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Malaysia
Rates on Hold January 29, 2007 By Deyi Tan and Chetan Ahya | Singapore, Mumbai Rates left unchanged: The central bank (BNM) kept the overnight policy rate unchanged at 3.5% today, in line with our and market expectations. Inflation remained subdued in December: Inflation rose 3.1% YoY (versus 3.0% YoY in November), bringing the full-year number to 3.6% YoY (versus +3.1% YoY in 2005). Specifically, inflationary pressures in major components of the CPI basket remain at similar levels compared to November. Food inflation reached 2.9% YoY in December (versus +3.0% YoY in November). Housing and utilities rose 1.7% (versus +1.6%) and transport inflation stayed at 8.7% YoY. Monetary policy consistent with expected steady growth path and lower inflation: In its monetary policy statement, the central bank reiterated its view that economic growth maintains on a “steady growth path” while inflation is likely to be contained going forward. It deemed the current level of policy rate as consistent with its growth and inflation outlook.
United States
Paybacks Ahead? January 29, 2007 By Richard Berner | New York Growth and inflation “paybacks” may lie ahead. Although the economy has recently gathered steam, unseasonably warm weather may have temporarily boosted economic activity towards a pace above trend, so a payback seems logical now that the weather seems to have turned more seasonable. Likewise, although inflation has recently cooled off, that slowing may owe partly to temporary factors, given that inflation fundamentals still point to lingering upside risks. Consequently, an inflation payback may also be coming, but in the opposite direction. How should investors handicap these crosscurrents? There’s no mistaking the stronger tone to recent economic data, although significant disconnects remain between official statistics and survey-based readings of business activity (see “Three Disconnects,” Global Economic Forum, January 22, 2007). After slowing significantly for much of last year, economic activity apparently accelerated over the last two months of 2006, lifting fourth-quarter growth close to its trend rate of 3% and setting up the first quarter for a pace that could be above trend. Much of the pickup was genuine, reflecting a combination of strong income gains, lower energy quotes, favorable financial conditions and hearty global growth. A sharp decline in inventory accumulation and nearly flat capital spending kept output growth restrained, but with inventories lean, we think gains in retailing, exports, and a December pickup in capital goods bookings augur strong momentum going into the first quarter. But some of the pickup in the economy may have been transitory. Warm weather may have muted the housing recession in the November-January period, and could also have boosted nonresidential construction, employment, the workweek, and even some lines of retailing. If so, how large was the temporary lift, and how big will be any payback now that the weather seems to have turned more seasonable? In my judgment, the influence of weather on overall activity was small, but reversals are especially likely in housing demand and construction, and renewed declines in housing may significantly color perceptions of the economy’s overall resilience. After all, pessimists have long seen housing as the economy’s Achilles’ heel: The housing recession and collateral damage on employment and housing-related spending, and from the effects of decelerating housing wealth on consumer spending were expected to eventually undermine growth. Despite evidence of offsetting strength in income and global growth, therefore, such a reversal would be honey for economy bears. Two strands of evidence point to a moderate payback. First, comparison of the recent aberrant weather with other climatic deviations suggests that the impact in November and December 2006 fell short of such events in the past. For example, while heating-degree days in December were 14% below the ten-year norm for that month, December’s average temperature was just 2.3 degrees above the ten-year norm of 34.8ºF. In contrast, the weather in January 2006 deviated by far more from the norm: Nationwide, the temperature was then 5.4ºF above the mean and heating degree-days fell 22.3% below the January average. Notably, utility output plunged by 8.4% last January, more than triple the decline in December. Northeast-centric investors and market participants may not have felt the difference. Last January the warm weather was spread across the country, especially in the A second piece of evidence also suggests a payback, but a moderate one. Econometric work by Macroeconomic Advisers hints that weather, especially harsh winter weather, can have significant effects on overall GDP. Their estimates indicate that the cold snap in late 2000 depressed GDP by 1 percentage point or more in Q4 2000 and Q1 2001 — hastening the onset of recession (at the time, I argued that the resulting spike in natural gas prices would aggravate the incipient weakness in the economy). By comparison, they find that — so far at least — the mild weather in November and December might have boosted GDP last quarter by 0.2%. Importantly, by including lags in their estimated equations, their work also suggests that paybacks in activity typically follow such weather effects. Meanwhile, inflation cooled over the past three months, after rising steadily for much of 2006. Measured by the CPI excluding food and energy over a 12-month span, core inflation fell from 2.9% to 2.6% in December 2006, and other metrics showed similar patterns. Some of that price deceleration was authentic, as a slowing economy and perhaps the influence of lower energy quotes inspired either less price pressure or even discounting of some goods and services. For example, lower energy quotes may have reduced airfares, while weak demand for But there are two sets of upside inflation risks that should become more visible in coming months. First, inflation fundamentals aren’t uniformly positive — far from it. Inflation expectations are well-anchored but remain elevated by comparison with the last two years. For example, median 5-10 year inflation expectations measured by the Finally, rising grain and corn prices — the product of drought in A second set of inflation risks is numerical; some of the deceleration in core inflation may reflect statistical quirks. Over the past five years, and despite sophisticated seasonal adjustment, CPI-based core inflation has averaged about 0.2 percentage point higher in the first half of the year than in the second half, and the gap appears to be more pronounced when inflation is rising or stable. In addition, core inflation measured by the personal consumption expenditures chain price index (PCEPI) includes a measure of prices for services furnished without payment by financial intermediaries. That imputed measure slowed in the second half of 2006, reducing the core PCEPI by 0.1%. It is unlikely to decline further, and could rise somewhat unless interest rates decline. The upshot is that a moderate growth payback that temporarily reduces the pace of economic activity back below trend is likely, perhaps in the second quarter. Indications of such a deceleration may show up in the next couple of months, especially in the weather-sensitive components of economic activity, such as construction. Likewise, fundamentals and statistics point to lingering upside inflation risks and less-favorable inflation data, especially in the next few months. For the Fed and investors, the timing and magnitude of any such paybacks will likely shape monetary policy and returns in the next few months. A significant growth payback could promote a mini-rally in bonds, as it could revive hopes for an eventual further decline in inflation and an easier monetary policy. But the combination of directional changes in both growth and inflation may not be so bond-friendly. Even if growth slowed again, an inflation pickup likely would keep the Fed on hold but biased to tighten. And if the growth payback is small, as I suspect, even stable inflation will leave policymakers with the same hawkish bias. It’s worth stating the obvious: Only the combination of a further decline in inflation and moderate growth would eventually pave the way for an easier monetary policy.
United States
Review and Preview January 29, 2007 By Ted Wieseman and David Greenlaw | New York, New York Over the past week, the Treasury market’s collapse since the early December peaks extended to eight weeks, with yields across the curve hitting their highs since August. Losses were long end-led and, in a reversal from the prior trend, driven by higher inflation expectations rather than higher real rates, as TIPS put in a very strong relative performance. There was very little in the way of economic data or other news to drive the market and what emerged was certainly not overly market negative. Existing and especially new home sales were solid, albeit with weather likely providing a meaningful boost, and a mixed durables goods report showed strength in orders, but softness in capital goods shipments and inventories, which led us to trim our 4Q GDP estimate to +2.8% from +3.0%. More technical-type pressures definitely hurt, with heavy Treasury and other supply coming to market, bouts of significant weakness in the MBS and swaps markets, the latter partly driven by mortgage-related paying that helped drive the benchmark 10-year swap spread to its highest level since November, and what was widely perceived to be a more general technical breakdown in the Treasury market. But while there wasn’t much in the way of obvious fundamental triggers for the latest week’s sell-off, as investors looked ahead to the upcoming FOMC meeting, where a continued hawkish stance is quite likely, and the employment report, where another month of solid results is expected, the major fundamental trend that has been underway for nearly two months merely continued — a major upgrading of views on the economy and accompanying rethinking of the Fed. Futures markets have now completely abandoned hopes of rate cuts any time soon, are barely pricing any easing at all over a longer time frame, and, for the first time in several months, actually see a very slight risk of another rate hike. Benchmark Treasury yields rose 6-12bp over the past week to their highs since August in a bear steepening sell-off in which the belly of the curve performed relatively poorly. The old 2-year yield increased 6bp to 4.98%, the 3-year yield 9bp to 4.92%, the old 5-year and the 10-year yields 10bp each, both to 4.88%, and the long bond yield 12bp to 4.98%. All off-the-run bonds with 2020 and beyond maturities are now yielding more than 5%, and these higher yields at the back end did bring in some real money buying late in the week, but not enough to halt the market’s downward momentum. The two new nominal issues ended the week under water, with the new 2-year closing Friday at 4.975% after being auctioned at 4.93% Wednesday and the new 5-year ending at 4.87% after being auctioned at 4.855% Thursday. The new 20-year TIPS also wound up a bit worse than its 2.42% Tuesday auction level. But TIPS still had a very strong week, with benchmark inflation breakevens moving 11bp higher for the 5-year and 10bp for the 10-year, leading the 5-year/5-year forward inflation breakeven that the Fed looks at as a market-based measure of inflation expectations to rise 8bp to 2.46%, a high since November. In the first six weeks of the now eight week sell-off since the December 1 highs, the upside in yields was more than accounted for by higher real rates -- the 10-year nominal yield rose 34bp over this period and the 10-year TIPS yield 40bp. More recently, however, this has reversed, and now rising inflation expectations are driving the losses — in the past two weeks, the 10-year nominal yield has risen 11bp, while the 10-year TIPS yield has fallen 3bp. The huge repricing in the Fed that has accompanied the Treasury market sell-off saw another significant move in the latest week. In a significant qualitative shift, these latest losses in the fed funds futures market left a marginal risk of a Fed rate hike priced in. The April contract held steady at 5.25% and the May contract lost 1.5bp to 5.25%, but the June contract lost 2bp to break through the 5.25% level and end the week at 5.26%. Losses in eurodollar futures left that market pricing in only one rate cut expected to come at the end of 2007 or sometime in 2008. The Dec 07 contract was off 9.5bp to 5.205% and the low rate Dec 08 contract lost 12.5bp to 5.085%. When Treasuries peaked on December 1, the futures markets were pricing in a 70% chance of a rate cut in March, a 4.75% funds target by mid-2007 and a 4.25% funds rate trough in 2008. Very little economic data were released the past week, and the results of what were released were somewhat mixed. Home sales were solid, continuing the recent trend of improvement, or at worst stabilization, across the range of housing-related numbers. We think that the unusually warm weather played a big part in this apparent recovery and now that winter has finally arrived look for renewed downside in the housing data in the months ahead. We expect a final bottom in the housing recession to be put in sometime in the late spring or summer. Meanwhile, the durables report was very strong on the orders side, but weaker on shipments in inventories, with the latter downside having a slightly negative impact on our 4Q GDP estimate. Existing home sales held basically steady for a fifth straight month in December, dipping 0.8% to a 6.22 million annual rate after small gains the prior two months. Sales of single-family homes fell 1.3% to 5.44 million units, having now held close to this level for six months. Condos, which had been in freefall, posted a second straight gain, rising 2.1% to 777,000 units. The inventory of unsold homes fell 7.9% in December for a 23.3% year-on-year increase. These numbers are not seasonally adjusted, and inventories always fall significantly in December, so the monthly change was not as impressive as it might sound. The months’ supply of unsold homes, also helped by seasonal swings, dropped to 6.8 from 7.3, a seven-month low. Meanwhile, new home sales rose 4.8% in December to a 1.120 million unit annual rate, an eight-month high, on top of an upwardly revised 7.4% jump in November. The regional breakdown suggested that warm weather played a significant role in this surprising strength, with sales in the Northeast up 110% and the Durable goods orders jumped 3.1% in December. A 25% surge in the volatile aircraft category helped, but underlying orders were nearly as strong, with the key core gauge — non-defense capital goods ex aircraft — up 2.4%. Upside in core orders was led by a sharp rebound in machinery after a plunge in November and a decent gain in high-tech products. Most other major categories also posted strong gains, including primary metals, fabricated metals and autos. In contrast to the nearly across-the-board strength in orders, other details of the report were soft. Non-defense capital goods ex aircraft shipments dipped 0.3% and were down 0.9% annualized for 4Q as a whole, pointing to soft investment spending. Inventories rose 0.4% on top of a 0.3% gain in November, the smallest two-month rise since March. With the big disconnect this month between orders and shipments, unfilled orders for non-defense capital goods ex aircraft jumped another 1.7% in December for a record (in the 15 years of available data) 17.8% year-on-year gain. These surging backlogs of unfilled capital goods orders should eventually show up in stronger investment spending, but the same could have been said at the end of 3Q, and the upside in investment certainly doesn’t look like it happened in 4Q. Based on the weakness in December capital goods shipments, we cut our estimate of 4Q business investment in equipment and software to just +0.4%. The smaller-than-expected rise in overall inventories in December also led us to boost our estimate of the drag on growth from slower inventory accumulation to a whopping 1.6 percentage points. Combining these two (each worth a tenth), we trimmed our 4Q GDP estimate to +2.8% from +3.0%. We continue to see the starting point for 1Q growth at this early point at +3.5%. After the very quiet past week, the calendar is extremely busy in the upcoming week with a lot of key data, highlighted by the employment, ISM and GDP reports, the FOMC meeting Tuesday and Wednesday, and the Treasury’s quarterly refunding announcement Wednesday. At the time of the December FOMC meeting, when GDP growth in 4Q looked to have slowed to a 1-handle and the latest inflation data had shown a meaningful slowing in core inflation, it seemed possible that the Fed might be considering shifting to neutral from its long-held tightening bias at this January meeting. Seven weeks later, that seems to be clearly off the table at this point. Growth in 4Q instead appears to have run near 3% and upside risks are dominant going into 1Q, core inflation returned to trend in the latest report after two unusually benign numbers, and the labor market has remained robust, with Fed officials seemingly quite perturbed that the unemployment rate actually declined during the mid-year period of sluggish growth. So little news appears likely to emerge from this FOMC meeting. An unchanged 5.25% funds target is all but guaranteed, and a reiteration of the tightening bias that has been in place since policy went on hold in June — “the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information” — highly likely. The Treasury’s refunding announcement on Wednesday and preceding announcement on Monday of its 1Q and 2Q borrowing estimates should reflect the continued good news on the budget front. After accounting for the significant upside surprise in the December budget surplus and an ongoing surge in January tax receipts — based on Daily Treasury Statement figures through the 24th, we see gross individual income and payroll and corporate taxes on track for a 12% year-on-year gain — as well as making adjustments to some of our assumptions on the spending side (most notably for Medicare and interest) after reading through CBO’s updated projections, we slashed our FY2007 budget deficit estimate to US$210 billion (1.5% of GDP) from US$265 billion. We also initiated a FY2008 forecast of US$185 billion (1.3% of GDP). Based on these new estimates, we now expect the Treasury to extend its recent coupon size cuts, reducing the 3-year size by US$1 billion at the refunding — for a US$40 billion package made up of US$18 billion 3s, US$13 billion 10s, and US$9 billion 30s — then cut the 2-year, 5-year, and 5-year TIPS sizes by US$1 billion each in April. It’s certainly too early to consider at this point, but if budget numbers continue to surprise on the upside, eliminating the 3-year note, which has never really found much sponsorship since being revived in 2003, entirely may be considered by Treasury at some point later this year (see The Disappearing Deficit, by David Greenlaw and Ted Wieseman, for more details. Note that the tax season — always a major swing factor for the full year budget results — essentially kicked off this Friday, when the first major round of tax refunds (which are almost all issued on Fridays) should have been distributed. Refunds will receive an extra boost this year by filers being able to claim a refund of past payment of the recently outlawed telephone excise tax. The data calendar is packed in the coming week, with key releases due out including Conference Board consumer confidence Tuesday, GDP, ECI, and construction spending Wednesday, personal income, ISM, and motor vehicle sales Thursday, and employment, University of Michigan consumer confidence, and factory orders Friday: * The Conference Board index has been running somewhat stronger than other sentiment gauges in recent months. So while we don’t look for as much improvement as seen in the * We forecast a 2.8% annualized gain in 4Q real GDP. A solid gain in consumer spending, together with a significant narrowing in the trade gap and an outsized advance in federal government defense outlays, should more than offset another sharp drop-off in residential construction and a sizeable drag from business inventories, leading to a reacceleration in overall GDP growth during the fourth quarter. Moreover, the expected mix of activity in 4Q points to a further pick-up in the pace of growth in economic activity during the current quarter. Finally, based on the monthly figures available at this point, it looks like the key core PCE price index will be up 2.1% in 4Q — a fractionally lower reading than seen in 3Q. * We expect the employment cost index to rise 1.0% in 4Q, matching the gain seen in 3Q and leading to some further acceleration in the year-on-year growth rate, to +3.5%. The component breakdown is expected to show wages up 1.0%, which would mark the sharpest jump in more than five years. Meanwhile, benefits are likely to match the +1.1% reading seen in 3Q. From a broader standpoint, it appears that the ECI is starting to follow the upward trajectory that has been evident in average hourly earnings for almost a year-and-a-half. This is consistent with the lagged response of the ECI that has become increasingly evident over the past decade or so. * We forecast a 0.6% rise in December construction spending. The housing starts data appeared to confirm that mild weather conditions across much of the nation helped give construction activity a bit of a boost as 2006 came to a close. In fact, in December, we expect this phenomenon to be more evident in the non-residential and public categories than in the residential sector. * We look for a 0.4% rise in December personal income and a 0.7% gain in spending. The employment report pointed to a moderate pace of income growth during December. Meanwhile, the retail sales data, along with the pick-up in motor vehicle buying, imply the best gain in overall consumer spending seen in the past few months. Finally, the core PCE price index is expected to match the +0.2% core CPI reading. * We expect the January ISM to fall to 50.0. With the exception of the report from the Philly Fed, regional results that have been released to this point have pointed to some deceleration in the pace of growth in manufacturing activity. Moreover, the Morgan Stanley Business Conditions Index showed some deterioration in January. So although we believe that the underlying fundamentals in the factory sector are improving, we could see some temporary slippage this month. * Preliminary industry reports point to a slight uptick in the pace of motor vehicle sales in January to a 16.8 million unit annual rate from 16.7 million in December, with the car segment outperforming light trucks. Mild weather conditions during the first half of the month may have provided a boost and helped offset a decline in fleet deliveries, which automakers have pared back in an attempt to bolster long-run profitability. * We forecast a 150,000 gain in January non-farm payrolls. The claims data have been somewhat mixed in recent weeks. However, on balance, the trends appear to point to some further improvement in labor market conditions. Mild weather across much of the nation during the survey period may also provide some support this month — for both jobs and the length of the average workweek. And the conclusion of a strike involving a major tire company should add about 10,000 factory workers to the payroll tally in January. Meanwhile, increasingly tight labor markets, along with minimum wage hikes that were effective in a number of states at the start of the calendar year, point to an above-trend 0.4% gain in average hourly earnings. Also, even though the household survey is expected to show another healthy gain in employment, a further rise in the participation rate is expected to lead to an uptick in the overall jobless rate to 4.7%. Finally, note that this report will include the annual benchmark revision to the payroll employment figures. Recall that back in October, the BLS provided a preliminary estimate of an 810,000 upward adjustment to the job level in the March 2006 benchmark month. * Based on the sharp jump in the durables component, we look for a 1.8% gain in overall December factory orders, which would be the biggest gain since March. Meanwhile, shipments are expected to tick up 0.5% with inventories likely to show a similar advance, leading to a steady I/S ratio.
Japan
The Godzilla of All Carry Trades January 29, 2007 By Robert Alan Feldman | Tokyo Morgan Stanley’s MacroVision conference last week featured much talk of exchange rates, and However, there is one discordant inconsistency: Although senior officials of the Ministry of Finance (MoF) have argued to the contrary, the consensus argues that the yen is far too weak, on virtually any measure of fair value. If you think the yen is too weak, but also think it will weaken further, you must logically start to consider how and why it might reverse. Flow models versus stock models In one sense, the MoF has a credible point. There has been no active intervention for almost three years. True, since the end of active intervention, foreign exchange reserves have risen from US$815 billion in April 2004 to US$895 billion in December 2006. However, all of this increase has come from accumulated interest and valuation changes. In this sense, market flows alone have determined the exchange rate. However, a lack of active intervention in flow markets does not necessarily mean that the exchange rate is market-determined. Indeed, the flow approach to exchange rates was largely abandoned by economists three decades ago, because it could not explain the discontinuous movements of exchanges in response to important events. Instead, stock models of the exchange rate emerged. These models are particularly relevant today, when very large stocks of foreign assets are held by investors around the world. For example, the yen moved sharply overnight at the end of 2005, when prospects for tightening by the Federal Reserve suddenly subsided in light of weak Logical consistency and policy credibility In the context of stock-based models, the MoF’s contention of ‘non-intervention’ is far less credible. When a single investor owns a very large stock of a commodity, it is hard to claim that the price of that commodity is market-determined. Moreover, when a ministry’s justifications for actions change over time, its credibility suffers. For example, the large interventions of 2003-04 were justified by the MoF as necessary to prevent excessive yen strength. Now, three years later, despite a strong stock market and a continuing economic upswing, excessive yen weakness is ignored. This lack of consistency over time leaves the MoF vulnerable to accusations of opportunism. In the short run, most forex investors are very short term-oriented, and do not care so much about logical consistency. In the long run, however, misaligned exchanges rates can destabilize both markets and economies. Distorted exchange rates, volatile markets Today, several oddities appear related to the misalignment of the yen. For example, even though earnings of Japanese companies have not clearly improved since the end of last year, the stock market has risen considerably. Most investors attribute this rise to the weakness of the yen. Second, the low long-term yields in the At some point, a misaligned exchange rate is bound to correct. When it does, large misalignments in other markets are likely to end as well. Correcting misalignments is good, but preventing them is better. This is where the G7 comes in. Correcting misalignments: A job for the G7 The upcoming G7 meetings in Investors are not prepared for G7 action on exchange rate misalignments. Indeed,
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