Refilling the Punch Bowl?
March 22, 2007
By David Greenlaw | New York
The statement issued by the FOMC on Wednesday afternoon contained one significant surprise. Specifically, the risk assessment language was altered in a way that left the tilt toward inflation concerns in place but removed the tightening bias. A reference to “additional firming” was replaced by “future policy adjustments” as seen below:
March 21 statement “In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.” January 31 Statement “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.” So, the tilt toward inflation concerns remains, but the potential policy response is now two-sided. We see the change as reflecting a ‘cleaning-up’ of the risk assessment language that carries little policy significance. However, we admit that there is one major problem with this interpretation. The Fed knows the risk assessment was being viewed as a signaling mechanism. Why change it now and risk generating market confusion about its near-term intentions? While the adjustment to the risk assessment came as a surprise, the changes to the growth and inflation language in the first part of the statement were very much in line with expectations. The depiction of economic growth was downgraded and the spin on the housing market reflected less optimism than seen in the January statement. This was countered by an expression of a bit more concern regarding recent inflation readings. Most importantly, the Fed still sees the economy expanding at a moderate pace in coming quarters while inflation pressures are expected to gradually ebb. In the immediate aftermath of the statement release, 2-year Treasury yields fell by about 10bp, the 2s/10s curve steepened by about 5bp and the implied probability of a rate cut by the time of June meeting, as measured by the fed funds futures market, rose from 25% to 40%. Credit spreads narrowed by about 5bp and the ABX index rallied. In the equity market, the S&P 500 jumped nearly 1.5%. The bottom line is that we doubt the FOMC was looking to signal a ‘Bernanke put’ to holders of risky assets. But, that is how some appear to be interpreting the message. Admittedly, all this leaves us a bit confused regarding the Fed’s policy message. We’ll be particularly anxious to see the details behind the tweaking of the risk assessment in the minutes of today’s meeting, which will be released on April 11.
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The 2007 Budget — No Free Lunch
March 22, 2007
By David Miles | London
Chancellor Brown had little room for manoeuvre in his eleventh — and almost certainly his last — Budget. In the past few months, tax revenues have been marginally weaker than he had anticipated, and he had limited scope for more borrowing, given his fiscal rules. So, his main changes had to be self-financing. Thus, despite the initial headlines that the Chancellor had managed to find some tax cuts, the reality is that these are matched by (somewhat less obvious) effective tax increases elsewhere. There were no free lunches here. The headline rate of corporate tax has come down — but this is financed by net reductions in capital allowances and a rise in the tax rate on small businesses. He has announced a cut in the basic (or headline) rate of income tax — but this is offset by removing a lower rate on the first band of taxable income and by an increase in the effective rate of national insurance on some earners. A substantial amount (£6 billion) has been found for pensioners employed by companies that went bankrupt and who were not covered by the recently created Pension Protection Fund. Education spending is one of the few elements of overall government expenditure forecasts to rise roughly in line with GDP; most other spending departments have to see their spending fall as a percent of GDP. Overall borrowing is marginally higher over the next few years, but is projected to stay just under the 40% net debt ceiling. Asset sales bring in significant revenues to finance some of the higher spending. The Debt Management Office (DMO) has announced that it will sell around £60 billion of gilts this year; about two-thirds will be long-dated bonds. Looking further ahead, borrowing is little changed from previous forecasts. Not surprisingly, the Chancellor announced that he had succeeded in balancing the current budget, on average, over a ten-year cycle, which he estimated to have just ended. The 2007 Budget: Main points in more detail Macroeconomic performance: - Slightly above trend growth is predicted for 2007 at 2.75-3.25%. Thereafter, growth is set at trend. We believe that the Treasury’s forecasts are slightly optimistic. They are based on fairly robust consumer spending. We anticipate that households will want to save more, and so in the near term, spending will be a bit less strong than in the budget forecasts. - The economic cycle is forecast to end in early 2007. This means that the aggregate surplus on the current budget over the estimated ten-year full cycle is approximately +£11 billion. This means that the Chancellor can say he has met the ‘Golden Rule’ over the last cycle. But it also means we begin a new cycle with a fiscal deficit. Government spending: - The Treasury now forecasts slightly higher overall spending over the next few years relative to the December Pre-Budget Report (PBR). Asset sales — more than new tax revenues or more borrowing — raise much of the funds needed to finance this. Borrowing: - Public Sector Net Borrowing is forecast to be slightly higher, and the budget deficit marginally worse. Net debt is forecast to (just) stay on the right side of the 40% ceiling. Tax receipts are predicted to rise by almost 1% of GDP over the next couple of years. What has been given away: - The basic rate of income tax, which will be reduced from 22p to 20p as of April 2008, but this is largely offset by the removal of the lower 10p starting rate. - The rate of corporation tax, which will be reduced from 30p to 28p as of April next year; this is largely offset by less generous capital allowances. - £6 billion of additional funding for individuals who lost their pensions as a consequence of pension fund bankruptcy. Where does the money come from? - Asset sales, including the securitisation of £6 billion of student loans, will generate an additional £18 billion over the next few years. - An increase in the rate of small business taxation from 20p this year to 22p by 2009. - National insurance contributions will be levied on more income. Debt management: - The Debt Management Office (DMO) plans to raise £59.8 billion in 2007/8, £58.4 billion of which is from gilt sales and the remaining £1.4 billion from Treasury Bills. Gilt issuance is marginally down on this year, largely because the debt office will run down its stock of cash. - Just under two-thirds of planned gilt sales will be long-dated in 2007/8. - There is little change in borrowing further ahead as compared to the December Pre-Budget report. Conclusion The budget is, overall, fiscally neutral; there has been little change in the planned level of borrowing. But within a broadly unchanged balance between planned spending and taxing, there have been some significant changes. The corporate tax changes will create winners and losers as the balance between tax rates on smaller and larger companies shifts, and capital allowances change. There have also been some significant changes in the way income tax and national insurance contributions are levied. Asset sales have helped allow the Chancellor make a big one-off contribution to those who had pensions with companies that became bankrupt. As with any broadly neutral budget, this one will create losers as well as winners. It creates a somewhat simpler system of corporate and personal income taxation — removing some of the intricacies Chancellor Brown had introduced in earlier budgets.
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Subprime Motives
March 22, 2007
By Serhan Cevik | London
Volatility is in the nature of financial markets and does not necessarily signal bad fundamentals. It never ends. Like fractals, volatility is omnipresent in every tic of data, driven by one reason or another. However, the outbursts of volatility in financial markets are not necessarily a sign of weak economic fundamentals. There are of course imbalances in the world economy, but we need to treat them carefully in the light of institutional developments and structural changes around the world that may well be, at least, partially responsible for the emergence of global imbalances in the first place. Last year, for example, market participants experienced two consecutive panic attacks — first, about the prospect of higher interest rates in the US, and then the risk of economic recession. In the end, it turned out to be just that — a panic attack. The global economy has remained on a robust growth trend with no runaway inflation, leading to a prolonged but steady recovery in financial markets. And the latest episode of global risk reduction has come on the back of a new set of factors — the risk of overheating in China, the end of yen-funded carry trades and the subprime lending implosion in the US. These difficulties could, in theory, spill over and slow economic growth, but economic fundamentals remain strong enough to withstand healthy corrections in lending activities and asset valuations (see Oh, Chicken Licken, What Have You Done?, March 12, 2007). Changes in global risk appetite have become the biggest risk to emerging economies. In the good old days, fiscal problems and structural weaknesses in developing countries used to be the trigger for abrupt adjustments in financial markets. That is no longer the case, thanks to prudent policies and structural reforms adopted by an increasing number of emerging economies. Instead, the abundance of liquidity and changes in global risk appetite present the most immediate threat. Let’s look into this issue from the Turkish perspective, once more. While holding approximately 70% of the free float in the stock market, foreign investors accumulated more than 20 billion lira worth of domestic government debt since last summer and now carry a fixed-income portfolio of 42 billion lira. In other words, non-residents own 35.7% of non-bank holdings of domestic debt, up from last year’s low of 20.7% and 11.5% at the end of 2003. With interest rates at 20%, it is not surprising to see Turkey as a magnet for carry trades, but it would be a grave mistake to leave it there. After all, interest rates stood at an average of 64.9% in 2002 and 46.1% in 2003, and foreign investors owned at the time just about 17% of their current holdings of domestic debt. In other words, today’s Turkey is not just a carry-trade story, but a strategic investment opportunity that attracts long-term and more committed capital flows. Stronger fundamentals and tighter domestic liquidity conditions shield the Turkish economy. Turkey is — and will remain for a long while — exposed to changes in global risk appetite, but stronger economic fundamentals and tighter domestic liquidity conditions shield the economy against occasional bursts of financial volatility around the world. Take, for example, the VIX index — a widely used measure of global volatility — and the volatility of the Turkish lira. During last year’s volatility eruption, when the VIX increased by 110%, the lira weakened more than 30% in a matter of weeks and its volatility surged by a staggering 1275%. This time around, however, while the VIX jumped by 96%, the lira has remained fairly stable and showed a 56% increase in its volatility. Turkey has a long way to achieve sustainable macroeconomic normalization, but fundamental improvements and tight liquidity conditions in domestic money markets certainly lessen the economy’s sensitivity to exogenous shocks and excessive fluctuations in financial markets. Look at, for example, the business cycle. After last year’s shocks, many expected the collapse of the Turkish economy, but it has weathered the storm and remained on a balanced growth path. While interest rate-sensitive sectors led to a healthy correction in domestic demand, the new, more export-oriented composition of economic activity has kept growth engines running. This is why we have long argued against indiscriminate risk reduction and for greater emphasis on economic fundamentals.
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Dragon’s Appetite
March 22, 2007
By Serhan Cevik | London
China’s demand for commodities will remain an important determinant of oil prices. The abundance of global liquidity has had various effects on economic activity and asset prices in the past five years. With cheaper and easier funding opportunities, investors have rushed into markets all around the world and even turned commodities into financial assets. Nevertheless, we should not dismiss the rise in commodity prices as pure speculation. There are real economic fundamentals (as well as geopolitical constraints) behind the sustained price movements. And among all these variables, the emergence of China as the world’s leading manufacturing base, and its increasing demand for commodities, have become a key factor in the international petroleum market. China may account for just 5.5% of global GDP and 7.5% of global demand for oil, but what matters is its rate of incremental growth, especially with tighter supply conditions. Indeed, China’s mineral fuel imports increased from US$6.7 billion at the end of 1998 to US$20.6 billion in 2000 and US$90 billion last year. Even after correcting for higher prices, this significant surge is responsible for about half of the increase in global oil demand and hence the windfall gains enjoyed by oil-producing nations. China’s appetite for energy resources remains robust, but is likely to ease in the future. The price of crude oil declined from the peak of US$78 a barrel last summer to as low as US$50 at the beginning of this year and lately stabilized around US$60, but this correction is largely due to the consolidation of investment positions and a weather-related drop in oil consumption. The China factor has not changed its direction or intensity yet. In fact, coupled with strong growth, China’s efforts to build strategic petroleum reserves (which will hold 90 million barrels by the end of next year and 500 million barrels by 2020) will keep increasing the country’s dependency on oil imports. On the other hand, while the People’s Bank of China has raised interest rates three times and tightened reserve requirements five times in the last 12 months, interest rates remain low and have had a limited effect on credit growth and economic activity in general. As a result, China’s industrial output growth is still running at an annual rate of 18.5% (up from 16.6% last year), and fixed investment (expanding at 23.4% in urban areas so far this year) shows no sign of consolidation. Nonetheless, as our chief economist Stephen Roach argues, the Chinese authorities are likely to introduce new measures aiming to bring the economy onto a more balanced growth trajectory (see Unstable, Unbalanced, Uncoordinated, and Unsustainable, March 19, 2007). Likewise, China will intensify its efforts to diversify energy resources, reduce distortionary subsidies and improve energy efficiency. That is why we think that even as China’s appetite for oil imports remains robust, a cyclical slowdown and structural changes improving energy intensity could lower its import demand, at least on the margin, and thereby lead to further price adjustments. Oil-dependent economies in the Middle East have become more vulnerable to a global slowdown. Judging from the development trajectory of other economies, the increase in China’s oil demand, albeit much larger in magnitude, is not abnormal at all. As urbanization accelerates and the composition of the economy shifts towards industrial sectors, China will continue to have a higher degree of energy intensity. However, it would be unfair to put all the ‘blame’ for higher oil prices on China, since America is still the leading consumer of oil, with 22 million barrels a day versus China’s 7 million barrels. From a different angle, such a skewed distribution of demand also presents a significant downside risk to the price of oil. Especially these days, with growing concerns about America’s economic health and the expected slowdown in China, commodity-producing countries are vulnerable to a synchronized slowdown in the global economy. OPEC members may have achieved a reasonable compliance ratio of 70% with the cuts in production quotas so far, but more pronounced cyclical pressures, coupled with the accumulated effect of energy conversation measures worldwide, could still lead to a marked drop in oil prices and shock oil-dependent economies in the Middle East.
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