Currencies
Inflation Targeting, Carry Trades and Misalignments
July 06, 2007

By Stephen Jen | London

Summary and conclusions

In this note, I argue that one of the reasons why carry trades are so popular may be the world’s fixation on inflation targeting. 

A fixation on inflation targeting

There are a number of conundrums in the currency markets, one of which is the weakness of JPY and CHF, despite strong economic growth in Japan and Switzerland.  Not only are low-interest rate currencies weak, but real-time movements in exchange rates also seem to closely track changes in the market’s opinions on central bank policies; changes in the real economic fundamentals, politics or geopolitics all seem to matter much less for currencies these days. 

I believe that the proliferation of inflation targeting, both as a monetary regime and a monetary policy ‘religion’, has played an important role in distorting the currency markets. 

I have these thoughts:

• Thought 1.  ‘Political correctness’ for monetary policy.  Inflation targeting is perhaps what most investors believe is the most ‘politically correct’ form of monetary policy.  The concept of inflation targeting has been so well explained and promoted that macro investors are now very familiar with the ‘language’ of inflation targeting.  In addition, super-transparency of monetary policy makers has further enhanced the confidence and success with which investors forecast monetary policy.  As a result, the game of tracking central banks has fundamentally changed in recent years, and currency investors may have, I suspect, become much more focused on monetary policies than before, over-emphasising them and, as a result, downplaying other factors (such as real output and productivity growth) that, in the past years, were at least as important as the nominal policy interest rates. 

In short, I believe that one reason why nominal cash interest rates have become so important in the currency markets is investors’ over-emphasis on monetary policy, which itself is an outcome of the popularity and ‘simplicity’ of inflation targeting. 

• Thought 2.  Supply shocks versus demand shocks.  Some investors may have been trained to think that when inflation goes up, central banks are expected to raise rates, and when inflation goes down, they are expected to cut rates.  But this presumes that inflationary pressures are coming from demand, not supply.  However, shocks to the economy could come from aggregate supply (AS) or aggregate demand (AD).  In fact, I believe that in recent years the world has experienced as many AS shocks as AD shocks. 

To me, globalisation is more about supply than demand.  Labour migration and productivity shifts could all be the results of pressures from globalisation.  Had it not been for immigration, Norway, Sweden and Switzerland should be experiencing higher inflation rates, at the rate their economies are growing.  Similarly, Japan has experienced an acceleration in labour productivity growth since 2002.  This has helped to hold down inflation, despite growth being above potential for three years in a row.  (Incidentally, I think this is one reason why Phillips Curves have flattened, as AS and AD may have become positively correlated due to globalisation.) 

In any case, in these countries with positive supply shocks, the monetary authorities have struggled to justify rate hikes, and have been surprised by relative currency weakness (JPY and CHF), or currencies under-performing expectations (SEK). 

Inflation targeting has led to perverse relationships between real economic fundamentals and exchange rates.  A country that experiences an acceleration in productivity, in the old days, would enjoy a currency appreciation.  However, with inflation targeting, a positive productivity shock is inflationary, and a not-so-hawkish central bank would actually hurt the currency.  Conversely, with inflation targeting and in a carry environment, a deceleration in productivity growth would actually lead to a stronger currency.  This is perverse. 

In fact, I am not sure if inflation targeting, in the strict form, is appropriate in an environment where AS shifts.  A monetary framework similar to that of the Federal Reserve, which is better described by a Taylor Rule relationship, may work better, in theory, and would lead to exchange rates that are not as misaligned.  

• Thought 3.  Official resistance is futile.  I do not believe that official interventions can correct the exchange rate mis-alignments, which, to me, are results of financial globalisation.  Take EUR/JPY for example — this cross has risen by close to 90% since 2000 (rising from 90 in 2000 to close to 170 now).  The economic fundamentals of Euroland and Japan cannot explain this move: the median fair value of EUR/JPY from our calculations is 109.  I have proposed the ‘Global Funneling Hypothesis’, which is a concept that is based on structural mis-matches between the world’s goods and asset markets, and asymmetry between trade globalisation and financial globalisation.  If my hypothesis is right, it would be very difficult for the G3 to reverse EUR/JPY’s trend through intervention.  

The RBNZ’s unprecedented intervention on June 11 has, as expected, failed to cap NZD/USD.  The SNB may very well be contemplating intervening to support the CHF, but I don’t think that it would be successful, either.  Global capital flows are so powerful that many exchange rates may remain mis-aligned from the economic fundamentals.

The dollar’s weakness

Recent weakness in the dollar is somewhat surprising.  Nevertheless, I maintain my view that the dollar is bottoming here and should assert itself in 2H.  As I wrote in Gradually Rotate into Dollar Shorts Against EM, May 10, 2007, I abandoned my call for a cyclical dollar correction, in light of signs of a recovery in the US economy.  I am, however, watchful of what the various central banks might do now that the dollar has weakened against a broad range of currencies.  In any case, from the perspective of economic fundamentals, the case for significant dollar weakening is not compelling to me. 

Bottom line

Currency investors may be overly focused on monetary policy, partly as a result of the ‘religion’ of inflation targeting, and downplaying other factors.  I don’t particularly believe that strict inflation targeting is the best regime, especially when there are significant shocks to aggregate supply.

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Japan
Mr. Abe’s Choice — Faster Reform, or Much Faster Reform
July 06, 2007

By Robert Alan Freedman | Tokyo

Fuzzy logic in the political debate

There is confusion among investors about Japanese politics. This confusion stems from the inherent complexity of the election on July 29 and from fuzzy logic in the debate itself.

The most visible problem is the fuzzy conclusions. One part of the debate concerns a “big loss” for the ruling Liberal Democratic Party (LDP). However, what is “big?” Even worse, the logic connecting premises to conclusions is often opaque. There is huge uncertainty about whether to base forecasts on the candidates themselves or to the parties they represent. The difference in outcomes is huge. (In an earlier report, I discussed the question of whether a defeat for PM Abe would slow reform or speed it. See The Election and the Market – CRIC Cycle Scenarios, June 22, 2007.)

Mechanics of an Upper House election

Predicting the outcome of an Upper House election requires understanding the mechanics of how the 121 winners are chosen. There are two types of districts — prefecture-based districts and a single nationwide proportional district.

Each prefecture is an election district, but the number of seats differs by prefecture. Each prefecture has at least one seat. However, the more populous prefectures have between two and five seats, with a total of 73 seats in all of the election districts combined. These seats are awarded to candidates by an ‘n-th past the post’ rule. This system creates a gap between the share of the vote for a party and the share of seats that a party wins. For example, in 2001, in the single seat districts, the LDP won 50% of the vote but 82% of the seats. In 2004, the LDP took 45% of this vote, but 55% of the seats.

The proportional district is a single, nationwide district. The 48 proportional seats are allotted to parties according to the d’Hondt method, which gives roughly the same share of seats to a party that it gets in the vote. (For a description of this method, see the appendix to Short-Sighted Election Consensus, August 25, 2005, p. 4-5.)

Two models (For details of these calculations, see Mr. Abe’s Choice:  Faster Reform or Much Faster Reform, July 2, 2007.)

There are two ways to forecast the election outcome — candidate-centered and party-centered. If an election is more about the individual candidates than about the parties, then it is better to base the forecast on an election that has as many of the same candidates as possible. This factor would naturally push one toward basing the forecast for 2007 on the results for 2001. However, if the election is more about parties than candidates, it is better to base the forecast on the 2004 election.

Aggregate results

In the candidate-based model, the LDP wins 42 seats in election districts and 15 seats in the proportional district, for a total of 57 seats. This is down by six from the 63 it currently holds. Together with its partner Komeito, the coalition as a whole has 127 seats. This is a narrower majority than the 132 it now enjoys, but enough for a stable government. This result is somewhat sensitive to assumptions, such as voter turnout. However, across a spectrum of the scenarios, the qualitative result is the same:  The LDP loses seats, but does not suffer a humiliation.

In the party-based model, however, the LDP coalition takes only 117 seats, and loses its majority. This result is not sensitive to voter turnout changes. Things are already so bad for the LDP that even a 4% increase of voter turnout only costs one seat in the election districts. In this case, however, the LDP will have suffered a humiliation.

What the results mean for economic reform

Thus, the likely outcomes range from a slim victory to a large defeat for the LDP. How would policy change across this range of outcomes?

The implications depend on two factors. (a) First is the ‘Kobayakawa Factor’ — the incentive for the right-wing inside the DPJ to bolt, form its own party, and join the coalition. (At the Battle of Sekigahara in 1600, a small force led by Hideaki Kobayakawa had pre-arranged to defect to the side of the Tokugawa forces during the course of the battle. After much dithering, Kobayakawa eventually kept his promise, and decisively turned the battle.) (b) The second is the ‘Macbeth Factor’. The worse the outcome for the LDP, the stronger is the likelihood of an anti-reform Macbeth toppling PM Abe. When such a possibility grows, there is an incentive for PM Abe to ‘go for broke’ by pushing economic reforms aggressively.

Interestingly, the combination that gives the strongest push for economic reform occurs when the coalition is just below a majority. The Kobayakawa factor is strongest when the bargaining position of a small rebel group is greatest, at a coalition seat total of about 117 seats. The Macbeth factor leads to a go-for-broke strategy if PM Abe is sandwiched between the anti-reform Macbeths and the pro-reform voters. In fact, he has little choice, because appeasing the anti-reformers would destroy any hope of the LDP winning the next general election.

Thus, even if the coalition does retain its majority in the Upper House, the Abe government will be scared about the next Lower House election. This fear will likely tilt toward more aggressive economic reforms. If the LDP has a slim loss of majority, there will be a double incentive for more aggressive reform, from both the Kobayakawa Factor and the Macbeth Factor.

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Japan
Sensing a Midsummer Surprise
July 06, 2007

By Takehiro Sato | Tokyo

How does the BoJ handle a GDP slowdown on top of a negative CPI?

We have been bullish on the Japanese economy in the medium term, but mindful of a mild summer slowdown risk. Our sense is proving right. In the extreme case, it is even possible that April-June real GDP data due out in mid-August will show 0% growth, in a retracement from the January-March quarter. The August 22-23 MPM will likely be a crucial point for the BoJ, in the midst of a negative CPI and real GDP growth close to 0%. Although we doubt that the BoJ will back down from its forward-looking stance on rate hikes, the markets’ outlook will likely waver before/after the rate hike.

Net exports and personal consumption components to prompt slowdown in April-June GDP

Net exports and personal consumption are the areas to watch in GDP data for the April-June quarter to be released around August 13. Net exports made a huge positive contribution in the January-March quarter as imports tumbled in March, and accounted for 1.9% points of the annualized growth of 3.3% in that quarter. Trade statistics show the volume of imports bouncing back in April and May, so the factor of net exports is going to push down GDP considerably in the April-June quarter. Changes in net external demand have a direct impact on headline GDP, and though these represent a technical factor, their adverse effect should not be underestimated.

We also expect personal consumption to drop back in response to comparatively brisk growth in the previous two quarters, as both demand-side factors such as the Household Survey and the Survey of Household Economy and supply-side factors such as the retail sales and the consumption goods shipments data in April and May have been wobbly . All the indicators of sentiment such as the Reuters Tankan and the Economy Watchers Survey have pointed to a slack consumption trend following the Golden Week break in May, and already concerns about the effect of the hike in residents’ tax from June are being voiced.

Capex, meanwhile, should remain firm in the April-June quarter, as the surge in capital goods shipments in April following a plunge in March creates a high initial platform. Capex plans in the recent Tankan, where the headline figure (including land investment, excluding software, and also excluding the financial sector) was generally seen as unimpressive because of the limited revision rate, especially in non-manufacturing, also come out looking rather different when recalibrated on a basis closer to nominal GDP data. Manufacturers’ capex plans especially for IT were cautious, but the plans of non-manufacturers call for relatively strong infrastructure and financial services investment, and the GDP contribution of the latter is far outstripping that of the former. Housing and public works investment is set to remain limp in April-June, however.

In view of this outlook, the question for April-June GDP will be how far the net exports blunt the positive overall contributions of domestic demand components. Since we believe that the hit from net exports will be comparatively hard, as we have explained, in an extreme case real GDP growth could be zero or even slightly negative.

Outlook for BoJ policy, which GDP slowdown would confound

The issue is how policy would unfold and how the markets would react in that event. The nationwide core CPI for June is to be released in advance of GDP data; if it reflects the negative contribution from hotel/lodging and package tours that the Tokyo area data identified for the same month, we could see the core index decline in YoY terms for the fifth consecutive month despite rising prices for oil products. If growth in April-June GDP is zero, even with the consensus having formed for a summer rate hike, markets’ expectations of monetary policy could be unsettled, resulting in increasing numbers looking for the rate hike to be pushed back to September or beyond.

The BoJ is determined to look forward, however, and we believe that its stated reluctance to be held hostage to price figures in particular makes it likely that the BoJ would press ahead with a rate hike even in the face of shaky price and GDP data. For some time now, the BoJ has viewed the volatility of GDP in quarter-by-quarter data as a problem, and appears to be looking as far as possible at moving averages for three quarters. In that eventuality, even zero growth in April-June would point to continuing firmness for the BoJ, as the three-quarter moving average for real GDP would show annualized growth of 2.9%. A blip in the most recent GDP data would not be a decisive problem for the BoJ, given such a perspective.

This approach offers some insulation from statistical noise, but has the disadvantage of blurring the view of turning points and inflection points in the economy. Even if the likely slowdown in April-June is in large part due to the technical factor of retracement from January-March, it is still possible that a rise in the overall household tax burden will see the economy, and especially consumption, stagnate in the July-September quarter as well.

Capital investment is likely to remain solid, but without a pick-up in consumption it will be tough for this to buoy the overall economy. If the BoJ sticks to its long-standing, stated aim of raising interest rates to pre-empt overheating in the economy, this economic situation would make its approach less understandable at large, and could leave the market with some cynical impressions. Our concern, in other words, is that a signal that the BoJ dislikes a surge in asset markets resulting from prolonging accommodative monetary conditions could be conveyed to the world’s investors. That would disillusion overseas equity investors just when they have shown a willingness to move back into Japan, and encourage a flattening yield curve bias in the bond markets.

Risks

As the scenario above assumes an August rate hike, we would need to reassess should the BoJ decide on a rate hike at the July 11-12 Monetary Policy Meeting. However, this does not seem likely to us, seeing as the BoJ has little to gain from bringing a rate hike forward in advance of the elections. In addition, a hasty move by the BoJ, when the ruling parties are struggling, could backfire, raising political voices against the BoJ in the future. Meanwhile, data for the June Trade Balance and Household Survey could still fuel hopes that April-June GDP data will not be as shaky as suggested earlier, and we will be updating this situation in our Data Watch comments. Most data for June will be available by the end of July, and we plan to update our forecasts around that time before the April-June GDP numbers come out.

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Currencies
Why Japan Should Have Its Own Sovereign Wealth Fund
July 06, 2007

By Stephen Jen | London

Japan likely to eventually have its own SWF

I believe that it makes sense for Japan to have its own sovereign wealth fund (SWF).  For a developed country like Japan, with a flexible exchange rate and easy access to global capital, there is no compelling reason to maintain US$911 billion in foreign sovereign bonds.   Not only does Japan have ample ability to have its own SWF, it should also be willing to do so in light of the demand that the aging population will place on the budget.  Tax hikes would not need to be as large if there is a prudent SWF portfolio that generates excess returns. 

In short, I believe that in Japan a better balance could be struck between the objectives of safety, liquidity and return.  The establishment of a SWF in Japan may very well take 2-3 years, given the political resistance to the idea now.  But with (1) the mounting burden of higher taxes, (2) the good performance of the SWFs of other countries, and (3) a greater tolerance for investment risk by the general public, I believe that Japan will eventually have one of the largest SWFs in the world. 

How much official reserves does Japan need?

In the 1980s and the 1990s, the simple rule-of-thumb for determining the minimal level of foreign reserve holdings was three months’ worth of import coverage.  However, in recent years, capital flows have become dominant and ‘sudden stops’ in foreign inflows have become the primary trigger for currency crises, and so the general rule-of-thumb has changed to one that is based on capital flows.  The most widely used rule for determining the appropriate level of reserves to provide adequate insurance against a liquidity crisis is the ‘Greenspan-Guidotti Rule’.  Named after former Federal Reserve Chairman Alan Greenspan and the former Deputy Finance Minister of Argentina, Pablo Guidotti, this rule stipulates that a healthy level of reserves should be enough to cover one year’s short-term foreign debt. 

For Japan, three months of imports are around US$140 billion and its total short-term foreign debt is around US$85 billion.  So, Japan easily passes both rules-of-thumb.  Even if we take the excessively conservative calculation of looking at the sum of import and debt coverage, Japan would need only US$225 billion of liquid reserves. 

Clearly, there are idiosyncratic country-specific considerations that also apply to this rule.  Broadly speaking, developing countries tend to need more foreign reserves for liquidity purposes than developed countries.  Access to international capital and exchange rate flexibility are important factors, but there are many other considerations.  For example, this threshold level of reserve should be adjusted upward if the country in question has an overvalued exchange rate or if it is running a large C/A deficit.  Given that Japan has a significantly under-valued currency, a large C/A surplus, an open capital account and easy access to international capital, and a flexible exchange rate, Japan may only ‘need’, conservatively estimated, US$225 billion of reserves for liquidity purposes, as suggested above.  This would leave US$700 billion of ‘excess reserves’ to be invested in a SWF. 

Good reasons to enhance Japan’s investment returns

Not only is Japan able to run a SWF, I believe that there are compelling reasons why it should be willing to enhance its investment returns. 

• Reason 1.  Japan’s fiscal position remains weak.  The ‘lost decade-and-a-half’ has exerted immense pressure on Japan’s fiscal position.  After peaking at around 8% of GDP in early 2000, Japan’s budget deficit is tracking 4.8% of GDP, and its total net public debt is around 85% of GDP.  To achieve debt sustainability, Japan needs to run a budget surplus of 5% of GDP within 10 years.   This targeted improvement in Japan’s fiscal position in the coming years would entail a hike in tax rates and rationalisation of the tax structure.  The likely tax burden on the private sector will remain a major source of uncertainty regarding the likely trajectory of the economy.  A SWF that generates excess returns could go a long way in alleviating the tax burden on the public. 

For example, there has been much discussion and angst about an inevitable hike in the consumption tax.   The total consumption tax revenue is around ¥10 trillion (or around US$80 billion).  So, for every 1% rise in the consumption tax rate, we’re talking about some US$16 billion of extra revenues a year.  Politicians and policy makers in Japan are concerned that this prospective tax increase may have a meaningfully negative impact on the economy.  But with US$911 billion in foreign reserves, a 2% ‘excess return’ on these investments would offset more than 1% of the tax rate increase in Year 1.  Compounded, these excess returns would go a long way in alleviating part of the tax burden on consumers.  

• Reason 2.  Offsetting the valuation loss from prospective JPY appreciation.  I believe that, over time, JPY will drift higher (strengthen).  This raises the issue of valuation losses (in JPY terms) from Japan’s foreign reserve holdings.  (Incidentally, it is remarkable why Japan has thus far been so averse toward interest rate and credit risks, yet dismissive of FX risk, regarding its foreign reserve management.)  Japan’s reserve management is fundamentally different from that of, say, Norges Bank, whose foreign assets are not financed by domestic liabilities.   Thus, taking an asset-liability management perspective, with its foreign assets financed by domestic liabilities, Japan should be mindful of the impact a decline in USD/JPY would have on its balance sheet.  Assuming that Japan can generate 3% or so of real return in foreign currency terms, this gain could be easily offset by a JPY appreciation, yielding a zero real return in JPY terms.  In my opinion, Japan does not have the luxury of foregoing the opportunity to earn excess returns to offset this prospective FX loss. 

• Reason 3.  Japan’s aging population will exert more pressure on the budget.  Japan will need to cope with the fiscal costs associated with an old and aging population.  We know that the world’s population growth rate is slowing, due to a simultaneous decline in fertility and mortality.  Japan has one of the lowest fertility rates in the developed world (1.29 children per woman).   As a result, the overall population in Japan began to decline in 2005.  At the same time, mortality rates have declined significantly throughout Asia.  In Japan, life expectancy at birth had risen from 50.1 (54.0) years in 1947 to 78.6 (85.6) years in 2004 for men (women).   Life expectancy for women in Japan is now the highest in the world.

As its fertility rate fell, Japan enjoyed an economic ‘dividend’ because the ratio of dependents to the working population fell.  Researchers have estimated this economic dividend to be very significant during the 1960s and 1970s.  As Japan’s population began to age, there was a second ‘dividend’ as a ‘wealth accumulation culture’ emerged, as the population began to save for their retirement.  High savings in Japan depressed interest rates and therefore lowered the cost of investment.

However, Japan’s demographic cycle has reached such a mature stage that the first economic dividend has evaporated, and the declining long-term economic prospects for a shrinking population have lowered the demand for investment.  The low cost of capital has thus ceased to be an economic benefit. 

Growing pension and medical demands will ultimately exacerbate an already-stressed fiscal situation.  The Cabinet Office estimates that, in the absence of fiscal adjustments, social security expenditure will reach 22% of GDP by 2025, and the government’s net debt could rise to over 150% of GDP.  As I mentioned above, I do not believe that Japan has the luxury of not maximising the return on its assets today. 

• Reason 4.  Running a SWF is the responsible thing to do for the ultimate stakeholder — the general public.  The official reserves are national wealth that ultimately belongs to the public.  The question is whether it is financially responsible to invest these funds in short-term liquid securities.  As Larry Summer has argued, “(a)fter all, a university with a substantial endowment that invested its resources only in Treasury bills would be guilty of financial malpractice.  A corporation with significant pension liabilities that invested its pension fund only in short-term financial investments would be guilty of financial malpractice”.  Already, retail investors in Japan, especially retirees, have elected to take more risk in exchange for higher expected investment returns.  I expect the general sentiment in Japan to gradually drift in favour of the government adopting a less risk-averse investment strategy. 

Bottom line

I believe that Japan should form its own SWF.  Of the total reserve holdings of US$911 billion, Japan may only ‘need’ US$225 billion for liquidity purposes.  Structural pressures on the budget, particularly in light of the demographic trend, do not permit Japan the luxury to not maximise its investment returns today.  Japan could have its SWF within the next 2-3 years.

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Euroland
Confusing ECB Communications
July 06, 2007

By Elga Bartsch | London

I have never been a big fan of the ECB’s traffic-light system of communicating the timing of the next refi rate hike by using a set of pre-defined code words (see EuroTower Insights: Too Much Communications, May 19, 2006). And I am even less a fan of it after this week’s press conference. Since spring 2006, the ECB has given markets more explicit guidance on interest rates. Now, it seems to be trying to break free from its traffic-light system of code words. But to do so when markets are already dealing with the added uncertainty created by the ECB’s traditional summer recess might not have been best choice in terms of timing.

From a more fundamental point of view, I would argue that too much direct communication on future interest rate decisions can be counterproductive. It can create a dilemma, where monetary policy makers have to choose between doing what they said they would and doing what they should do in the light of their mandate. In addition, the central bank might also put itself into a tough spot because financial markets will typically read conditional comments on future interest rate decisions as an explicit pre-commitment, rather than an opinion based on the information available at that time. But more importantly, it induces markets to focus less and less on the economic reasons behind an interest rate decision. Hence, giving too much guidance on future interest rate decisions could cause risk premiums to rise, if repeated conflicts between credibility and predictability take a toll on the former. It could also take a toll on the markets’ grasp of the economic and inflation outlook underlying the decisions over the longer haul.

Contrary to my expectations, the ECB did not raise its monitoring of the risks to price stability from “closely” to “very closely” after this week’s holding operation. In the press conference, ECB President Trichet tried to play down the difference between the two phrases though, saying that they are essentially equivalent. This leaves me somewhat puzzled about the timing of the next rate hike. After all, the ECB had just moved back to “monitoring closely” in June for the first time in a year, which made sense in my view as we were gradually grinding towards the end of the tightening campaign. I had expected the word “very” to be added back in today as the phrase “monitoring risks very closely” has historically been used to signal that the next ECB rate hike was two months away. As a result, I now have less confidence in our call for a September rate hike than before and acknowledge that it could be more of a toss-up between September and October than we had assumed previously.

Yet, the release of new staff projections and keeping the option of another rate hike before year-end open should still tip the balance towards September. ECB President Trichet also emphasised that he does not intend to change market expectations for September and October, which were also favouring September over October. Furthermore, the Governing Council’s detailed analysis of the risks to price stability in the context of the two-pillar strategy did not contain many noteworthy changes, the only exception being that now the capacity is being considered high and that constraints here and on labour markets are emerging that could “lead in particular to stronger-than-expected wage and profit margin developments”. Previously, the ECB Council had been only concerned about wage developments adding to domestic inflation pressures. On the whole, the economic analysis contained in the introductory statement suggests to us that the ECB’s views are largely unchanged from June.  In order to signal a September rate hike, the ECB would now need to raise its language to “strong vigilance” in August. In the words of Jean-Claude Trichet, “strong vigilance, that means something”. Note though that thus far the ECB has never gone directly from “monitoring risks closely” to “strong vigilance”. In this context, the president was adamant that he would be able to get the message across even in the absence of an August press conference. Our best guess is that we would read about it in the August Monthly Bulletin. Yet, we would not rule out a statement being issued after the decision and the ECB itself seems to not be ruling out calling a press briefing at short notice either. So, mark your diaries for August 2.

We had highlighted before that a September rate hike isn’t a done deal yet. This impression was reinforced by this week’s press conference. It is also supported by our ECB Refi-meter, which puts the probability of a September rate hike only slightly above the critical threshold.  For October, the Refi-meter would not predict a rate move by the ECB.  The Refi-meter is a simple statistical model, which estimates the probability of an ECB rate hike, based on a few economic indicators. These indicators include business sentiment, inflation expectations and monetary developments. These variables mimic the ECB’s two-pillar approach to assessing the risks to price stability relatively well, we think, allowing us to provide estimates for the next three meetings. Interestingly, the Refi-meter relies on M1 and loans to the private sector rather than M3 money supply growth to capture monetary developments. These two variables have featured prominently in recent press conferences as early indications that past rate hikes are starting to take effect. Nonetheless, the ECB’s work isn’t done yet, we believe. Despite being somewhat puzzled by this week’s communication, we continue to expect two more rate hikes in the remainder of this year.

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UK
Where Might the UK Economy Be Heading?
July 06, 2007

By David Miles | London

The Bank of England’s decision this week to raise rates was prompted by a concern that the pressure of demand was such that it might prevent inflation falling back to the target level. Consumer spending — by far the largest component of overall demand in the economy — has remained robust, even while real disposable incomes have stagnated over the past year and interest rates have moved up. What has been striking over the recent past is just how difficult it has proved to slow consumer spending. If that continues to be the case, rates may need to go higher, and that will affect incentives to invest and the ability to export, as sterling will be kept strong if rates look set to move even higher. All this would be problematic because a rebalancing away from consumer spending and towards more investment and net exports is needed to preserve capacity and to close what has become a significant current account deficit.

On balance, we believe that consumer spending is set to slow substantially — and with it inflationary pressures stemming from domestic demand. But just looking at the latest statistics on the economy reveals why the Bank of England felt less than confident about this.

The real disposable income of UK households has fallen for the last two quarters for which data are available. Households’ real disposable income was lower in 1Q07 than it was in 4Q05, despite GDP growing by 3.9% over the same period.  But stagnant disposable incomes have so far not dampened the UK consumer’s enthusiasm for spending. Household consumption grew by 2.7% (at an annual rate) over the last two quarters, in line with its long-term average. An inevitable consequence of steady growth in consumption and virtually no growth in disposable income has been a continuation of the trend fall in the household saving rate.

If we exclude payments by companies made on behalf of workers into corporate pension funds, then the household savings rate in the UK turned negative earlier this year.  This is now at around the lowest levels seen at any time over the past 50 years — since reliable records on household saving out of income began.

Such has been the decline in household saving, and the willingness of households to borrow, that there has been a marked turnaround in recent years in the position of corporate and household lending. Usually companies are net borrowers — with desired investment above non-distributed incomes. Governments have generally been net borrowers also — and certainly this has been true recently in the UK, with the government running a substantial fiscal deficit even as growth has been steady and the tax take out of GDP been rising. Usually the household sector is a net source of funds — it is a net lender. But not any more in the UK. The turnaround has been significant over the past decade. Since around 2002, households have become net borrowers while non-financial companies in the UK have become net lenders.

The scale on which households have been borrowing — net — has steadily moved up over the past four years. Household net borrowing has risen more substantially than corporate net lending, and with the fiscal deficit having been persistently significant, the current account has widened. The current account deficit of the balance of payments is currently in excess of 3% of GDP. 

Can this continue?

It is likely that much of the eventual impact of the 100bp increase in interest rates between August 2006 and May of this year has not yet hit households and is not showing up in the statistics on spending and saving. Another unusual feature of household financial behaviour in recent years has been the preference for short-term fixed-rate mortgages — between 70% and 80% of new mortgage lending over the past few years in the UK has been at mortgage rates that are fixed, usually for 2-3 years. This has likely slowed the transmission mechanism from rate increases from the Bank of England to slower household spending. But clearly it has not neutralised the impact — merely slowed it.

This combination of stagnant real disposable incomes, exceptionally low savings rates and the delayed impact of rate rises seen over the past year is one which we believe means much slower growth in consumer spending over the next year or so. Consumer spending growth could fall sharply. This is a major factor behind our assessment that inflation pressures in the UK will fall back so that inflation will be close to the target level of 2% by the end of this year, and may dip beneath it for much of next year.

If that view on consumer spending and inflation pressures turns out to be right — and it is no more than a central forecast (or a best guess) — it would mean that a serous discussion might be taking place in the Bank of England about easing monetary policy by year-end. That might seem an unlikely scenario this week, but one of the lessons of even a cursory reading of post-war economic history is how sharply assessments of where the economy is heading can change over a period as short as six months.

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Japan
Low Legitimacy, High Anxiety
July 06, 2007

By Robert Alan Freedman | Tokyo

One issue now concerning investors is whether PM Abe may be forced from office in the wake of the July 20 Upper House election. In another piece (Mr. Abe’s Choice: Faster Reform, or Much Faster Reform, July 2, 2007), I have been skeptical of this view, and now another argument for him remaining has emerged:  The Upper House of the Diet has low democratic legitimacy. That said, voters want more Koizumi-type reforms, not less. If the LDP fails to deliver reform clearly, the next Lower House election result for the LDP will be severe. The short and long-term implications for the equity market could be important.

The new argument on whether PM might want to stay even if the coalition falls short of a majority concerns the legitimacy of the Upper House as a representative of the will of the Japanese people. One measure of the legitimacy of a democratic parliament is how closely the distribution of seats among election districts mimics the distribution of eligible voters. This note calculates the democratic legitimacy of Japan’s two houses of the Diet. There is a stunning differential.

The Lower House has a ‘seat gap’ of 25 seats. (The d’Hondt system is used in Japan to allocate seats in multi-member districts among the parties that run in the election. However, the same system can also be used to allocate a total number of seats in a chamber among individual districts. For details on how the d’Hondt system works, see Short-Sighted Election Consensus, August 25, 2005.) Since there are 300 election district seats, the percentage seat gap is 8%. In contrast, the Upper House has a seat gap of 35 seats. Since there are only 146 election district seats in the Upper House, this seat gap represents a whopping 24%. The gaps in Upper House legitimacy are particularly large in Tokyo, Osaka, and Kanagawa prefectures. According to the d’Hondt method, these areas should have 16 seats, 11 seats and 11 seats, respectively, but actually have 9, 6 and 6 — accounting for half of the under-representation.

Does this low level of Upper House legitimacy mean anything for post-election policy and for asset prices? I think so. There has been a long debate in Japan about whether the Upper House is even necessary. For example, there is no clear division of labor between the Upper and Lower Houses. The fact that seats in the Upper House are so unequally distributed only deepens concerns that it may be a barrier to expressing the voters’ will, rather than a conduit for that will.

Should things in the Upper House turn out badly for the LDP, as seems likely, there would likely be a renewed debate over the legitimacy of the Upper House. It is hard to argue that the Lower House, which has a relatively high congruence of seat distribution and eligible voter distribution, should pay much attention to a body that is three times less legitimate. This is particularly true, since the LDP coalition has more than a two-thirds majority in the Lower House, and thus can override any rejection of bills by the Upper House.

One can easily imagine PM Abe and the LDP saying, “Voters of Japan. We hear you. You want safe pensions, more reform, a zero tolerance policy on gaffes, clean government, and an efficient public sector. We will deliver on your demands by the next general election. In the meantime, we will consult with the Upper House for useful ideas, but override it, if necessary, because it does not accurately reflect the will of you, the people of Japan. And, by the way, we will also reallocate seats among Upper House districts, in order to make it more representative of the electorate.”

In short, the low democratic legitimacy of the Upper House gives the LDP and PM Abe a reason to remain in office. The quid pro quo is that reform must accelerate.

For markets, the key issue is whether reform accelerates, not who implements it. If PM Abe delivers on reform, then sustainable earnings should accelerate. If he does not, then, as per democratic practice, he and the LDP will be replaced by a different government. The new government will then have to deliver on reform in order to remain in office itself. The first scenario is faster and cleaner. But even the second, despite its uncertainties and slower timing, is fundamentally supportive of Japanese equity prices.

 

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Global
Revisiting US$80/bbl?
July 06, 2007

By Eric Chaney and Richard Berner | London, New York

The price of crude oil is blazing again.  On the London IPE, the Brent swap price rose to US$75 during the week and markets are so nervous that a further rise is a possibility.  Are these renewed tensions coming from the demand, or the supply side?  This distinction is crucial for the analysis of the economic consequences of the price spike, if this turns out to be one: if prices go up because of stronger demand, then the causality link goes from GDP growth to oil prices and we should not worry too much.  If supply factors are behind the rise, then the causality is inverted and aggregate demand could suffer.

For the moment, we believe that the new elements that are driving crude and refined product prices higher are coming from supply rather than from demand.  According to the IEA report, demand for crude and refined products is growing in line with expectations, if not slightly lower.  For example, European demand was revised down for 1Q, due to mild weather conditions.  Chinese imports have increased by 9.7%Y since the beginning of the year, which is broadly in line with GDP growth, actual or expected.  And the US Energy Information Agency (EIA) estimates of US demand in 2007 haven’t changed in the past few months.

By contrast, supply uncertainties have increased and dominant producers such as Saudi Arabia and the Emirates seem to be reining in shipments: according to Norwegian Energy, total oil in transit for the four weeks ending July 21 is down 12.5 million barrels (bbls) from one year ago, which suggests possible difficulties for the peak summer demand season in the US.  We suspect that OPEC exporters are disappointed by the weakness of the USD, and are doing their best to keep their reference price close to US$70/bbl (the OPEC basket broke the US$70 line on July 5, at 70.22/bl), by telling the markets that there is no need to increase production: “market fundamentals do not indicate that additional supply is necessary at that time” writes the June oil market report of the cartel, which estimates that its spare capacity will reach 15% in the second half of the year.

As for weather-related supply disruptions, the US NOAA continues to expect 7-10 hurricanes in the Atlantic basin, of which 3-5 may be of category 3 or higher, which is above normal, with a 75% probability.  To be sure, experts have not revised their estimates recently, and maintain that the likelihood of a repeat of the destruction caused by Hurricanes Katrina and Rita in 2005 is relatively small. But the hurricane season has begun, and the weather forecasters have not lowered their warnings either, which tends to give them more credibility.  Based on those forecasts, the EIA expects a total of about 13.2 mbbls of crude oil and 86.5 billion cubic feet (bcf) of natural gas produced in the Gulf of Mexico to be shut in during the 2007 hurricane season.  Those are 8% and 11% respectively of the cumulative impact of Hurricanes Katrina and Rita.  But context matters; added to other factors elevating prices, the anticipation of some hurricane-induced supply shocks is building a risk premium into the price.

Accordingly, we are boosting our oil price baseline.  We expect crude quotes (Brent) to hover slightly above US$70/bbl during the summer, with risks of a significantly higher spike, and we raise our year-end target to US$70, from US$62.  Looking forward, we stick to our U-shaped price profile, considering that more refinery capacity will come on-stream in 2008-09 and that the oil intensity of global GDP will continue to decline, as a result of higher petroleum product prices.  For 2008 as a whole, we have raised our baseline from US$59/bbl to US$64.  In the longer run, however, the real price of crude oil should rise faster than the real rate of interest, according to our modified Hotelling rule (see, for instance, A Higher Risk Premium on Oil Prices, Eric Chaney and Richard Berner, May 9, 2007).

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