity, higher term premium.    The experience of the last few years suggests that, even if short-rate expectations are revised up due to, say, higher inflation expectations or a better growth outlook, this need not translate into a rise in long-term bond yields, because this might be offset by a decline in the term premium.  (Recall that the term premium is usually defined as the gap between the expected average short-term interest rates over the lifetime of a bond and the yield on that bond.)  Most estimates suggest that the term premium has declined significantly in recent years (see J. Fels and M. Pradhan, Fairy Tales of the US Bond Market, 26 July 2006).  While there are several competing explanations for the vanishing term premium, I continue to think that global excess liquidity, created by central banks around the world due to overly expansionary policies, is the main culprit. 

While the Fed and the ECB are no longer expansionary on our measures, the Bank of Japan is still at the pump, and perhaps even more important, other Asian central banks along with their peers in the Middle East, Russia and Latin America are still flooding bond markets with excess liquidity as they recycle their growing external surpluses.  Excess liquidity is unlikely to drop sharply in 2007, but it should become tighter at the margin.  The Bank of Japan is likely to raise interest rates at least twice next year.  Thus, G3 excess liquidity is likely to tighten further, at least until the Fed starts to cut interest rates.  Moreover, with the global slowdown unfolding, Asian external surpluses will grow less rapidly or even shrink, and lower commodity and oil prices resulting from the slowdown would reduce producers’ revenues.  Thus, Asian, Middle Eastern and Latin American central banks would have less fresh money to recycle into global bond markets, and so, somewhat paradoxically, weaker global growth would push bond yields higher.

Market outlook for 2007.   I expect a combination of a global mid-cycle slowdown, re-emerging inflation concerns, and tighter global liquidity to push bond prices lower during 2007.  In each of the G3 countries, I expect 10-year bond yields to climb towards and possibly break above their temporary highs reached in mid-2006 — 5.25% in the US, 4.15% in the euro area, and 2% in Japan.  Investors should brace themselves for steeper yield curves and consider buying inflation protection.  Euro area bonds should outperform US Treasuries in the bear market, as the upbeat expectations about European growth are likely to be disappointed.  And with liquidity getting less plentiful and bond yields expected to rise significantly, risky assets will have a tough time repeating their stellar performance of recent years.  Exit Dr. Jekyll, enter Mr. Hyde!

Sir Winston Churchill may well have been mistaken for a market strategist talking about the term premium rather than the foreign policy of the former Soviet Union.   Bond yields and term premiums have stubbornly refused to come off their lows in spite of rising policy rates, strong growth and rising inflation.

The enigma: Why are bond yields so low? Will they stay low?   Our proprietary model MS-FAYRE suggests that US 10-year Treasury yields should be at 5.5% — a whole 100 bps above their current levels (Fels and Pradhan, Fairy Tales of the US Bond Market, July 2006).   If historical relationships are still valid, then the 17 increases in the fed funds rate and rising inflation expectations should have led 10-year rates higher.   In this sense, 10-year rates have stayed too ‘low’, well below the fair value predicted by MS FAYRE and models of other researchers.   The fact that the 10-year rate has stayed flat despite the tightening of monetary policy led ex Fed Chairman Greenspan to dub the enigma of low bond yields a “conundrum”.  

A direct implication of the conundrum is that some factor(s) must be exerting downward pressure on the 10-year rate equal in magnitude to the upward pull from the factors included in fair value models.

Yield curves in the US and euro area have flattened dramatically since mid-2004, with the 10y-30y segment flattening more than the 2y-10y flattening would warrant.   This is about the time that pension funds started buying long-dated bonds to cover the shortfall in duration from their liabilities.   As the bonds with the highest duration at the end of the curve get richer, demand shifts to earlier points on the curve, with yields falling in inverse proportion to the duration of the bond.

Asian central banks have accumulated reserves far in excess of import requirements.   Given the risk profile of these institutions, government securities in the US and Europe have been obvious destinations without much sensitivity to the price.   Their sustained presence in bond markets is likely to have kept bond yields low (see Mutkin, Guzzo, Pradhan, Dec. 2006). 

The impact of these factors also has implications for the estimates of term premiums from quantitative models.

The Riddle — Why has the term premium fallen?   Will it stay low?   The term premium estimated from the FAYRE model and from the model of Fed researchers Kim and Wright (2005) are highly correlated even though they use very different methodologies (see Fels and Pradhan, July 2006).   These robust estimates suggest that the term premium has fallen since the 1980s as part of the Great Moderation, and has stayed close to zero during the 'conundrum' period.   What accounts for such low term premiums, and will they continue to stay so low?

The potential solutions to the 'conundrum' may partly explain why the estimated term premium has been pushed so low.   These recent forces have pushed bond yields lower than they would have been otherwise.   What remains beyond the effect of the standard factors, i.e., the term premium, will be a much lower number than would have been the case.

However, the term premium riddle is not so easy to solve.   The term premium can itself fall for fundamental reasons, taking yields lower with it.   Thus, we are left with a ‘signal extraction’ problem:   did yields fall because of special factors, or did they fall because of a decrease in the term premium?   The answer probably is a bit of both!   The term premium on the 10-year Treasury rate has been very well correlated with the MOVE index, an index of implied volatility on options on Treasuries.   Intuitively, lower volatility in the market for Treasury securities implies investors will receive lower compensation for the reduced uncertainty, pushing term premiums and yields lower.   The decline in volatility is at least part of the answer to the riddle of the low term premium.   Finally, if interest rate volatility and the term premium are related, then volatility coming off its lows could mean a similar movement in the term premium and yields.

The Puzzle — Why has volatility fallen? Will it stay low?  The correlation between interest rate volatility and the term premium leaves us with a final puzzle:   What could have moved interest rate volatility to its current lows, and what could a trigger a rebound?   Implied volatility on interest rate options tends to reflect periods of uncertainty regarding interest rate decisions, macroeconomic events or technical factors.

There are indications, however, that the current bout of low volatility can be attributed to a much-talked-about and less easily defined force — excess liquidity coupled with increasing integration of financial markets.   The intuition behind excess liquidity can be extended to refer not just to the easy availability of credit and loose financial conditions, but also to the willingness to use these conditions to enter into leveraged positions seeking returns.   This 'search for yield’ has led investors from asset class to asset class, bidding up prices and sustaining investor interest in spite of adverse news and events.   The willingness to take on and maintain positions has made prices less pervious to shocks and news, i.e., it has lowered volatility across asset classes.   As a result, spreads have compressed and implied volatility measures across interest rates, equities and currencies have moved to near-historic lows together.

However, if excess liquidity is reason enough for volatility to plunge, then its withdrawal should be reason for it to surge. Even though some measures of excess liquidity suggest a withdrawal of liquidity is at an advanced stage, no tell-tale surge in volatility has taken place as yet to confirm this link.

Excess liquidity is difficult to define and equally difficult to measure.   Metrics that view excess liquidity via its price (i.e., interest rates) or its quantity (measures of money stock) may provide different answers.   Quantity measures of excess narrow money in the G5 set of countries suggest that liquidity is no longer excessive (see Fels, Turn of the Liquidity Cycle, May 2006) . However, measures for broader definitions of money don't give the same answer, suggesting that financial conditions may still be easy.   While our proprietary natural rate of interest models suggest that interest rates are at neutral in the euro area and above neutral in the US, this is definitely not the case in Japan or even China.   Another proprietary measure of G-10 interest rates relative to their long-term mean (Stephen Jen, Charles St-Arnaud, Aug 2006) suggests that interest rates still have a distance to go to reach ‘normal’ levels.   The upshot is that there are indications of a broad-based withdrawal of liquidity from the world economy, but this withdrawal has not yet become ubiquitous.  

With US rates unlikely to push below neutral, and most other central banks looking to normalize interest rates (i.e., bring them in line with neutral rates), it seems but a matter of time before the withdrawal of excess liquidity shows up in most metrics, and most importantly in the availability of credit and the attitude of investors.   The end of easy financial conditions in 2007 could put the puzzle together, sending volatility higher.   Term premiums may follow, solving part of the riddle.   Finally, the increase in term premiums would take yields higher, providing at least partial relief from the 'conundrum' of low bond yields. 

Global trade linkages have deepened across all major regions in 2005, with global trade as a share of GDP expected to exceed $14 trillion, or 30% of world GDP, this year.  From 1987 to 2005, global trade accounted for 36% of global GDP growth (at market exchange rates), more than double the 17% seen during the 1974 to 1986 period.  According to IMF estimates, world trade volumes of goods and services will have grown 8.9% in 2006, well above the 7.5% longer-term growth trend and our call for 5% GDP growth this year.  While technological advances contributed to a sharp reduction in transportation and telecommunications costs, thereby stimulating trade, it was a more inclusive trading system that generated tailwinds for economic growth and recovery.  Developing countries are benefiting from this integration as well — the ratio of trade to GDP of least developed countries increased from 25% in 2000 to 30% in 2004, the latest year for which data are available.  As a result, any move toward reduced openness could limit their potential for growth.

Pundits have argued that a mix of factors preordained the death of Doha — decision-making based on consensus in an increasingly disparate WTO membership, recalcitrance of developing countries represented by the G-20, and the more prominent role of bilateral and regional free trade agreements.  Reluctance of the US and Europe to meaningfully liberalize their highly subsidized agricultural sectors has not helped either.  Yet it is precisely those countries and regional blocs most exposed to the competitive pressures of globalization that have reaped the benefits of free trade in recent years.   Between 2003 and 2005, average annual growth in the export of goods from ASEAN, Mercosur and the Andean Community exceeded that of the EU-25 and NAFTA (18%, 25% and 31%, respectively, versus 13%).  While the former are dwarfed in absolute size by the latter, their export and import shares with the rest of the world are considerably higher.  This is not to say that free trade alone fuels economic performance, as fiscal prudence and balance of payments are equally, if not more so, important, but it helps.  GDP growth in the Mercosur is expected to remain above 4% this year and next, and our prognosis for the ASEAN-5 is equally strong with 5%+ growth projected through 2008.  This contrasts with a deceleration of growth below 3% in NAFTA next year, and weaker growth in Europe as well.

If free trade is so beneficial for growth, then why have negotiators refused to compromise?  Poor countries, led by Brazil, India and South Africa, have argued that as latecomers to a game created by and primarily for the rich, they are at a distinct disadvantage and hence should be expected to yield less ground.  Yet inter-regional export diversification is most pronounced in Africa, the Middle East and Latin America, accounting for trade shares of 84%, 72% and 90%, respectively.  Bilateral trade flows between China and Africa have more than tripled since 2002, and Africa’s net trade with China is now positive.  Moreover, according to the World Bank, more than half of the costs associated with the exports of poor countries results from restrictions imposed by other poor countries.  For example, the tariff structure imposed by India on textiles from neighboring countries such as Bangladesh and Sri Lanka effectively doubles or triples final product prices, heavily skewing the terms of trade.  Roughly sixty percent of total customs duties collected on merchandise imports worldwide accrue to the developing world, based on data from the WTO.

Unfortunately, the explosion of bilateral and regional trade deals over the past several years has distracted from multilateral efforts, consuming limited political capital which will be needed if Doha is eventually to succeed.  Asking politicians to repeatedly take the stand for trade liberalization, no matter how small or inconsequential the deal, is neither a smart nor sustainable strategy.  Yet just about all 149 WTO members participate in at least one of the nearly 200 regional trade agreements currently in effect.  Not only does this lead to inefficiencies for multinational companies who must devote more resources to understand the myriad of rules and regulations affecting their products, but it negatively impacts smaller or poorer countries that often do not possess the clout to extract favorable trade terms.  To fix the mess they started, the US and Europe must exercise greater leadership in curbing preferential trade agreement (PTA) contagion if discipline is ever to be restored to the global trading system.  This is particularly urgent given the enabling clause of the GATT, whereby trade amongst developing countries is unbound by Article 24 and the nondiscriminatory most-favored nation rights that apply to developed countries.  For burgeoning economies such as China’s, which is expected to become the world’s second largest trader in 2007, the unrestrained ability to cherry-pick who gets what level of preferential tariff treatment is unlikely to nurture support for freer trade elsewhere in the world.

Acknowledging the redistributive nature of trade and implementing more robust mechanisms to support those who fall between the cracks will be necessary to stem the backlash against globalization.  Deep-seated mistrust for further global integration has already been evidenced through a bevy of protectionist events ranging from the razor-thin passage of CAFTA in the US, rejection of the EU Constitution, and economic patriotism vis à vis the failed deals of Unocal/CNOOC and Dubai Ports World.   China-bashing is also on the rise, with more than two dozen pieces of anti-China legislation circulating in the US Congress.  Expanding trade adjustment assistance, in the form of worker retraining programs, enhanced educational opportunities and wage/health insurance schemes, could rebuild public support for freer trade in industrialized countries at relatively little costs.  Estimates by the Institute for International Economics show that this would amount to an additional $3-12 billion annually in the US, a paltry sum compared to the $500 billion potential gain from further liberalization.  Finally, multilateral organizations such as the World Bank are in a unique position to incentivize poor countries to open their markets through the administration of aid-for-trade programs that provide technical assistance and compensation for lost tariff revenues and special preferences.

To regain momentum on the global trade front, the world needs a policy jolt akin to the inaugural Asia-Pacific Economic Cooperation (APEC) summit held in November 1993.  What worked as a catalyst for the Uruguay Round could work again for Doha.  With roughly 40% of the world’s population, the 21-country trading bloc accounts for 57% of world GDP and 48% of world trade.  As was the case then, the economic costs associated with the potential exclusion from an Asian Union or Free Trade Area of the Asia Pacific could bring Europe and other major holdouts back to the bargaining table.  Aspirations of the Association of Southeast Asian Nations (ASEAN) to accelerate the creation of a single-market economy amongst its 10 members by 2015, and the proliferation of PTAs throughout the region, could also promote an outgrowth of competitive liberalization that reinvigorates Doha and puts global trade liberalization back on track.

Bilateral and other less-than-multilateral trade agreements are a poor substitute for a global deal, and lead down a dangerous road pot-holed with reciprocal barriers and other retaliatory measures.  By further reducing market distortions such as tariffs, subsidies and quotas, Doha has the potential to reintroduce much needed discipline into trade negotiations that have increasingly favored one-off deals driven more by political rather than economic considerations.  As part of a rules-based regime, developing countries are for once on a level playing field to have their voices heard.  Threats from terrorism, escalating confrontations in the Middle East and heightened tensions with North Korea further underscore the imperatives to reform rogue states through economic integration rather than isolation.  While laissez faire liberalism may not be the answer, neither is forfeiting on a more inclusive international rules-based trading system. 

This is a time for reflection on 2006

I am saving my 2007 outlook for the first week of January.  Instead of looking ahead, I think it is useful, at the end of the year, to take a moment to reflect on the year that has just gone by, and to evaluate my calls this year and draw lessons from how the currency markets behaved this year. 

What I said at the beginning of the year

1.    “The story for the dollar this year will be cyclical and closely linked with the developments in the US housing market.”  I argued that the ‘trendy’ phase was over and for 2006, I saw a “gentle turn in the dollar in sync with a soft-landing in the US housing market.  I also argued that the US current account deficit would reach an ‘inflection point’ in 2006, which should diffuse much of the angst about the dollar from a structural perspective. 

2.  “2006 will be the Year of the CNY.   More flexibility and more meaningful appreciation of the Chinese currency are expected.”  As the CNY appreciates, it will push all the Asian currencies stronger against the dollar.   JPY will be the laggard in this bunch due to its very low yield … China will become the largest foreign reserve holder in the world later this year, surpassing Japan.

3.  “The dollar’s movements this year will likely be asynchronous against various currencies.”  “In contrast to the previous four years, the dollar’s movements are likely to be asynchronous against different currencies.  In other words, the USD is likely to peak at different points in time against various currencies.

My good and bad calls this year

In my view, my call for a cyclical dollar correction centered on the US housing market has been broadly correct.  I argued a year ago that EUR/USD was forming a bottom in the 1.17-1.18 range.  I was also correct in expecting USD/AXJ, led by USD/CNY, to trade lower this year, with USD/JPY being the laggard due to the low yields in Japan.  Importantly, my prediction that the US current account deficit would reach an inflection point this year also seems to be correct. 

I was, however, wrong on several fronts.  (1) I had underestimated the market’s support for EUR/USD and the ability of the Euroland economy (Germany in particular) to recover.  (2) In contrast, I was too aggressive on USD/JPY this year, thinking that USD/JPY would go on being weighed down by positive real economic fundamentals, and that the relative low nominal yields would matter less over time.  (3) I underestimated the scope for EUR/JPY to trade higher.  Even though I proposed the ‘Global Funneling’ concept as an explanation for this upward structural drift in EUR/JPY, I did so quite late (August).  (4) I had expected the three commodity currencies to depreciate against the dollar, as the global economy decelerated with the US, and because these currencies were already over-valued.  Further, I had expected that the prospective unwinding of the JPY carry trades would weigh on these high yield commodity currencies. 

Lessons from 2006

There are several key lessons from 2006 that will be important to keep in mind for 2007.

•   Lesson 1.   Financial globalization will remain a powerful driver of exchange rates.   By financial globalization, I mean the sharp rise in cross-border capital flows, both private and official, in recent years.  Trade balances and globalization of the goods markets are clearly important, but I believe that capital flows and financial globalization are even more important in dictating where exchange rates go. 

First, it has been a global trend that ‘home biases’ have declined in most countries.  This has made current account imbalances a much less powerful predictor for exchange rates. 

Second, as virtually all countries are diversifying, it has been difficult to draw clear, definitive conclusions for currencies.  As a result, investors have thus been forced to extrapolate from announcements made by a few central banks and countries that are unfriendly toward the US, such as Iran, North Korea and Venezuela.  My view on this subject of central bank diversification is quite different from popular opinion in the market, but I concede that since the prevalent view can neither be proved nor disproved, comments and rumors will continue to fuel bouts of mini-attacks on the dollar, interrupted by sporadic surges in the dollar based on economic fundamentals. 

Third, as the official reserves of several key central banks in the world exceed what are needed for liquidity purposes, many central banks will likely deploy the additional or new foreign reserves to investments that are higher-risk but with higher expected returns.  This evolution from pure reserves to the ‘sovereign wealth funds’ has begun, and will have very significant implications for not only the currency markets but also bond and equity markets in the years ahead. 

Fourth, in thinking about the fair values (FVs) of exchange rates, it is also important to consider a concept I proposed several years ago: Multiple Shadow Prices.  The basic idea is that, while most fair value calculations, including ours, are based on real economic fundamentals, given the importance of global capital flows, a parallel concept is that some countries may have very different exchange rate FVs, from the perspective of capital markets. 

•   Lesson 2.   Cash yield differentials will likely remain important.  I have long resisted accepting that nominal cash yield differentials could be such the dominant driver for exchange rates.  To me, over time, real economic fundamentals (such as productivity and the terms of trade) should be important and carry should not.  How the currency markets have behaved in 2006 suggests otherwise, however. 

First, cross-border asset holdings have grown drastically in recent years, the need to hedge should also have increased.  Since hedging costs are dictated by nominal short-term interest rates, cash yield differentials may have become a more powerful driver than in the past. 

Second, I have recently realized that the sensitivity of exchange rates to nominal cash interest rates may also have been due to the enhanced transparency of central banks in their communication strategy. 

• Lesson 3.   Don’t bet against the Fed.   To me, the Fed has been the best forecaster of the US economy.  At virtually all turning points since 2002, the Fed has been ahead of the market and made the correct call.  I am not saying that the Fed does not make mistakes, but merely pointing out: (i) the remarkable level of confidence the Fed’s detractors have in this environment of uncertainty; and (ii) the recent superior track record of the Fed, compared to anyone else in the market. 

•   Lesson 4.  Beijing to be more flexible in the years ahead.  I believe that the single most important development in China this year has been the explosive growth in its trade surplus.  There is no way around: (i) China’s additional reserves being converted into a ‘sovereign wealth fund’; and (ii) the rate of crawl of USD/CNY accelerating further.

•   Lesson 5.  Don’t underestimate any economy, even Euroland.   Back in early 2005, Japan surprised many with its economic recovery, as did Germany a year later. The point here is that a lesson I have learned is not to dogmatically cling to preconceived notions: a structurally flawed Euroland can exhibit surprising resilience.  The durability of the recovery we are witnessing is the next test for Euroland, but commentators (like myself) and investors should be open-minded about this. 

Bottom line

Many of the key themes that have dominated this year will likely carry over to 2007.  I will present my 2007 currency outlook in more detail early next year. 

Inflation appears to have peaked in September, and inflation risks seem to have moderated, as both inflation expectations and growth have cooled over the past few months.  For example, year-over-year “core” inflation measured by the CPI has declined by 0.3% in the past two months to 2.6% in November, and measured by the Fed’s preferred gauge, the personal consumption price index (PCEPI), it probably declined to 2.2%.  Surprising softness in a broad range of categories — motor vehicles, air fares, communication and apparel — yielded a flat core rate in November.

Adding to the good inflation news, longer-term inflation expectations calculated by the University of Michigan’s consumer canvass remain below their summer peaks, although they edged up to 3.1% in early December.  And distant-forward (5-year, 5-year) inflation compensation has moved down by 25 basis points from summer levels.  Together with slower growth, those factors prompted us to reduce slightly our baseline inflation forecast for 2007 to 2.4%, and to predict a steady monetary policy until late next year.  Is that inflation forecast now too high?

It could be, but before jumping to that conclusion, it’s worth remembering that there’s still considerable uncertainty over inflation measurement and key inflation determinants, and thus about the outlook.  That uncertainty will probably dominate the inflation outlook and thus the monetary policy debate in 2007.  Some officials legitimately take comfort from today’s well-anchored inflation expectations.  But as I see it, neither policymakers nor investors should take them for granted; today’s well-behaved readings could change and don’t guarantee that inflation will recede.  The commitment of monetary policy and possible policy action to assure that outcome is the missing link.  Thus the Fed’s policy bias may be slow to change.

There is, to start, uncertainty over the “right” measure of underlying or core inflation.  The two popular measures of core inflation both moved up over 2006, but the core CPI accelerated by 60 bp but core inflation measured by the PCEPI rose by only 0.1%.  The main culprit for the divergence: Shelter, which has twice the weight in the core CPI as in the PCEPI, took off with increased demand for apartments and a sympathetic response in the so-called owners’ equivalent rent category.  As these and other factors fade, these two metrics are converging.  In the three months ended in November, the core CPI rose at just a 1.6% rate, while the core PCEPI probably decelerated to 1.8%. 

Nonetheless, these data may exaggerate the inflation downshift.  We’re suspicious that some of November’s price softness may exaggerate reality or may not last.  In particular, motor vehicle discounting may ebb with inventories of new cars and trucks back to desired levels.  Moreover, while airlines may have passed on lower fuel costs to fares in recent months, load factors are high and anecdotal reports point to a recent rebound in fares.   And the unusual weakness in the communications category this month largely reflected a sharp drop in the price of internet access services — perhaps tied to recent price slashing by a major provider.

What’s more, there’s much less certainty over how to measure key inflation determinants and the model that links them to inflation.  What are those determinants?  The workhorse “markup over cost” inflation model has proven increasingly less reliable, courtesy perhaps of good monetary policy, globalization, and changes in firm pricing behavior.  Indeed my own analysis suggests that firms now price “to market,” setting prices based on conditions of demand and supply in global product markets. 

Both models do include three key elements, however: A measure of inflation expectations, a gauge of slack in the economy, and factors that “pass through” to underlying inflation, like changes in energy or import prices.  But it appears that the slack-inflation relationship has loosened over the past several years, and that the pass-through has also diminished.  This flattening of the so-called “Phillips curve” means that as slack dwindles, inflation may not rise as much today as it did in the past.  But it also means that the cost of bringing inflation down may have risen. 

Or has it?  The price to market model may help explain this phenomenon, as companies absorb costs, including currency swings more readily into margins.  But lower and more stable inflation expectations may also have shifted the relationship rather than altered its slope, so that empirical analysis must consider all these factors.  Indeed, recent studies show that inflation expectations may exert a “gravitational pull” on inflation so long as a credible monetary policy provides a “nominal anchor” for them (see Brian Sack and Joel Prakken, “Inflation Modeling,” Macroeconomic Advisers, December 13, 2006).  The pricing dynamics of such models are consistent with my price-to-market hypothesis.

Operationally, however, our inability to measure economic slack and inflation expectations with any precision also adds to inflation uncertainty.  Measures of slack in the economy, like the output gap, are unobserved, and the unemployment rate only measures slack in labor markets, not in product markets.  Some fear that potential growth has recently shrunk by as much as 1 percentage point to 2½%.  In my view, it has declined, but to about 3%.  In any case, that issue is a key source of today’s inflation uncertainty among policymakers and investors alike. 

Likewise, Fed Vice-Chairman Kohn recently noted that “the reliability and usefulness of the existing data [on inflation expectations] are less than we might like.”   And “inflation compensation measures are ‘contaminated’ both by an inflation risk premium and by differences in liquidity between the markets for nominal and indexed Treasury securities…and give only a sense of where inflation is expected to go, not why it is going there.” 

That statement highlights a risk in using market-based measures of inflation compensation as independent evidence on inflation expectations: Fed policies affect market prices, so breakeven inflation reflects the Fed’s own views.  Thus, Vincent Reinhart, FOMC secretary, opined in 2003 “to rely exclusively on market prices to inform policy decisions is like looking in a mirror” (“Making Monetary Policy in an Uncertain World,” August 28, 2003).  

But there is also a positive element to such market-based measures: They serve as barometers of the Fed’s commitment to keeping inflation both low and stable.  Fed officials can look to such measures as one barometer of their commitment to assure the right outcome.  But they are not the only such measures.  Richmond Fed President Lacker worries that three years of inflation running above the Fed’s presumed comfort zone will allow inflation expectations to drift higher.  In that context, the Fed’s tightening policy bias serves as a commitment to cap inflation, and a contingent signal for action if needed.

Given inflation uncertainty, inflation risks seem evenly balanced around our baseline outlook: A stumbling economy could reduce inflation faster than we think likely, while stronger growth that reduced product and labor-market slack would boost it.  In the spirit of the holiday season, however, it’s worth noting that one admittedly uncertain metric puts inflation well above the Fed’s presumed “comfort zone:” PNC’s Christmas Price Index.  According to the 22nd annual survey, the cost of the gifts in “The Twelve Days of Christmas” is $18,920 in 2006, a 3.1 percent increase over last year.  Even so, I’m most certain that the Fed’s tolerance for higher inflation than today’s is limited. 

Over the past few months, the two-tiered nature of US economic activity has become increasingly apparent.   The goods sector has displayed significant softness — primarily concentrated in the homebuilding and motor vehicle industries.   Meanwhile, the service sector looks to be cruising along at a healthy growth clip.   To be sure, the results of the Institute for Supply Management (ISM) surveys covering the manufacturing and service sectors in November highlighted the sharp divergence.   However, there now appear to be indications of a near-term bottoming in motor vehicle assemblies as well as a possible moderation in the pace of decline in home construction. 

The motor vehicle industry — accounting for about 3% of overall GDP — has certainly undergone a gut-wrenching correction over the course of 2006.   In an attempt to improve long-run profitability, low margin fleet sales have been pared and legacy costs have been written down.   The downsizing has been significant.   From 2002 to 2005, domestic vehicle production averaged 12.1 million units annually — with very little variation around that pace (specifically, output was 12.3 in 2002, 12.1 in 2003, 12.0 in 2004 and 12.0 in 2005).   Over the course of 2006, assemblies were cut to about an 11.0 million unit pace.  Based on the Federal Reserve’s seasonally adjusted data, the downshift in vehicle production played out gradually over the course of this past year.   Indeed, after troughing at 10.4 million units (annualized) in October, current assembly schedules point to sequential upticks in both November and December, followed by a flattening out in the first quarter of 2007.

Is such stabilization reasonable?   We think it is.   Our latest US economic forecast shows overall light vehicle sales (including imports) running near 16.1 million units in both 2007 and 2008.  This represents a further slowing relative to the 16.5 million units sold in 2006 and the 16.8 average pace recorded during 2002–2005.  Most importantly, current inventory levels appear to be in reasonably good shape.   Indeed, at the end of November, stockpiles were 3.5% below last year and the lowest for that particular month in the past five years.   So, with domestic production having been shaved by more than 1.0 million units relative to the 2002–2005 run rate and with sales likely to decline by a somewhat smaller amount — even after allowing for some pickup in imports — the industry appears to have already reached a production equilibrium.   Thus, the powerful economic headwind associated with the downshift in motor vehicle production may now be behind us.

One other quirk involving the motor vehicle sector deserves mention.   In 3Q, the statisticians at the Fed came up with a dramatically different estimate of seasonally adjusted motor vehicle output than seen in the GDP data.   Specifically, the Fed’s IP figures showed a sharp decline in assemblies — enough to subtract 0.6 percentage point from GDP growth.   Meanwhile, the GDP accounts showed motor vehicles adding 0.8 percentage point.  While there is always some divergence between these two measures, due largely to differing seasonal adjustment factors, the gap evident in 3Q is unprecedented.   We expect to see an offsetting swing in the respective measures in 4Q and have built this into our GDP estimate.   However, the Fed’s data series is cleaner and certainly fits much better with the widespread indications of a significant pullback in vehicle production during 3Q.   Down the road somewhere, we wouldn’t be at all surprised to see the Commerce Department revise its motor vehicle data in a manner that brings it into better alignment with the Fed series.

What about the other major identifiable headwind confronting the US economy — housing?   As my colleague Dick Berner laid out in a recent analysis, while there have been some encouraging signs of late — in particular, a noticeable upturn in weekly mortgage application volume — it is still far too early to call a bottom (see “False Dawn for Housing Demand?” December 8, 2006).  But, it does seem clear that progress is being made. The accompanying chart shows the NAR’s measure of housing affordability.   The affordability gauge is a relatively simple metric that can be used to help value the housing market. It’s based on only three variables: home prices, mortgage rates and median household income.  The higher the index the better — that is, a high reading implies high affordability and vice versa.  Over the course of much of the past decade, affordability remained elevated despite skyrocketing home prices.   Obviously, this was largely a reflection of declining mortgage rates.   Only in the past year and a half did affordability start to show signs of becoming increasingly stretched as home prices continued to rise as mortgage rates bottomed out.   By mid-2005, the affordability gauge was pointing to a fundamental misvaluation in the housing market.   And the market now appears to be undergoing a price correction that will eventually restore a reasonable degree of affordability.   Indeed, the figure shows historical data plotted through October with an extension of the series going forward based upon the following assumptions:   (1) a 5% decline in home prices over the next year, (2) steady mortgage rates, and (3) a trend rate of growth in household incomes.   In such a scenario, affordability is restored to an equilibrium level within a year or so.

Obviously, such an outcome does not necessarily mean that prices won’t go down by more than 5% in some markets.   As seen in the figure, while affordability in the West (dominated by California) is consistently more stretched than for the nation as a whole, a 5% price drop would not be sufficient to restore the index to its 1995–2005 average.   Indeed, certain regions of the country already appear to be experiencing significant price declines in response to severely stretched affordability.   But this is all part of the adjustment process.  As long as mortgage rates don’t rise too much, we expect the price correction nationwide to be roughly in line with that experienced in the 1990 episode.   In that instance, real home prices, as measured by the OFHEO index, declined by about 6% over a 1-year timeframe.

What would such a price swing imply for the consumer?  With the household sector’s holdings of residential real estate valued at a shade over $20 trillion as of end-3Q, a 5% decline in home prices would lead to about a $1 trillion loss of wealth.  Applying a standard wealth effect of .04 (that is, a 4 cent impact on consumer spending for every dollar of change in wealth), implies a $40 billion hit to consumer spending in a static sense.   This is significant, representing nearly 0.5 percentage point of consumer spending.   However, it actually pales in comparison to the potential short-run impact associated with the recent plunge in gasoline prices.   Through much of the spring and summer, the national average price of regular gasoline hovered around $3/gallon.  Over the past few months, the price dipped to about $2.25/gallon.   With gasoline and fuel oil accounting for 4% of overall consumer spending, such a swing in prices frees up roughly $90 billion of discretionary spending.  In our view, this is one factor — in conjunction with generally stimulative financial conditions — that has helped to prevent the spillover of the housing market correction to the rest of the economy.

Of course, the sharp drop in homebuilding activity experienced during recent quarters has been a major direct hit to the overall economy.   Indeed, our latest estimates suggest that Fed Chairman Bernanke was spot on when he indicated during a Q&A session following an October 4 speech that the decline in residential construction activity would shave about 1 percentage point from GDP growth during the second half of 2006.  However, as the inventory of unsold new homes begins to respond to the cutback in new construction, the drag on the overall economy from reduced homebuilding should begin to ebb as we head toward mid-2007.

Setting the stage for 2007 growth.   In sum, we appear to be at the end of a major correction in the motor vehicle sector and within a quarter or two of experiencing a deceleration in the pace of decline in residential construction activity.   This should set the stage for the economy to resume growth at (or even a bit better than) trend in the second half of 2007. 

After a flood of revenue growth that offset continued elevated spending led to a sharp narrowing in the budget gap in the past two fiscal years, we look for stabilization in FY2007, with revenue growth normalizing back towards GDP growth and spending growth decelerating to its slowest growth of the Bush Administration as tight budgets the past couple years take hold and gridlock rules in Washington.  Net Treasury supply should rise relatively modestly this year, but with a compositional shift towards bills and away from coupons.  Relative stability should rule through 2008, but the outcome of the 2008 elections and a sharp rise in maturing coupons in FY2009 create considerable uncertainty for the budget and Treasury financing beyond then.

Surging revenues drove another upside surprise in FY2006.  With significant additional spending on tap for hurricane rebuilding and the beginning of the Medicare prescription drug plan and an expected moderation in tax revenue back towards the growth rate of the economy after the 14.6% spike in FY2005, we came into FY2006 expecting a significant temporary widening in the budget deficit to over $400 billion from the $319 billion recorded in FY2005.  And boy were we wrong — revenues continued to surge, spending proved a bit more restrained than expected, with little growth on an underlying basis in nondefense discretionary outlays, and the deficit surprisingly narrowed significantly further to $248 billion, or 1.9% of GDP versus 2.6% in FY2005.

Total revenue jumped another 11.8% in FY2006, making for the strongest two-year rise since FY1980-81 (and with inflation running in double digits back then, the real rise the past two years was much stronger).  Upside was seen across all categories.  Individual income taxes rose 12.6%, with withheld taxes up 7.9% and nonwithheld 20.7%, the latter apparently reflecting in part the surge in options and bonuses that so sharply boosted Q1 wage and salary income in the national accounts.  Corporate taxes jumped 27.2% and have now nearly tripled since the FY2003 trough.  Social insurance taxes gained 5.5%.  And driven by sharply higher remittances from the Fed, miscellaneous other revenues even spiked 17.6%.  Meanwhile spending rose 7.4%.  While this was in line with the elevated gains during the prior four years, on an underlying basis the results pointed to improvement.  In particular, excluding defense, Social Security, Medicare (which was boosted by about $25 billion by the beginning of the prescription drug plan), Medicaid and other health programs, and net interest, spending rose 6.7% or $48 billion.  Almost all of this reflected two special items — a $29 billion increase in spending by FEMA for flood insurance and other hurricane cleanup related spending, and about $15 billion in noncash accounting adjustments to revalue subsidies on student and housing loans made in prior years.  Stripping these out clearly indicated that the tight lids on nondiscretionary budget authority passed in FY2005 and FY2006 finally started to take hold in a major way to restrain nondefense discretionary outlays — an underlying improvement that should be much more evident in FY2007 without the one-off boosts to spending.

Stabilization in 2007.  We look for the deficit to widen modestly in FY2007 to $265 billion, which would keep it steady as a share of GDP at a relatively low 1.9%, with both revenue (+4.6%) and outlays (+4.8%) growth expected to moderate significantly.  Relative to GDP, revenues plunged from a peak of 20.9% in FY2000 to a low of 16.3% in FY2003 before recovering to 18.4% in FY2006 — very close to the long-term average.  We look for revenue to hold close to this share in FY2007, with growth expected to be just slightly less than our estimate for nominal GDP growth.  This slightly slower expected revenue growth compared to GDP is largely from two sources.  First, individual tax refund growth should be unusually strong relative to recent history in 2007 as a result of consumers’ ability to claim a refund of previously paid long distance telephone excise taxes that were overturned by the courts on their 2006 tax returns.  This should boost refunds in 2007 by about $10 billion.  Second, we are looking for a sharp slowing in corporate profits over the course of 2007.  After rising at about 25% a year the past four years, we expect pre-tax corporate book profit growth to moderate to less than 5% in FY2007, and we also expect the effective tax rate to moderate slightly after a sharp surge in recent years.  Taken together, we expect net corporate taxes to be up 4.0%.  Otherwise, we expect withheld income (+5.4%), nonwithheld income (+5.9%), and social insurance (+5.2%) taxes together to run in line with our estimated growth in personal income, which we recently scaled back somewhat as we marked down our 2007 GDP forecast and incorporated the downward revisions to income in the last GDP revision.

The significant slowing in underlying nondefense discretionary spending growth that was seen in FY2006 should become more apparent in FY2007.  This underlying restraint, the absence of special items that boosted outlays last year, and some continuing moderation in defense spending growth should help to offset upside in nondiscretionary spending — particularly Medicare and interest — to keep overall spending growth at +4.8%, which would be the smallest rise since FY2001 and a major improvement from average rises of 7.3% in the first five full years of the Bush Administration.  On the upside, Medicare spending growth is likely to accelerate significantly further in FY2007 with the first full year of the prescription drug plan and a legislative change that shifted some payments out of 2006 and into 2007.  Since the Medicare prescription plan picks up some costs that were previously covered by Medicaid, it makes more sense to look at them together — we expect overall spending in Medicare, Medicaid, and other health programs to rise 11.3% this year after rising 6.0% last year, accounting for more than half of the overall spending rise we project.  Interest expense growth should moderate somewhat from the sharp surge seen last year as rates flatten out, but still see significant growth. 

Meanwhile, on the positive side, discretionary spending growth, particularly nondefense, looks set to decelerate significantly.  Since surging 16.3% in FY2003, defense spending growth has moderated each year since to +6.8% in FY2006, and we expect further slowing in FY2007 to +4.9%.  After having surged 73% from FY2001 through FY2006, defense spending appears to moving towards gradually topping out at a high level.  Meanwhile, after the spending spree of the early years of the Bush Administration, the White House requested and Congress passed tight limits on regular nondefense discretionary budget authority in both FY2005 and FY2006 of only about +2% in each year.  And after a bit of a lag, this restraint clearly became apparent on an underlying basis in FY2006, even as overall spending was boosted by unusual items.  Clearly, after the recent election the outlook here is somewhat cloudy for FY2007.  With the outgoing Congress having passed only two of the eleven appropriations bills, the bulk of the budget is operating under a continuing resolution through February 15 that holds spending at last year’s levels.  Our baseline case is that the likely gridlock next year keeps discretionary spending growth on a tight leash, as happened for an extended period during the Clinton Administration, which along with the continuing impact of the tight budgets passed the prior couple years should keep overall nondefense discretionary spending growth slow in FY2007.  Adding in the impact of the absence of the special factors that boosted outlays in FY2006, we expect spending outside of defense, Social Security, Medicare, Medicaid and health, and interest to fall 2% this year.

Treasury financing implications.   We expect overall net Treasury issuance to rise to $249 billion in FY2007 from $213 billion in FY2006.  The $17 billion increase we expect in the budget deficit explains only about half of this. The rest should result from a smaller contribution from nonmarketable debt issuance and “other means of financing.”  The combination of these two items reached a record +$103 billion in FY2005, and, while moderating significantly, remained very elevated at +$61 billion in FY2006.  We look for some normalization to +$5 billion in FY2007.  Nonmarketable debt issuance — which is primarily State and Local Government Series (SLGS) debt that municipal governments use as a means to invest proceeds from pre-refundings without running afoul of laws against their arbitraging the tax advantaged status of their debt — has already slowed sharply from a record $64 billion in FY2005 to $13 billion in FY2006.  We look for a modest further slowing to $8 billion this year.  The much bigger swing factor we estimate to be other means, which ran extremely strong relative to typical levels in each of the prior two years, as various off budget sources or uses of money turned significantly more positive.  Our base case at this early stage is that these positive swings have run their course and other means will swing from a $48 billion source of cash in FY2006 to a slight use of money this year. 

At current coupon sizes, we estimate Treasury faces a financing gap — the amount of increased market issuance through higher coupon sizes and net bill issuance needed to fund the budget gap plus nonmarketable funding sources or uses — in FY2007 of $97 billion.  This — and any reasonably likely deviation from it — can be easily met within the current financing structure.  The main shift we project in the current fiscal year is some rebalancing between bills and coupons.  In FY2007 the first full year of revived 3-year notes will mature, leading to a $50 billion increase in overall coupon maturities.  We expect coupon sizes to move somewhat higher starting with the 2-year and 5-year issues at the end of January and continuing with the February refunding and for these slightly levels to be maintained through year-end.  We project a $2 billion boost in the 2-year size to $22 billion, a $1 billion increase in the 5-year to $15 billion, a $1 billion increase in the 3-year to $20 billion, and a $1 billion increase in the 10-year to $14 billion new/$9 billion reopening.  Starting in February, 30-year issuance will shift to quarterly from semi-annual, with new issues in February and August and reopenings in May and November.  We expect the run rate for 30-year issuance to rise from $24 billion to $30 billion ($9 billion new/$6 billion reopening), but since there was no bond in November, actual bond issuance would be unchanged at $24 billion in FY2007 under this pattern.  Combined with an expected $70 billion in TIPS issuance, we see overall gross coupon issuance rising $20 billion to $698 billion, but net issuance falling to $190 billion from $217 billion.  Offsetting this should be a pickup in net issuance of bills.  The recent budget surprises led to net bill paydowns in each of the last two fiscal years and a sharp decline in the bill share of the outstanding publicly held debt from 22.4% at the end of FY2004 to 18.0% at the end of FY2006.  The debt managers have suggested that the recent paydowns were neither intended nor particularly desirable and have seemingly driven the bill share below where Treasury would like it to be.  The swing to about $60 billion in net bill issuance we project for FY2007, would start to rectify this, lifting the bill share about a half percentage point.

Medium-term issues.  The Democratic takeover of Congress clearly presents significant uncertainties for the medium-term budget outlook.  Our assumption is that not much of anything will happen for the remaining two years of the Bush Administration, keeping spending relatively restrained and the deficit near current levels as the trend like GDP growth we anticipate keeps revenue growth reasonably healthy.  The key uncertainties will not be decided until the 2008 elections.  The major Bush tax cuts begin to expire at the end of 2010, and unless Republicans hold the White House and retake Congress most of them likely will be allowed to expire.  A Democratic sweep in 2008 would probably mean that the increased revenues this would bring in would be spent on programs the Democrats feel were neglected under the Republicans.  A continuation of split government, in which tax cuts expired and not much in the way of new spending was able to get past the White House, could put the budget on a significantly improving path.  As far as more medium-term funding issues, assuming the deficit stays reasonably close to current levels, the existing financing calendar is fine through FY2008.  In FY2009, however, the first full year of monthly 5-year issues mature, leading to a sharp rise in coupon maturities and a large resulting financing gap that could possibly call for more substantive adjustments to the current auction schedule than the relatively small swings in coupon sizes and net bill issuance we expect for the next couple years

Business conditions continued to deteriorate, remaining below 50% for the seventh consecutive month, but the deterioration isn’t intensifying.  The Morgan Stanley Business Conditions Index (MSBCI) increased by four points in early December to 44%, retracing some of November’s decline.  The less-volatile three-month moving average edged up two points to 43%, the highest level since August.  At 43%, the fourth quarter average only stands one point above the third quarter average, meaning analysts are essentially just as pessimistic in the current quarter as they were last quarter. 

Last month we noted that our bullish forecasts were out of sync with gloomy analyst reports, although we admitted that analysts were more accurate on conditions in the 3rd quarter than we were.  Earlier this week, given incoming data, we sharply lowered our near-term GDP forecast, with the three quarter growth rate ending in 1Q07 averaging only 2%.  However, there are also glimmers of improvement: A positive employment report and a blow-out retail sales report have led us to revise our current quarter GDP tracking estimate up 0.9 pp to 2.5%.  Furthermore, advance bookings were higher in the Empire State manufacturing survey.   Score: Analysts 1: Economists 1?  The jury is still out!

Results from this month’s survey suggest that analysts may be preoccupied with slower volume growth and fading pricing power, leading to lower top-line results in nominal terms.  On the volume side, the advance bookings index declined three points to 40%, the lowest level of the index since April 2003.  Also, our pricing conditions index plunged twelve points to 51%, the lowest level since January 2005.  The breadth of responses was roughly equal between lower prices compared to a year ago, unchanged prices, and higher prices; only one-third of analysts said that companies have increased prices, down from the peak of 64% in February. 

So what about the bottom line?  Despite the moderation in price increases, a full 34% of analysts noted that prices charged have increased faster than unit costs over the past three months, the highest percentage since June.  Furthermore, a full 61% said that margins are higher compared to a year ago at companies under their coverage.  Luckily, our survey is in line with analysts on the Street: As of this Wednesday, Street analysts expected 61% of companies in the S&P 500 to have rising margins in 2006.  S&P 500 earnings revisions have also improved, from 4.8% in early November to 7.9% this week.

We also asked analysts this month about the impact of lower energy quotes and higher materials prices on the bottom line.  Lower energy prices will have little to no impact for 65% of the groups and will be a negative factor for the energy and utility companies.  Higher metals and industrial commodity and foodstuff quotes will hurt the bottom line somewhat for 17% of the groups and significantly for 9% of the groups.  Half of the analysts reported that these commodities have no impact on earnings.

Still, results from this month’s survey suggest that there is no sign of a revival yet, at least according to Morgan Stanley analysts.  Along with the dismally low advance bookings index, our business conditions expectations index declined four points to 36%, matching September’s record low.  This month, only one-fifth of analysts expect business conditions to improve over the next six months.  Plans to hire and increase capex also declined in early December; 35% of groups plan to increase hiring over the next three months, retracing some of November’s record bounce to 41%.  Only 43% of groups plan to increase capex, below the historical average of 46%.  However, a full 45% of the groups that plan to increase capex plan to do so by 6% or more.  We still maintain that there is pent-up demand for capital spending and expect that the deceleration in equipment and software outlays in 2006 will give way to roughly 7% annualized growth in the first two quarters of 2007.

The breadth of results narrowed in early December.  54% of analysts noted that conditions were unchanged over the past month, up from 41% in early November, while the percentage of analysts noting deteriorating conditions was only 30%, down from 41%.  No analysts reported either noticeably deteriorated conditions or noticeably improved.  Conditions improved for the consumer staples group and marginally for healthcare, while conditions deteriorated for IT, materials, industrials, financials and consumer discretionary. 

On a positive note, the credit conditions index remained at 55%, indicating that financial conditions are still supportive of growth.  We believe the decline in interest rates, the tightening of credit spreads, and the decline in the dollar have recently made financial conditions easier.  We also asked analysts this month how much the declining dollar will contribute to bottom-line results at companies they cover.  A full 41% said the dollar will have no impact, while 22% said it would have a marginal impact.  The declining dollar will have a larger impact mostly for the consumer staples, IT, and materials groups, but will actually be a negative factor for the wireless services and railroads.

There have certainly been bigger market movers in recent years, but Friday’s CPI report was one of the most shocking data releases in memory.  The reason -- unlike employment numbers or retail sales data -- the CPI figures tend to exhibit very little month-to-month volatility. In fact, a forecast miss of 0.2 percentage points on the core CPI is about a two standard deviation event. To put it another way, over the past 10 years, the core CPI outcome has been 0.2 percentage points higher or lower than the consensus on only 8 occasions (or 6.7% of the time).  Most importantly, when such a surprise does occur, it is almost always traceable to a big move in a single volatile component -- such as tobacco or hotel rates. In this case, there was no such sole special factor responsible. And, to top it all off, the big downside surprise in November followed on the heels of a notable -- although not quite as large -- downside surprise in October.

Friday’s report was particularly shocking from another standpoint. Mathematically, it is virtually impossible to get a 0.0% result for the core when the shelter category, which accounts for 41.7% of the core, is up 0.4%. Yet that is exactly what happened in November. As seen in the accompanying figure, the core CPI excluding shelter was -0.2% in November -- the lowest reading in the 40-year history of the data.

From our standpoint there are three possible explanations for the sharp deceleration seen in the core CPI over the past two months.

1)  The data are correct and should be taken at face value. Core inflation experienced a significant run-up in the first nine months of the year (rising from around +2.0% to a +2.9% yr/yr rate in September) and we are now simply seeing a rapid unwind, reflecting the pullback in energy prices and a weaker economy.  Of course, the problem with this story is that the transmission from energy prices to consumer prices is hardly instantaneous. It takes at least a few months -- if not a few quarters -- for this chain of events to play out. Moreover, while economic growth has slowed, labor markets remain very tight and cost pressures -- even after taking into account the latest revisions -- continue to edge gradually higher. We assign about a 20% probability to this scenario.

2)  The October and November data reflect statistical quirks that will be unwound in relatively short order.  While there was no single special factor responsible for the much lower than expected core CPI results over the past couple of months, some of the categories that played important roles simply do not seem to square with reality. Two obvious such items are motor vehicles and air fares. Automakers have pared production dramatically over the course of 2006 so that they could discount less -- not more. Indeed, vehicle inventories at the end of November were at their lowest level for that particular month in the past five years -- hardly a recipe for a stepped-up pace of price cuts. Meanwhile, airline industry load factors remain quite elevated and industry pricing data simply do not support the notion that there have been sizeable fare reductions of late. It’s certainly conceivable that we will see a sharp rebound in vehicle prices and air fares along with a flattening out of apparel prices and a continued escalation in OER over the course of coming months. This could put us right back at a +2.9% yr/yr rate by February. We assign about a 35% probability to this scenario.

3) Finally, it’s quite possible that the October and November data merely reflect an unwind of some quirks which had temporarily elevated the core CPI readings in the first three quarters of the year. In other words, both the prior up moves and the down moves of late have merely reflected statistical noise. Core inflation has actually been holding fairly steady all along. One possible culprit in this scenario is inadequate seasonal adjustment. Interestingly, in both 2004 and 2005, the core CPI experienced a run-up in the early part of the year followed by significant deceleration later on. While this seems to us to be the most likely scenario -- we assign it a 45% probability -- there are still plenty of unanswered question. Specifically, while a seasonal bias may be evident in the data over the past few years, the swings in both 2004 and 2005 are almost entirely attributable to big moves in a single volatile category -- hotel rates. And, there does not appear to be any sign of such a seasonal bias in the core CPI for the 10 years or so prior to 2004. 

In the end, only time will help tell us which one of these scenarios best explains the swings in the core CPI over the course of 2006.  In the meantime, it seems reasonable to assume that the inflation picture is not as scary as previously feared. However, with labor markets still tight, with productivity showing signs of some modest cyclical slowing, and with energy prices remaining quite elevated relative to a few years ago, it would be wrong to assume that inflation risk has disappeared entirely.

As the risks surrounding a global slowdown increase, it might seem overly optimistic to be upbeat on the prospects for Latin America for 2007.  After all, the region has benefited in recent years from a period of unprecedented Chinese demand that has boosted prices for commodities from the region and contributed to a prolonged bout of above-trend US growth and low interest rates.  Interest rates have now been rising around the globe, the US economy has slumped in the post-housing-bubble shakeout, and there is increasing debate over whether China will engineer a successful moderation of growth.  Meanwhile, the region continues to have its “problem countries.”  In the past month, Hugo Chavez was re-elected as president in Venezuela, and Ecuador voted in a new president who campaigned on the moral need to repudiate the country’s debt.  Still, we are optimistic about Latin America.

Latin America is benefiting from the arrival of macro stability and a dose, however partial, of certainty.  In a region where growth has frequently been punctured by crises that have brought down currencies, economic models, and heads of state, the mere fact that 2007 should mark the fifth year of good growth and low inflation is an important accomplishment.  Is it enough?  Most certainly not.  Most of the region’s inhabitants still suffer from glaring shortcomings — from inadequate healthcare and education to an irregular regulatory framework — all of which have limited stronger growth in productivity.  But we would argue against underestimating the power of a dose of stability.

Perhaps nowhere is the change that the region is undergoing clearer than in Brazil.  Just four years ago this month, Brazil watchers were engaged in a debate over whether the country was on a path leading to debt default and capital controls.  Today, Brazil has zero net public external debt (net of international reserves), a declining debt path for its domestic debt, and inflation hovering around that of the US. 

Benefits from Macro Stability Should Not Be Underestimated

Our optimism on Brazil might seem mistaken.  Indeed, Brazil’s disappointing growth record has prompted calls from within the global economics team at Morgan Stanley to strip the country of its place within the BRICs (see “Hitting a BRIC Wall,” in This Week in Latin America, September 25, 2006).  But we would argue that this is precisely the wrong moment to disqualify Brazil from its place within the BRICs.  We suspect that Brazil is on the verge of much stronger growth in 2007 and in the coming years, as it delivers continuity on the macro front of the sort that we have seen in recent years. 

Our upbeat assessment on Brazil’s growth path in 2007 is predicated on our view that there is a strong case for significant interest rate reduction.  Indeed, perhaps nowhere in the emerging markets is the case for a reduction in rates stronger than in Brazil.  Inflation has plummeted even as real rates have remained largely unchanged.  And that, we believe, sets Brazil up for an important bout of monetary easing in 2007 as real rates begin to decline at a pace previously reserved for nominal rates.

We expect the targeted Selic interest rate to reach 11.25% by the end of 2007 and to fall further in 2008.  With projected real rates at their lowest level in decades, we expect Brazil’s growth path to improve.  Of course, the challenge is not simply a matter of monetary policy.  The economy needs a stronger investment platform, and that means changes in the regulatory environment, improved infrastructure, and a healthier public sector.  But the benefits from stability and hence lower interest rates are likely to prove powerful forces boosting the investment cycle in Brazil. 

Looking elsewhere in the region, even in Mexico there is still room for progress.  Although we are less optimistic about the new administration’s ability to build the much-needed consensus for reforms on the fiscal and energy fronts, there is still room for progress on the stealth reform agenda.  Low inflation — core inflation has been running within Banco de Mexico’s target range for the past four years — has begat a dramatic extension of the yield curve and the birth of mortgages and credit to those who had long been beyond the reach of financial intermediaries.  That trend is likely to continue uninterrupted in 2007 and provide a significant cushion to a slowing export-based manufacturing sector.

And we still expect Argentina to remain the fastest-growing economy in the region despite its distortionary policy mix.  While price controls, negative real interest rates, a heavily managed exchange rate appreciation, and export regulations aimed at controlling inflationary pressures are not long-term sustainable policies, the long term is unlikely to arrive in 2007.  Even in the most vulnerable sector, namely electricity generation, we see no major dislocations in 2007.  In fact, we expect the economy to keep powering ahead, with domestic consumption doing most of the heavy lifting through expanding credit, a real estate market boom, and rising real incomes. 

Bottom Line

We are fairly upbeat on the prospects for Latin America for 2007.  If our global team is right and the world sees good, albeit slower growth, Latin America should post another above-trend result.  Now five years into the current growth upturn, we have seen little of the excesses of past upturns in the region.  The current cycle has not produced the ballooning trade and current-account deficits fueled by consumer spending seen in the past, nor widening fiscal deficits, nor the spectacle of central banks burning through reserves to prop up woefully overvalued currencies.  Thus, while the region is hardly immune to a potential global slowdown, we suspect the consequences would be much milder than in the past and would ultimately strengthen the region’s newfound stability. 

The short-term outlook for the euro area is clouded by major macro uncertainties, from the nature of the slowdown in the US to the consequences of a three-point VAT rate hike in Germany, effective on January 1.  Yet we believe that the domestic recovery, fuelled by a powerful monetary stimulus and structural improvements such as faster productivity and more flexible labor markets, should provide a robust base for growth next year.  While GDP growth should decelerate significantly, from 2.7% in 2006 to 1.9% in 2007, on our forecasts, the consequences of the VAT hike in Germany should be limited, being fully anticipated by German consumers and companies operating on the German market.  Nevertheless, uncertainties are so high that financial markets may turn much more volatile than they were in 2006.  These uncertainties will likely also cause the ECB to approach further tightening more cautiously (see Elga Bartsch’s “The ECB’s Balancing Act” in this issue).

While increasing risks for investors, volatility also generates investment opportunities.  Here are three macro themes that could provide investors with such opportunities: US-Europe decoupling; labor market reforms and tensions between capital and politics.

1.  A ‘soft decoupling’ between the US and Europe.  A widespread view in the markets is that Europe follows the US cycle with a six-month lag.  This theory may regain popularity, but for the wrong reasons, we believe:   growth is likely to slow in Europe in the first months of 2007, for domestic reasons — a 150 basis point monetary tightening by the ECB and a 0.6% of EMU GDP fiscal tightening in the German and Italian budgets.  Rather, we anticipate a ‘soft decoupling’ between the US and Europe:   GDP growth falling significantly below trend in the US while decelerating towards trend in Europe.  Because domestic demand is the main driver of growth in both regions, business cycles are not necessarily synchronized.  For sure, financial linkages matter, as we learned during the previous downturn, when European companies slashed investment projects from 2001 to 2003.  Massive capital outflows to the US — mostly driven by acquisitions — at the outset of EMU had made investment projects by European companies highly sensitive to the US capex cycle.  However, this time, the US slowdown is coming from housing investment, to which neither companies nor investors in Europe seem to be exposed.  As we see it, once fiscal policies relax their grip, growth should re-accelerate in Europe, where the personal savings rate should decline further, while the US economy is likely to continue to grow below trend speed, as the personal savings rate rises.  Thus, ‘hard’ decoupling could become a popular theme in the course of the year.

2. Labor markets: end of ‘easy reforms’?  So far the rapid decline in euro area unemployment hasn't fuelled wage inflation, a sign that structural unemployment is steadily declining.  Policies aimed at reducing the cost of low-skilled jobs (by cutting social contributions most of the time) have worked, but their unwelcome side effect was the creation of two-tier labor markets.  Also, the secular upward trend in the female participation rate is increasing the share of flexi-jobs, on trend, which helps reduce structural unemployment.  However, with euro area unemployment likely to ebb towards 7% in the next 12–18 months, tensions in labor markets may appear, leading to higher wage inflation.  Since dual labor markets generate inefficiencies and social tensions, governments will have to consider more far-reaching reforms, such as relaxing wage-bargaining systems, removing obstacles to redundancies or simplifying labor contracts.  Labor market policies are likely to be hotly debated ahead of the French presidential election but could also return to the forefront of political debate in Italy and Germany.  More ambitious reforms would probably help the ECB keep rates lower, thus boosting growth and profits.

3.  Watch tensions between capital and politicians.  Together with ample liquidity, rising cross-border capital flows within the single currency area and divergent dynamics in domestic demand have fuelled rising current account imbalances.  While Spain is heading towards a double-digit current account deficit to GDP ratio, Germany and the Netherlands are both running a current account surplus to GDP ratio of similar magnitude.  A potential rise in intra-EMU imbalances may fuel political tensions, we think, against a general backdrop of anti-globalization sentiment.  Interestingly, in the new EU member states, capital inflows also seem to fuel political tensions here and there.  With slower growth ahead and large war chests accumulated in previous years making companies more aggressive, tensions may rise further next year.  Taking a longer-term view, political leaders seem to have largely underestimated the practical implications of the European Monetary Union and of the EU enlargement: with capital easily crossing borders, restructuring has become a permanent and obsessive theme for European companies.  The result is that companies operating on a pan-European basis and having global ambitions have a growing influence on economies, while governments have less.  The tug-of-war between the power of capital moving freely across borders, while most workers won’t, and institutions changing slowly, creates investment opportunities.  For that, investors need to pay attention to two elements: political resistance, which differs across countries and sectors, but also the long-term picture, which is in my view the emergence of large global companies operating from their historical European base. 

So far, tightening monetary policy in the euro area was easy.   Coming from a record low of 2% for its main refinancing rate, the ECB Council was unanimously in favour of a gradual withdrawal of monetary stimulus over the last 12 months.   Throughout the first year of the new ECB interest rate cycle, inflation and GDP growth forecasts were steadily upgraded providing arguments for nudging interest rates higher.   Money markets and ECB watchers, by and large, anticipated the future course of ECB action correctly thanks to a set of code words signaling the timing of the next move.   Financial markets took the ECB’s tightening campaign in stride.   The common currency grinded higher only gradually, with the brief exception of a more rapid rise in late November.   Yields of longer-dated government bonds hovered in a trading range between 3.5 and 4.0% for most of the year.   The next 12 months are likely to demand a much more delicate balancing act from the ECB, in our view.

We expect the ECB to hike interest rates further in 2007 — in the light of GDP growth at or above trend, ongoing robust job creation, and rapid money and credit growth.   We forecast a total of 50 bps of ECB interest rate hikes by December 2007.   This compares with market expectations of slightly more than 25 bps.   A total tightening of 50 bps would constitute a noticeable slowdown in the pace of tightening compared with the ‘every-other-meeting’ pace pursued in the second half of 2006.   The much more gradual tempo of tightening reflects the fact that the ECB would be pushing the refi rate towards the upper end of the neutral range, which we estimated to be between 3.5% and 4.0%.   Even though the inflation outlook isn’t showing significant pressures at present, the risks remain tilted to upside, in the view of the ECB.   This perception was emphasised again in the December press conference.   Even though that press briefing gave conflicting signals with regard to the timing of the next move, we still believe that the most likely timeframe is March.   But by stating that it “monitors risks to price stability very closely” — a phrase that in the past indicated that the next rate hike was only two meetings away — February is a possibility too.

Against this backdrop of further ECB tightening, we expect ten-year Bund yields to rise from the current 3.76% level and eventually break markedly above 4% in 2007.   Demand for long-dated bonds, a moderation in nominal GDP growth and pre-emptive monetary policy action will likely limit the rise in bond yields at the far end of the yield curve though.   As a result, would not even rule out a renewed inversion of the yield curve in the next 6–9 months.   When the spread between the ten-year Bund and two-year Schatz briefly dipped into the red in November, investors debated whether this would signal a recession.   This debate could resurface if the spread would move into negative territory again.   Historically, the yield curve has been the most reliable leading indicator for recessions.    But a number of factors distorting the long-end of th