Are Financial Conditions Turning Restrictive?
June 08, 2007
By Richard Berner | New York
The recent backup in US interest rates and the very recent selloff in equities are making financial conditions less supportive of growth, especially for credit-sensitive areas like housing. Judging by 10-year TIPS rates, real yields have risen some 50 basis points (bp) since the beginning of May, to a level rivaling their cycle high in June 2006. More ominously, in just the past 24 hours, a jump in the inflation component has added another 15 bp to nominal US yields. US and global equity markets, which rallied 11-14% after the correction in March, have declined 2-4% over the past week and our strategists believe there is more to come. For example, our European team’s tactical indicators are all now flashing yellow. That’s happened five times since 1980, and produced an average decline in prices of 15% over the following six months (see Teun Draaisma, “A Full House Sell Signal – We Stay Neutral Equities,” June 4, 2007).
Against the backdrop of decelerating earnings, there’s thus no mistaking the near-term risks to US markets from these developments, but what about the parallel risks to US growth? With mortgage originators tightening lending standards and adjustable-rate mortgages resetting this year and next, this latest rate backup could hobble any recovery in housing, potentially put further pressure on home prices, and thus undermine wealth for the hitherto unsinkable US consumer. Together with the rise in energy and food quotes, the backup in yields and an incipient decline in equity markets seem to have the makings of another perfect storm for US growth. In my view, it is premature to reach that conclusion. Most important, the reason that rates are rising matters. As I see it, it is primarily strong global growth and a change in the mix of global saving and investment — and not a drying up of global liquidity — that are pushing up real yields (see “The Conundrum Unwinds,” Global Economic Forum, May 21, 2007). To be sure, in response to strong growth abroad and the risk that rising operating rates abroad will push up inflation, central banks ranging from the Reserve Bank of New Zealand to the European Central Bank are tightening monetary policy. But these moves largely represent a renormalization of rates rather than a move in global monetary policy to outright restraint. And technical factors have reinforced the recent rout in bonds, as higher rates have reduced mortgage prepayments. Thus, while these developments obviously aren’t a plus for growth, this modest restraint will likely change the composition of US growth more than it will affect the total. Specifically, it reinforces our belief that the housing downturn has further to go, and that any meaningful recovery probably will be deferred until 2009. But it also underscores a key theme in our outlook, namely that, for the first time in two decades, the strength of growth abroad will contribute to US output and job growth via improvement in US net exports. The changing mix of global saving and investment is also pushing up real yields in the context of stronger growth abroad. The critical change is that more of the income generated from strong growth in overseas output and from the favorable “terms of trade” in commodity-producing economies is showing up in stronger final demand in our major trading partners. Thus, some of the flow of saving from overseas that has so far helped to finance the US current account deficit on attractive terms will now be diverted to finance demand growth in many of our overseas trading partners — and in this context, that may contribute to somewhat higher US real interest rates. To be sure, domestic forces also matter, but they mimic the global factors. US real rates are getting a lift from an evident pickup in second-quarter US growth, which we see tracking at about 3½% annualized. And “term premiums” — the compensation for moving out the risk-free yield curve —seem to have risen slightly as uncertainty about the global economic and monetary policy outlook has increased. Rising term premiums would add slightly to financial restraint. Likewise, swap spreads — the benchmark generic risk premium for high-quality borrowers — have widened by about 10 bp over the past few weeks, adding to funding costs for intermediaries and their clients. To assess its impact on US growth, it is important to set this change in financial conditions in perspective. Four factors are critical in that regard. First, the restraint is modest, at least so far. For example, US equity prices following the selloff are still up 5-8% this year and 18-20% over the past twelve months. And real rates are below historical norms and ‘fair value,’ given current economic circumstances, as my colleague Joachim Fels’ work suggests. Second, there are financial offsets to rising rates and falling equity quotes. A weaker dollar, tight credit spreads, and still-ample credit availability leave overall financial conditions favorable. On a broad, trade-weighted basis, the dollar has declined by 2.3% so far this year. And more is likely: If Asian and Middle Eastern central banks allow their currencies to appreciate against the dollar at a faster pace, or de-peg them from the dollar, they will accumulate dollar-denominated reserves more slowly. The gradual diversification of such reserves away from the dollar and from liquid fixed-income securities through the growth of Sovereign Wealth Funds seems likely to further weaken the dollar (as well as boosting US real rates). Measured by an index of high-grade credit default swaps, credit spreads are 2-3 bp narrower today than at the beginning of the year. And while mortgage lending standards have tightened significantly, lenders have loosened standards on commercial loans to large firms and to credit-card borrowers over the last three months. Third, as I see it, the economy is less sensitive to changes in interest rates than in the past. That’s partly because financial innovation has enabled households to bridge shortfalls in income or revenue by borrowing (see Karen Dynan, Douglas Elmendorf, and Daniel Sichel, “Financial Innovation and the Great Moderation: What Do Household Data Say?” 2006). And financial innovation can diffuse credit risks across markets and may tend to reduce risk concentration by putting such risks in the hands of those who want and are better equipped to hold them. This evolving structure acts as a set of financial shock absorbers for the economy, making financial infrastructure more resilient than in the past (see “Credit Derivatives: Benefits and Risks,” Global Economic Forum, May 18, 2007). Finally, any change in financial conditions works with a lag, one that probably ranges from a few months in the case of mortgage resets to two years or more for the impact of equity wealth on consumer spending or of changes in equity prices on the cost of corporate capital. Thus, the easier financial conditions prevailing in the past are still helping growth. For financial market participants, assessing the interplay between financial conditions and the economy — meaning the global economy — is fundamental for determining future direction. The economy-rates connection is now clear: Yields have broken out of the 4½-5% range that has prevailed for much of this year, as market participants have recognized the strong global growth dynamic and largely given up on expectations for Fed ease. Beyond that, the analysis is more complex. Whether yields stay at these levels partly depends on the moves in other asset classes. For example, the combination of rising real rates and stronger growth is a mixed blessing for risky assets: Courtesy of global growth, earnings are stronger than expected, but investors may be wary of paying more for them (see “Corporate Profits, the Dollar and Global Growth,” Global Economic Forum, June 1, 2007). In my view, the correction in equities is a healthy development, since it will remind investors of their risk. Risks in this context abound. A major surge in yields could present more of a headwind to US and global growth, especially if it significantly undermined asset prices. And if global central banks go too far in tightening, growth abroad might be threatened. The real danger for investors lies in lingering upside risks to US inflation, partly from domestic causes, but also from incipient inflation abroad and from rising protectionist sentiment in the US.
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Still Positive on Risky Assets and Non-G10 Currencies
June 08, 2007
By Stephen Jen & Luca Bindelli | London
Summary and conclusions We remain positive on risky assets, and favour high-beta currencies such as the CAD, AUD, NZD and several non-G10 currencies. The majors (G7) are likely to remain in a range in the coming weeks, with the dollar gradually gaining momentum in the coming months against the EUR and GBP. The JPY will continue be treated as ‘guilty until proven innocent’. We will refresh our forecasts next week. We are still positive on risky assets Our currency call is predicated on, among other things, whether risky assets perform well. Although we don’t have an independent view on assets that are covered by our colleagues (Henry McVey in the US and Teun Draaisma in Europe), in general, we hold a very positive view on risky assets over the coming months. To begin with, we believe that the bond-equity arbitrage has a lot further to go, despite the recent sell-off in bonds. Our research shows that the yields on G3 equities and (3M) bonds are still substantially different enough that there is significant scope for the P/E multiples (6.0%) to expand and for interest rates (3.8%) to rise. We do not subscribe to the view that ‘higher interest rates = lower equity prices’: the Fed and other central banks have been tightening for the past two-and-a-half years, and global equities have done just fine. As long as the global economy remains robust and central banks stay ahead of the curve (i.e., there are inflationary pressures but not actual inflation), as we think will be the case, we believe that risky assets should continue to perform well. The four pillars supporting risky assets that we presented in an earlier note (Gradually Rotating Into Dollar Shorts Against EM, May 10, 2007) continue to form a key part of our thinking. Specifically, as long as the world under-invests, real long-term interest rates are likely to remain low. Second, the problem of an ‘asset shortage’ is not going to go away soon. Third, the global economic backdrop, with recent confirmations that the US may have established a trough in 1Q, is so positive that we feel that there can be no better time to be positive on risky assets than now. Fourth, the activation of SWFs should be positive for risky assets (in particular for equities) and negative for risk-free assets.(See Sovereign Wealth Funds and the Official Reserves (September 14, 2006), Tracking the Tectonic Shift in Foreign Reserves and SWFs (March 15, 2007), Russia: The Newest Member of the SWF Club (April 26, 2007), How Big Could Sovereign Wealth Funds Be by 2015? (May 3, 2007), and Sovereign Wealth Funds and Bond and Equity Prices (May 31, 2007).) G7 in a range, followed by USD strength The G7 currencies (e.g., EUR, GBP and USD) are likely to remain in a range. With the US economy on its gradual recovery path, the dollar is unlikely to weaken too much against the EUR or GBP in the near term, and should be meaningfully stronger by year-end, in our view. The UK’s inflation is a major source of uncertainty to us; our guess is that our UK economist and the BoE will most likely be right on inflation drifting lower and consumption weakening in the coming months. A prospective sell-off in cable will drag down EUR/USD. European fundamentals are solid (indeed, our Euroland economists have just raised her refi forecast to 4.50% this year — see E. Chaney, E. Bartsch, T. Gade & V. Pillonca, Stronger Growth, Higher Inflation, Higher Rates, June 6, 2007), but the US economy is also quickly reasserting itself, making EUR/USD less directional in the coming weeks than in late 1Q/early 2Q. We believe that investors are still sufficiently bearish on the US economy, but uniformly bullish enough on Euroland that the risk to EUR/USD is biased to the downside. The next Fed move will likely be a hike, in our opinion. 122 is toppish for USD/JPY Portfolio rebalancing continues to dominate economic fundamentals and valuation. We maintain our view that USD/JPY should be lower (Japan’s GDP growth is about the same as that in Euroland, but this fact does not seem to be consistent with market sentiment), but the trigger for the drivers of USD/JPY to shift from ‘portfolio-related’ reasons to ‘economic fundamentals-driven’ reasons is still not clear. For now, the right strategy, we believe, is to refrain from ‘picking the top’, given how costly it is to maintain long JPY positions, particularly now, with the rest of the world’s interest rates rising faster than in Japan. Regarding the process of portfolio rebalancing in Japan, we believe it is important to stress that the term ‘carry trades’ is a misnomer of the true process that is taking place. Japanese retail investors are raising their exposure to risky and higher-return assets and are not necessarily engaged in ‘carry trades’. In fact, the monthly investment trust flows into foreign equities are about six to seven times larger than those heading into foreign bonds (Uridashis). To us, it is more of a portfolio diversification, risk-seeking process than pure carry. This has several implications. First, even if the BoJ tightens once or twice more this year, it is far from clear that the JPY will rally. Second, Japanese retail investors are taking more risk, not just foreign currency risk. We believe that if the Nikkei starts to outperform, this trend outflow could be arrested and reversed. Our equity strategist, Kamiyama-san, believes that Japanese equities should flatten out later this summer(see N. Kamiyama, Japan as an Underperformer, June 6, 2007). However, we find it remarkable that, as our research shows, the equity-bond yield spread, at 420bp (compared to the G3 average of 220bp), is widest in Japan. Thus, while it does not seem particularly likely according to Kamiyama-san, if the Nikkei does start to outperform other equity markets, the scope for the outflows to be arrested and reversed is significant. In any case, before this happens, the JPY will likely stay weak. Positive on the CAD, AUD and NZD We are positive on these three commodity currencies. First, the global growth outlook is immensely positive; it is both strong from a headline perspective (4.9% this year and next), and much more balanced than in 2002-05. Commodity prices — hard, soft and energy — continue to squeeze higher, reflecting robust global conditions. Second, remarkably, these three commodity economies have not been overly reliant on net exports. Third, as the US economy gradually recovers and as China fails to materially slow down growth, the RBA and the RBNZ could be forced to lean on the hawkish side. Fourth, from a longer-term perspective, the assets of these three countries are clear targets of SWFs. G7 versus non-G7 If risk-taking continues, and financial globalisation proceeds apace, with investment portfolios gradually seeking out high-beta markets such as large developing economies, the commodity currencies and large EM currencies should perform well. We continue to see this general broadening out of risk progressing and believe that, in many cases, central banks will permit greater currency strength (see The Trilemma and De-Dollarisation, June 7, 2007). SE Asian currencies such as the CNY, RUB, TRL and BRL should all perform well against the dollar. Keep our eyes on the global economic fundamentals While market sentiment has been fickle and nervous all year, with sentiment shifting from fear in February/March to cautious greed in April and back to fear again, our view remains that the real economic fundamentals are key: as long as the global economy remains robust, with low inflation, risky assets will continue to do well. The wiggles in asset prices will turn out to be just wiggles, and not indications that the up-trends are undermined. It is less of a dollar story but more of a G7-versus-non-G7 story, whereby several non-G7 currencies will outperform both the USD and the EUR. This is both a cyclical and a structural trend. Bottom line We remain very constructive on the global economy, and therefore positive on risky assets. This is the single most important assumption behind our currency outlook. We no longer see significant movements among G7 currencies, but are positive on the three commodity currencies. We also remain positive on selected major emerging market (EM) currencies, and expect a broadening of risk-taking away from core G7 markets to benefit these non-core currencies, at the expense of both the USD and EUR. Our currency forecasts will be refreshed next week.
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The ‘Trilemma’ and De-Dollarisation
June 08, 2007
By Stephen Jen & Charles St-Arnaud | London
Summary and conclusions Many emerging markets are now confronting a difficult ‘trilemma’ on whether to (i) stabilise inflation and (ii) target the exchange rate while (iii) keeping a relatively open capital market — three macroeconomic objectives that cannot be satisfied at the same time. As a result, some central banks (e.g., some SE Asian countries, Russia and some LatAm economies) have been forced to allow their exchange rates to appreciate to help alleviate rising inflationary pressures, i.e., the exchange rate is becoming the ‘weakest link’ in the macro stabilisation process in these economies, providing currency investors with interesting opportunities while the G3 markets are so quiet. In this note, I argue that this trend is likely to continue, but caution that some structural and cyclical factors may, to some extent, help these economies cope with the ‘trilemma’. While we fully agree with the notion that many non-G10 currencies will gradually appreciate against both the dollar and the euro, because of mounting inflationary pressures arising from large balance of payments (BoP) surpluses, we believe it is important to highlight a couple of subtle processes — related to changing money demand — that are at work that may temper the speed with which these economies let their currencies appreciate. The idea of the ‘trilemma’ In theory, with an open capital account, a country cannot target the inflation rate and the exchange rate at the same time. Attempts to raise interest rates to arrest inflationary pressures could, in turn, attract capital inflows. As a result, the exchange rate could appreciate, undermining the central bank’s objective on the exchange rate. This policy spillover effect is particularly powerful in the current environment where carry trades are a fad. Similarly, attempts to support or depress an exchange rate would have monetary implications, unless these operations are fully sterilised. For emerging markets with less developed money and financial markets, this ‘trilemma’ could be particularly acute. Confronted with these three-way trade-offs, different countries may have different policy reactions. For example, Thailand and Colombia chose to impose capital controls to block out the inflow of capital (removing the third leg of the ‘trilemma’). Russia, meanwhile, has allowed the ruble to appreciate to alleviate inflationary pressures. Until recently, most Asian central banks have targeted exchange rates more than they have targeted inflation. Two factors raising money demand in EM While the logic of this ‘trilemma’ is quite clear, in practice, how rapidly a positive BoP shock propagates through money supply to affect inflation and, in turn, the urgency with which central banks allow currency appreciation is a function of how fast money demand strengthens. The faster the pace of increase in money demand, the more difficult it would be for growing money supply to lead to inflationary pressures. There are two main factors pushing up money demand in many emerging markets: Factor 1. Structural improvement in the local financial and monetary systems. In general (and this applies to both developed and developing countries), structural developments in the financial and monetary systems in an economy enhance the demand for the local money. This means that monetary aggregates could gradually rise, as a percentage of nominal GDP, and such a trend would not be inconsistent with stable inflation. I believe that, a decade after the last financial crisis in Asia, and more than a decade after the last meltdown in Latin America, financial markets in many emerging economies may indeed have experienced meaningful enough improvement that a trend decline in money velocity in these countries may have helped contain inflationary pressures, despite surging monetary aggregates. Our research shows the GDP-weighted trends in M1, M2 and inflation in 19 selected economies (China, Hong Kong, India, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, Thailand, Brazil, Mexico, Russia, Hungary, Poland, Czech Republic, Turkey, UAE and Saudia Arabia) and their inflation rates. On average, inflation for these countries has been remarkably tame, relative to the rapid growth in the monetary aggregates. Specifically, the gap between the growth rates of M1 and M2 and inflation denotes a deceleration in money velocity, or a structural increase in money demand. At the same time, there is a steady negative relationship between the per capita income of an economy — which is a proxy for the level of development of the country or its financial system — and money velocity: the wealthier the economy, the lower the money velocity or the higher the Marshallian-k. Our research shows that, for this collection of 19 countries, this relationship holds. Factor 2. De-dollarisation. In addition to the structural improvement in the local financial markets, there could be another reason why money demand in these industrialising countries has grown sufficiently to hold down inflation: the process of ‘de-dollarisation’. ‘Dollarisation’, on the other hand, is a term used to describe the process of investors in industrialising countries substituting a trusted foreign currency (most often the dollar) for its local currency. In times when an industrialising country experiences financial stress, ‘dollarisation’ could take place if dollars were perceived to be less risky. A distinction is usually made between ‘currency dollarisation’ (holding cash in dollars for transactions purposes) and ‘financial dollarisation’ (holding USD-denominated assets or liabilities). Dollarisation and the reverse process — de-dollarisation — could contribute to unstable money demand, and disrupt monetary management. This process has been particularly well-studied and documented in Russia. In light of the large BoP surpluses of many of these industrialising countries, the popular view on the dollar in these countries, against their local currencies, may not be as positive as before. As a result, de-dollarisation could have a broad-based effect on money demand, helping to hold down inflation, despite rapid growth in money supply. Our thoughts We have the following thoughts: Thought 1. More currency appreciation. Confronted with this ‘trilemma’, many developing economy central banks will likely permit further currency appreciation. Brazil, India, Indonesia, Malaysia, Russia, Turkey and perhaps even GCC countries will let the exchange rate be the shock absorber, while retaining their inflation objective and refraining from imposing capital controls. Thought 2. However, we need to be patient. We need to recognise that inflationary pressures in these countries are really not that great yet, and that the need for these countries to let their currencies move is far from urgent. The 19-country average CPI inflation in 1Q was only 2.8%, down from 3.4% in 2006. Except for Hungary, India and the UAE, no other country in our sample has shown a clear acceleration in inflation from this low level. Thought 3. Think about money demand for the EUR. Euroland M3 growth has averaged above 10% this year, compared to nominal GDP growth of around 4.5% (hence the ECB’s reference M3 growth rate of 4.5%). However, money demand may have surged for the EUR, as it is increasingly seen as a legitimate, liquid and viable reserve currency. Rapid monetary growth could be consistent with low inflation, if changes in money demand are properly accounted for. Thought 4. Be careful using money aggregate to measure ‘liquidity’. One key objection (of several) I have to analysts using monetary aggregates to measure ‘liquidity’ is that this approach makes no reference to structural changes to the demand of and supply for money. Bottom line Some emerging countries are confronting a policy ‘trilemma’, and will likely allow their currencies to appreciate. However, investors should be aware that money supply growth in these countries may not immediately translate into high inflation, because money demand is also rising, partly due to ‘de-dollarisation’. Thus, these EM currencies are likely to rally gradually, not abruptly.
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Inflation and Interest Rates in the UK — How Might it All Look by Christmas?
June 08, 2007
By David Miles | London
Consumer price inflation in the UK is still only a bit under the 3% level that triggered an explanatory letter from the Governor of the Bank of England to the Chancellor a few months ago. That letter was to explain why inflation had risen to a level over 1% above the 2% target. Retail price inflation remains around 4.5%. Consumer confidence seems resilient and growth in recent quarters has been at a rate marginally above consensus estimates of trend — or sustainable — levels. House prices are, on average, 10% higher than a year ago and still rising. Given all this, it is not surprising that more rate rises from the Bank of England are being priced in by fixed income markets. Right now, the consensus is for close to 6% rates by Christmas. That is by no means an extreme view. But is it a plausible central forecast of where we might be at Christmas? We suspect not. Two factors account for this scepticism. First, if consumer spending slows significantly in the second half of this year, it makes the likelihood of rates going to 6% lower. We take the view that with an exceptionally low saving rate, virtually stagnant real disposable incomes and with much of the impact of the 100bp rise in rates since the end of last summer yet to come through, a sharp slowdown in spending growth is likely. Second, the actual rate of inflation looks set to move lower in the very near term and — more important for monetary policy — we see forces at work to keep it in check into next year. A key factor here remains the ongoing influence of low-cost sources of supply of goods. Our retail analysts recently looked in detail at drivers of pricing for retail firms in the UK and the role of imports from the East. Here is what they concluded: “We believe that the main reason why there has been so little inflation (and, indeed, deflation in many product categories) over the last ten years can be summed up in one word: China … Clearly not all products can be sourced from China and other Far Eastern countries, but we think it very interesting to note that those that do not lend themselves to such sourcing have seen much less deflation than those that do. Over the next 12-18 months, we would not be surprised to see the incremental buying benefits from Far East sourcing to slow a little (given capacity constraints in China). However, as China’s interior regions are opened up, and other economies (particularly India) begin to industrialise along similar lines, we think the ‘buying benefits’ of Far East sourcing still have some way to run. If they do, then we believe that the divergence between cost inflation and selling price inflation will not disappear for the foreseeable future”. (An Introduction to the UK Retail Industry, Ruddell, Coulter, Kent, Bjelland, Bone. June 4 2007.) Bottom line Our single best guess is that, by the end of this year, three things will be true: 1. Actual CPI inflation will be close to the 2% target level; 2. Consumer spending growth will be weak; 3. The inflation outlook looking ahead to 2008 will not have deteriorated. If those things are true, rates would probably not be at 6% — indeed, they may be below today’s level. Needless to say, there is considerable uncertainty about all this. It is that uncertainty which makes any single forecast of rates much less useful than an estimated distribution of probabilities. Our current assessment of the probability distribution of rates for December 2007 is skewed, with a significantly higher chance that rates are above what we consider to be the single most likely outcome than below it. For that reason, the single most likely outcome (in our view, a rate of 5.25%) is lower than the expected outcome — the probability-weighted outcome — which is 5.5%. It is never entirely clear what people mean when they ask “where do you think rates will be by the year-end” – it could be a question about one’s assessment of the single most likely outcome (the mode) or about the probability-weighted outcome (the mean). For us, those two numbers are somewhat different.
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Déjà Vu
June 08, 2007
By Takehiro Sato | Tokyo
Are gains in share prices and interest rates sustainable? A pick-up in the US economy and firm domestic capex have propelled the Nikkei to about ¥18,000 and long-term interest rates to the 1.8%+ level. We now expect long-term yields to head for the 2%+ level. However, as far as the general picture goes, these movements are still within a range in a broad sense, and we do not believe that a genuine uptrend has begun for either share prices or long-term interest rates. Long-term yields in particular held within a range of just 20bp or so for a full nine months after the CPI shock of August 2006, so the current movement looks substantial and sharp by comparison. However, in absolute terms, rates have merely returned to the level of before the CPI shock. Useful points of reference when forecasting the outlook for interest rate markets are 1) the annual pattern of fluctuations in long-term rates, 2) the extent to which rate hikes are currently discounted, and the pace of future rate hikes, 3) neutral policy rate levels, and 4) the level for arbitrage with bank lending rates. The annual pattern for fluctuations in long-term yields The annual pattern for fluctuations in long-term yields has shown some anomalies since 2000, when rates have risen heading into the summer, and fallen towards year-end. From a fundamentals viewpoint, although expectations of economic expansion tend to mount between the start of the financial year and the summer, the typical pattern is for both share prices and JGB yields to lose upward momentum as economic activity heads into a summer lull. This year, too, as with the pattern of annual fluctuations seen since 2000, it appears that pressure for growth in long-term rates has started to build since May. The US economy seemingly picked up again above the potential output growth rate in April-June, and we believe that rising expectations of a further domestic interest rate hike in the summer (on which we take a cautious view) are also contributing. For this reason, we cannot yet rule out the possibility of long-term yields moving up to the 2%+ level, as seen in the pattern anomalies discussed above. The problem we have relates to momentum in the economy and prices after that. If, as we expect, the economy (particularly consumption) loses some of its impetus from the summer, and counter to the market’s heated expectations, price growth does not accelerate all that much either, we would expect the markets to settle down again from the summer, and buying operations of real money investors to gain prominence in the market. Extent to which rate hikes are discounted, and the pace of rate hikes from here The market has fully accounted for a summer rate hike. The probability of a rate hike based on our fixed income strategy team’s OIS (Overnight Index Swap) market pricing calculations is 34% at the July Policy Meeting, 84% at the August meeting, and 100% at the September meeting (as of June 7, same below). Moreover, at 1.4%+ for December 2008 maturity, euro-yen futures contracts more or less completely factor for a policy rate of 1.25%. A policy rate of 1.25% at the end of 2008 would signify three further rate hikes at a rate of one every six months. However, considering the upcoming expiration of Mr. Fukui’s term as BoJ governor in March next year, it seems unlikely to us that the pace of rate hikes would accelerate, though it could slow down. In other words, looking at relations between the BoJ and the government/ruling parties as they stand at present, it seems fairly unlikely that the next BoJ governor will be more hawkish than Mr. Fukui. Most speculation is focusing on Deputy Governor Toshiro Muto, who hails from the MoF, and we think the ministry is likely to put its full weight behind supporting Mr. Muto’s appointment. Even so, if Mr. Muto does indeed take over the position, about the best we can hope for is that he will follow the same line as Mr. Fukui, and it is hard to envisage him acting more hawkishly, considering the relationship with his alma mater as well. Moreover, in the event that economic and share price performance subside after the Upper House elections, someone with a more dovish background than Mr. Muto could be nominated. In addition, should the Cabinet be emasculated after the Upper House elections in July, it is possible that the worm would turn, with the administration taking an even tougher stance in relation to the BoJ. If that happened, it is even possible that monetary policy from March 2008 would be totally different from the shape the market is currently factoring for. Thus, in looking for three rate hikes by the end of 2008, the market is maximising expectations for the Fukui line being maintained, and with these expectations fully discounted, there seems to be little scope at present for further substantial selling in the bond markets. In particular, we think that the zone of up to about two years, where policy rates can be influential, is already in ‘overshoot’ territory. From a risk-reward perspective, we think that the bond markets are approaching a buying season. Considering the neutral interest rate level The neutral interest rate level generally weighs the economy’s potential output growth rate with the target inflation rate. This would fall in the upper reaches of the 2% range (i.e., 2.5-3.0%) if the BoJ sees potential growth in the upper 1% range and the target inflation rate as +1%, representing the midpoint of board members’ views for ‘the understanding of the price stability’ as soft inflation targeting. The question is how long it will take to get there. If we continue to see semi-annual rate hikes totaling 50bp a year as posited above, it would take four years to reach a policy rate of 2.5%. Since there is no guarantee that the economy will keep expanding during the next four years, the policy of tightening could stall before this level is reached. The timeframe for moving to a neutral policy rate is thus hyper-extended, and the path towards it is subject to risks which cannot be predicted. Under a Taylor Rule perspective, on the other hand, the neutral policy rate level currently comes down to 1.5%, assuming that the BoJ’s target for the real unsecured overnight call rate is equivalent to the potential growth rate of 1.5%. This is because, with a positive output gap but prices now turning down, the inflation gap serves to lower the appropriate policy interest rate level. Under such conditions, not much change is likely for the rest of the year as prices continue to trend below year-earlier levels, and the equilibrium interest rate under the Taylor Rule might not rise above 1.5% for the time being. The Taylor Rule itself of course only indicates the appropriate policy rate level ex ante, and does not offer any pointers as to precisely how the current policy rate of 0.5% might rise to a neutral policy level. With prices recently ultra-stable, however, and a Taylor Rule perspective suggesting that the appropriate policy rate level should not rise far, it is hard to envision expectations for the future level of the policy rate to rise without interruption. Considering the flow of funds The market outlook above, in broad terms, reflects our view that the banks — the main buyers of medium and short end of the curve because of slack lending — will have to come back into the bond market at some point in order to employ their surplus funds. The average contracted bank lending rates is in the 1.8% range for new loans and 1.9% for existing loans, and the 10-year yield is often capped by the interest rate on new loans. Even if yields rise above the new loan rate, on only three occasions (1994, 1995-96, 2006) in the last 15 years have they topped the stock-based bank lending rate, and for only about six months at most in each case. In these conditions, recent lending data, despite a 0.5-0.6 ppt boost from major M&A deals, now seem to be losing steam. Clearly, at some point banks will be hard-pressed to employ their surplus funds gainfully. Risks The main risks to the scenario we have outlined are that domestic consumption and consumer prices hold up better than we expect in the summer, and that expectations for interest rate hikes gather momentum. Consumption could slow by less than we expect if a heat wave bumps up spending on summer goods, while occurrences like hurricane damage could spur higher oil prices when drivers hit the road in summer, supporting consumer prices. Either event could quicken the pace of rate hikes relative to the biannual hikes outlook that the markets have discounted.
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