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Tighter Lending Ahead
July 30, 2007

By Oliver Weeks | London

The latest official attempts to restrain explosive bank lending growth in Kazakhstan appear once again underwhelming.  However, more difficult external conditions and higher local rates are likely to be more effective in prompting a long-awaited slowdown in local borrowing.  A soft landing for credit growth still appears most likely to us, suggesting that KZT weakness is likely to be temporary. 

Cost of reserve hike limited.  The pace of local bank credit growth has continued to accelerate, reaching a record 110.8% year on year in June, largely funded by 130%Y growth in foreign liabilities.  The National Bank’s latest response — a hike in required reserve ratios on foreign borrowing and all bond issuance from 8% to 10%, and a cut in the ratio for domestic borrowing (except bonds) from 6% to 5% — was in line with our recent expectations and unlikely to have been a surprise to the local market.  It was also significantly watered down from original proposals for a hike to around 25% on incremental foreign borrowing (not the whole stock as in the final version).  Overall, the move will modestly tighten monetary conditions — see also last week’s EM Economist for details.  The stock of banks’ FX borrowing stands at US$40.7 billion in gross terms at the end of June (US$19.8 billion in net terms), while domestic liabilities are the equivalent of US$33.7 billion — implying a net increase in required reserves of just under US$0.5 billion.  Given average yields on bank lending of around 12%, and no remuneration on required reserves, the additional FX funding cost is just over 0.2 pp, while local costs would fall around 0.1 pp — unlikely in itself to change behavior significantly.

External market a tighter constraint.  However, the impact of the new measures is currently dwarfed by that of external market conditions, which are much more likely to become a constraint on new borrowing.  Balance of payments data put banks’ short-term (maturing in less than a year) gross foreign debt at US$5.3 billion as of the end of March.  Our own analysis identifies US$3.0 billion of bank loans maturing in the rest of the year, and only US$0.3 billion of Eurobonds, but this does not account for some bilateral loans, or for interest payments. 

Were banks unable to roll over this debt and extend borrowing, the balance of payments impact would be significant.  The current account deficit in 1Q was US$0.4 billion, with a further US$1.1 billion of errors and omissions outflows.  This was well covered by US$1.8 billion of net FDI inflows, a US$0.5 billion portfolio outflow (largely discretionary, driven by government investment for the oil fund) and above all by US$3.4 billion of net bank borrowing.  Over the next few quarters, we expect inward FDI to rise, but also outward FDI and the current account deficit.  A reversal in bank flows could tip the overall balance of payments into deficit and put stronger downward pressure on the KZT, but so far this still seems unlikely to us unless external markets effectively close to Kazakh banks for a long period.  KZT moves are likely to remain largely at the discretion of the NBK.

Higher costs likely to be passed on.  Strong demand for bank lending, justified by a still very strong long-term economic outlook, suggests to us that banks are likely to be able to pass on higher borrowing costs.  While the lending rates tracked by the NBK have yet to rise, local interbank rates are already rising significantly. 

So far, banks also still appear interested in funding at higher rates.  Still, a slowdown in the pace of credit growth seems inevitable to us.  At around 62% of GDP, private sector credit is well above any comparable levels in Eastern Europe, including even the Baltics, after adjusting for wealth levels.  Average prices for new housing in June were up 52%Y nationally and a still exuberant 130%Y in Almaty, to US$1,200 and US$2,700 respectively per square meter.  (Note that prices in Moscow have been falling since January.)  Hopes of future wealth look very well founded to us, based on sharp increases in commodity exports over the next ten years, but the pace of recent credit growth still looks unlikely to be sustained.  While the apparent strength of the banking sector lobby is a concern, the most likely scenario to us remains a soft landing for credit growth, driven by a more discriminating external market and gradual further tightening of domestic policy. 

The NBK has been consistent this year in squeezing local short-term interest rates higher.  M3 growth has already begun to slow as the balance of payments surplus weakens, from a peak of 80.5% in January to 66.0% in June; however, still rising inflation and looser fiscal policy suggest that the NBK is unlikely to welcome significant KZT depreciation.  In an environment of higher local rates and a controlled slowdown in foreign borrowing, we would expect near-term KZT weakness — as local banks adjust to the new conditions — to be short-lived.


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United States
Repricing Risk: Phase II
July 30, 2007

By Richard Berner | New York

The repricing of risk in financial markets has moved into a new phase, spreading to all asset classes on a global basis.  Credit, loan, and mortgage markets have continued their month-long plunge, with spreads widening to two-year highs and lenders clearly becoming more circumspect.  More recently, the carnage extended to global equity markets and promoted a massive flight-to-quality bond-market rally.  Small wonder: Fears rose that tighter financial conditions would hurt the economy, and increased financial-market volatility heightened uncertainty.  The reversal in performance of stocks and bonds in the past 2-3 weeks has quickly unwound roughly two-thirds of developed-market equity returns and an even larger fraction of the rise in risk-free yields since the beginning of 2007.

The resulting tightening of financial conditions raises three key questions: What will be the economic fallout from these developments and from further tightening of financial conditions?  How will central banks respond? And what should investors do? 

In our view, financial conditions probably will tighten further, but we haven’t changed our view from a month ago that a credit crunch still seems unlikely (see “Credit Crunch: Will This Time Be For Real?” Global Economic Forum, June 29, 2007).  That’s partly because credit quality has yet to deteriorate broadly across the quality or seniority spectrum, and balance sheets in the aggregate are healthy.  To be sure, the US housing downturn will intensify and both consumer and capital spending are at risk, pointing to subpar growth.  But we still think strong personal income and overseas growth rule out significant US economic weakness.  For their part, Fed officials and those at other central banks likely will not respond to market declines unless they threaten the economy or financial stability or both.  Under most scenarios, investors should anticipate a further steepening of yield curves; we favor bear steepeners as yields rise back over 5%. 

There’s no mistaking the downdraft in risky asset prices, but their influence on overall financial conditions has — so far at least — been mixed.  Credit spreads have more than doubled over the past month, with investment-grade CDX index spreads widening 42 bp to 80 bp, the high yield index 260 bp to 546 bp, and the emerging markets index up 102 bp to 220 bp.  Likewise, ten-year swap spreads — the benchmark for pricing many loans — jumped to five-year highs at 76 bp, and spreads on the two-month-old leveraged loan LCDX index widened by 206 bp to 384 bp.  And virtually all segments of the mortgage default swap market, where the subprime meltdown first showed up last February, plunged to new lows.  But equity prices, although down 6-11% from their recent highs, are still up on the year.  Moreover, the prices of risky assets are now beginning more appropriately to reflect the quality of the collateral.  Finally, the gapping down in risk free-yields has significantly offset the gapping up in risk spreads, and the dollar has weakened. 

The debate over the influence of financial conditions on growth will center over whether the credit meltdown, which is now broad based, does turn into a credit crunch — when creditworthy borrowers can’t get access to credit — and threaten the economy.  To be sure, credit availability is declining, especially in subprime mortgages and for less creditworthy corporate deals.  And lending standards have tightened even for prime borrowers, in the form of increased documentation, lower LTVs, and a shunning of ‘covenant-lite’ structures.  The Fed’s July Senior Loan Officer Survey, due out in two weeks, likely will evince a further tightening in mortgage lending standards and the first signs of tighter corporate standards in three years. 

In our view, housing activity is clearly at risk, and we see no real recovery until 2009.  We believe that the economic costs of subprime loan defaults largely will be borne by lenders rather than borrowers because such borrowers have scant equity in their home.  Thus, the spillover risk to the economy depends on whether lenders tighten lending standards significantly further.  We do expect that the tightening in lending standards will crimp demand; indeed, the downdraft in June home sales to new lows suggests that the tightening in mortgage credit is already starting to bite.  The ongoing buildup in inventories of unsold new and existing homes points to a mismatch between supply and demand that will require at least a 20% decline in 1-family housing starts to correct; that drop is already built in to our forecasts.  In addition, we estimate that foreclosures over the coming year could add 7% to the inventory of homes available for sale and put further downward pressure on home prices and thus, potentially, on consumer spending.  Likewise, the increase in the cost of capital and tighter standards for business borrowers means that the sluggish capex expansion is also at risk. 

But there are also several reasons to be suspicious that such forces will materially weaken the economy.  First, magnitude and duration both matter for assessing the extent to which any such credit tightening will affect growth; this episode has been modest and recent — so far.  Second, other dimensions of financial conditions are moving in the opposite direction.  Third, and contrary to the pessimists’ claims that the US economy’s sole source of fuel is a high-octane credit market, we continue to think that strong overseas growth and hearty domestic income gains will support overall US growth in general, and consumer spending in particular.  Indeed, while market participants are ignoring past economic data on the theory that they don’t reflect the recent changes in financial conditions, initial economic conditions do matter.  In particular, net exports have added 0.4% to overall US growth over the past year for the first time in a decade, and prospects for global growth remain strong.  And US real disposable income rose by 3.2% over the past year — faster than the pace of spending. 

Many are comparing this episode with the events of 1998.  The downdraft in market pricing potentially could be similar, and in some respects, the economic setting is comparable to the earlier period.  But we think that the economic comparison is misplaced for two reasons.  First, the financial-market dislocations in 1998 followed the Asian financial crisis that began in 1997, which put a significant chunk of the global economy into recession, so officials were not confident that the US economy could withstand tighter financial conditions.  In addition, unlike today, the dollar rallied massively against sinking AXJ currencies, tightening that dimension of financial conditions. 

For their part, Fed officials and those at other central banks likely view recent developments as a welcome and long-overdue normalization of risky asset prices.  Central banks officials have long been concerned that financial-market risk was mispriced, and thus we think officials welcome an orderly correction in credit and equity markets and a return to higher levels of market volatility that would convince investors of the two-sided risks inherent in risky asset prices.  We took a quick survey of our global economics team to test that thesis; the responses overwhelmingly indicated that this repricing of risk was welcome and overdue, but that officials would watch closely developments in the US.  Thus, as we see it, officials will not respond to market downdrafts unless they threaten the economy or financial stability or both. 

To be sure, the repricing of risk is rapid and feels disorderly.  But prime lenders seem to be very much in business lending to prime borrowers and looking at this turmoil as an opportunity to strengthen their hand.  Doubtless there will be stories of people in trouble, and some will believe these disruptions threaten financial stability and that the Fed must bail out, just as in 1998.  However, this Fed is under different leadership from the one in 1998.  Chairman Bernanke and his colleagues seem to believe that the longer-term cost of the moral hazard involved in such bailouts — the so-called Greenspan Put that nurtures ever more risk taking — far exceeds the short-term gain. 

What’s critical for monetary policy is whether market conditions become disorderly and liquidity appears to be drying up.  The Fed and other central banks would become more concerned about credit availability if signs of a cascade of defaults, margin calls, forced selling and counterparty risk threatened the ability of borrowers and lenders to transact and manage risk, and menaced the stability of the financial system

However, there is clearly a significant difference between a repricing of risk — with its inevitably abrupt and bumpy price action — and a significant tightening of financial conditions that menaces growth.  We think that officials share our view that current conditions do not add up to a credit crunch and that we are still far from it.  Although we can create scenarios in which the Fed would ease, we are far from reaching that point, in our view. 

Fixed-income investors should anticipate a further steepening of yield curves under most scenarios.  If the economy weakens again, the bull steepening that began in the flight-to-quality rally could proceed further, as investors anticipate eventual Fed ease.  In contrast, we favor bear steepeners as markets price out Fed ease, concerns about inflation resurface, and yields rise back over 5%.

In the immediate future, economic risks tilt towards weaker growth and lower inflation, which will be bullish for bonds.  Financial turmoil creates uncertainty, which is the enemy of growth.  Absent significant economic weakness, however, risks ultimately will favor higher yields.  The last risk may involve an ironic twist: The repricing of risk and a less-favorable deal backdrop may suppress LBOs and short-term gains for senior management.  But when the dust settles, it might just rechannel animal spirits into business capital spending, as managers focus on how to grow earnings from within rather than from levering up the capital structure.


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ECB on the Beach
July 30, 2007

By Elga Bartsch | London

Amid considerable financial market turmoil, the ECB Governing Council will hold its monthly monetary policy meeting this coming week. The meeting is widely expected to result in another holding operation. Contrary to the other 11 meetings during the year, the August meeting takes place by teleconference as the ECB Governing Council takes its annual summer holidays. Last year, the Council exceptionally decided to meet in person because of the rising concerns for price stability at the time. As a result of these concerns, the Council also decided to call a press conference one month in advance and hiked interest rates by 25bp at the August meeting. This year, the Council hasn’t scheduled an additional press conference and, in our view, is unlikely to call a press conference at very short notice. Given market expectations for another refi rate hike in September, the main question regarding the ECB’s August meeting is one of communication: when will the ECB introduce “strong vigilance” into its official language to signal that a refi rate hike is imminent?

The ECB has several options to signal a September rate hike. The most likely one, in our view, is to use the August Monthly Bulletin out on August 9 to adapt the official language. The Monthly Bulletin always contains a verbatim transcript of the introductory statement to the press conference in its editorial. Alternatively, the Council could decide to publish an introductory statement immediately after the meeting this coming Thursday together with its interest rate decision. In our view, however, the most likely scenario is that we will find “strong vigilance” in the Monthly Bulletin. But just in case, we will stay close to our screens next Thursday too. If the ECB Council instead decides to leave the language unchanged in the Bulletin and continues to “monitor the risks to price stability closely”, the market would most likely conclude that a September rate hike is no longer on the cards and start to look towards October as the most likely timeframe for further firming in euro area monetary policy. To come out afterwards and pre-announce a refi rate hike on an ad hoc basis in a speech or an interview — note that the ECB remains adamant that ECB President Trichet would be able to get a message across to the markets at any time — would likely add to the current market volatility.

As we are inching towards the end of the current tightening campaign, the timing of the next move is subject to greater uncertainty. Take for instance our Refi-meter model: While, on balance, it favours a September rate hike by the ECB, the signal is weaker than it was for instance for the last rate hike in June. Similarly, our own conviction about September has been dented by the last press conference, where contrary to our expectations the language wasn’t upped from “monitoring risks closely” to monitoring them “very closely”. True, the ECB has gone from “monitoring closely” to “strong vigilance” in one go before, but only once. Usually, it goes from “monitoring risks very closely” to “strong vigilance”. ECB President Trichet tried to play down the difference between the two, saying that they were essentially the same. If that was the case, however, it is not clear why for the first time in a year the ECB went back to “monitoring risks closely” after the June rate hike. The main reason why we would still marginally favour September over October as the most likely timeframe for another ECB rate hike is that in September a new set of staff projections will be released.

Since the July meeting, the macroeconomic fundamentals haven’t really changed much. Business sentiment has proven to be relatively robust (see Eric Chaney’s July Business Cycle Watch), inflation seems likely to have been stable and money and credit growth has accelerated further. The main change is the drama currently unfolding in financial markets. First the euro started to rally sharply, and now credit markets have started to tank. But on both counts, the market is jumping to conclusions, I think, by starting to question a 4.5% terminal rate for the ECB’s tightening cycle. In my mind, like many of its global counterparts, the ECB will look at the current meltdown in certain segments of the credit market as a healthy correction of the previous excess risk taking, which it has long warned about. If the LBO market shuts down for the summer, this would probably be partly welcomed at central bank headquarters, given the concerns they have had about this particular part of investment activity.

The obstacles to an interest rate reaction from the ECB, which would put further tightening on hold or even reverse past rate hikes, are rather high, I think.  The chances of seeing interest rates cut in response are even more remote. If growth prospects were dented a bit by an ongoing correction in risky assets, this would merely help to fend off existing and rising inflationary pressures in the euro area. In my mind, the tipping point for the interest rate outlook will likely be found in the ECB’s second pillar — its monetary analysis. A slowdown of headline money and credit growth would probably not be sufficient to change the ECB’s assessment fundamentally. Instead, the ECB probably has to see core lending to non-financial corporations and households taking a hit. Slower lending to other financial institutions, for instance, will likely be seen as a side effect of the scaling back of excessive risk taking. Together with the M&A boom and the rapid rise of retail derivatives, it has been one of the factors bloating headline M3 growth, according to the ECB.

Given that the ECB worries about the impact of excess liquidity, it would be premature to see it opening the flood-gates again in the event of a further shake-out in risky assets.   At the same time, however, it knows from the experience in Japan in the 1990s that monetary indicators are where trouble tends to show first. So, who said that money doesn’t matter anymore?


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Towards an Orderly Slowdown
July 30, 2007

By Eric Chaney | London

“Will GDP Ever Slow?” we asked one month ago, after yet another batch of strong business surveys.  The answer came earlier than we thought and, if surveys data could be translated into plain English, it would be: “Yes and it is now”.  Not that manufacturing surveys (Ifo, Insee, Isae and others) were particularly negative this month, with the exception of a significant dip in Italy, but simply because the normalisation of demand that is unfolding, even incremental, implies softer production growth.  The slowdown comes from manufacturing sectors, and is probably explained by the combined effects of several macro headwinds.  Its impact on the overall economy should be benign, according to our survey-based GDP indicator, thanks to improving business trends in services.  After five quarters of above-trend GDP growth, a slowdown should be welcome by the European Central Bank, given its worries about inflation risks and, since it is concentrated in the job-poor manufacturing sector, should not raise serious concerns among policy makers and investors.  However, because the re-pricing of risky assets is now affecting credit and equity markets, any further signs of weakness from the real economy should be carefully scrutinised.

Production: mild correction and re-synchronisation

The production indicator lost 0.1 standard deviation (s.d.) to 1.0 s.d. above its long-term average.  Its remarkable stability, around one standard deviation, is good news for corporate Europe: excessive supply volatility implies higher costs for carrying larger inventories than otherwise.  The steady deceleration that started in January in Germany, combined with some improvement in other euro club members is now yielding a re-synchronisation of production across the area, a sign that the large intra-EMU imbalances that had developed since 1999 might start to ebb.

Demand: uneven slowdown

For the euro area, the demand indicator declined by 0.2 s.d. to 1.3, still significantly above average, but nevertheless the lowest reading since September 2006.  The correction was unevenly distributed, with demand continuing to defy gravity in Germany at 2.0 s.d., but posting significant corrections in Italy and the Netherlands.  A possible interpretation could be that the latter are highly sensitive to German domestic demand, while demand reported by German firms is more sensitive to overseas orders.  However, this is not very convincing: exports to Asia have tumbled since their spectacular acceleration in the second half of last year, and demand reported by French producers, which are also highly sensitive to the German factor, was stable.  It makes probably more sense to focus on the aggregate picture: macro headwinds, such as higher interest rates, a stronger currency, higher input costs (energy in particular, but not only) and the boomerang effect of the German VAT hike, may start to have some impact on aggregate demand.  In addition, very poor weather conditions in June and July in most of Western Europe may have temporarily affected consumers’ demand.

Companies rewarded for having been conservative

Despite somewhat softer demand, companies kept their production plans unchanged at 0.9 s.d., that is, significantly above long-term average.  Because they took the buoyancy of demand with a pinch of salt — was it sustainable, after all the short-lived recoveries Europe went through since 1994? — they were not taken off-guard by the slowdown.  Hence, our Surprise Gap Index tumbled from the acceleration zone down to the neutral band, indicating that, in the short term at least, production is neither likely to accelerate nor decelerate.  Although country-specific Surprise Gaps’ excessive volatility makes them harder to decipher, it is worth signaling that the German Index experienced a harder fall.  But even there, the index remained in the neutral band.

3Q GDP growth could drop below trend

Our manufacturing production indicator, which is driven by production plans (flat) and orders (down), turned more pessimistic for the third quarter.  It is now predicting 0.1%Q production growth instead of 0.4% one month ago.  This negative contribution was partially offset by better news from services, so that our early GDP indicator was revised down only marginally, from 0.45%Q (1.8% in annualised terms) to 0.4% (1.6% annualised).  If confirmed, this would be clearly below a trend that we see at 2.25% (annual rate, or 0.56%Q) but still robust, after five quarters of above-trend growth.

Good news for the ECB?

In the real world, adverse weather conditions may have a negative impact on 2Q GDP growth, that we estimate at 0.7% and that our GDP indicator sees even higher at 0.8% (3.1% annualised).  Hence, the slowdown in 3Q could be softer than indicated by our tools.  However, the message from European companies is clear, in my view: GDP growth is more likely to decelerate in the coming two quarters than to stay above trend, and this should not come as a surprise, given the negative factors we have listed earlier.  It should be good news for the ECB.  Since measuring the degree of slack in euro area economies is a highly uncertain exercise — the output gap is a powerful concept for monetary policy, but it cannot be measured accurately before the statistical dust has settled.  The same holds for the natural rate of unemployment, or the NAIRU.  However, there is a set of indicators, from unemployment to operating rates, which are pointing to a rapidly shrinking output gap, justifying that the ECB should take some further insurance against the risk of inflation.  Accordingly, a slowdown in the third quarter should be welcome by the ECB.   If confirmed by the September round of business surveys — August surveys are volatile and poorly reliable because too many respondents are on the beaches — the debate within the Council about a second rate hike might intensify, all the more so if the correction in financial markets goes significantly further than it has done so far.


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Review and Preview
July 30, 2007

By Ted Wieseman | New York

Treasury yields plummeted over the past week in a massive further flight-to-quality rally as investors fled to the safety of Treasuries from intensified turmoil in credit, loan and mortgage markets. Stocks, after somehow pushing to a record high on July 19, also finally noticed the turmoil in other markets and joined in as well. Investors were so panicked by the market turmoil that a 40% chance of a rate cut by the September FOMC meeting was priced in at the peak of the chaos Thursday, before backing off somewhat Friday but still ending the week seeing a one-in-three chance of imminent Fed action. If not immediately, one rate cut by year-end and another by around the middle of next year are now fully priced in. It was the market’s best showing since the week of March 2 in the aftermath of the big drop in global stocks in late February after a plunge in Chinese equities. Back then, the market was so spooked by the global stock market declines that it moved to price in similarly high odds of an imminent rate cut. That reaction certainly seems ludicrous in retrospect (not that it made much sense at the time either). We think that this latest similarly panicked belief that the Fed might soon ride to the rescue of traders stuck in losing positions put on in risky assets that weren’t providing much risk premium will prove just as unfounded. We certainly hope that the Fed recognizes the pernicious consequences of the 1998 rate cuts that many investors seem to be taking as a template for looming Fed action now. Nothing contributed more to the eventual 2001 recession than the Fed’s providing further stimulus to an already booming and overheating economy in 1998 in order to bail out investors stuck in bad positions. Fed Chairman Bernanke’s complete silence this week was an encouraging indication that the Greenspan put is dead and an implicit signal that the Fed for now is content to let the markets deal with their bad investments on their own.

Economic data released the past week continued to be completely ignored by investors. But a big part of why we believe the Fed is far from seriously thinking about cutting rates at this point is that the big pick-up in economic growth in 2Q came through right as expected. While we think that the 3.4% jump in 2Q GDP overstated the underlying trend as much as the 0.6% rise in 1Q understated it, the rebound off that first quarter trough certainly eases fears about downside risks to growth (including among FOMC members, as explicitly noted in the minutes of the June FOMC meeting); particularly coming against the headwind of a major energy price shock that knocked consumption growth down to just over 1%, it highlighted the broad resilience of the economy. There’s a slew of key data in the coming week — employment, ISM, core PCE inflation, motor vehicle sales, et al. — but economic news will likely continue to be largely ignored by investors until the risk reduction trade eventually runs its course.

Benchmark Treasury yields plunged 12-26bp over the past week to their lowest levels since March at the front end and May at the intermediate and long ends. Almost all of the gains came in a huge panicked flight-to-safety rally on Thursday as risk markets saw an across-the-board disorderly rout. For the week, the 2-year yield fell 22bp to 4.55% (with 1bp of that coming from the roll into the new issue), the 3-year 26bp to 4.525% as 2s-3s inverted for the first time in seven weeks, the 5-year 24bp to 4.60% (also boosted about 1bp by the new issue roll), the 10-year 17bp to 4.79%, and the long bond 12bp to 4.95%. This left 2s-10s and 2s-30s at their steepest levels since early autumn 2005. The 5-year TIPS yield fell 14bp to 2.51% and the 10-year 13bp to 2.47%, so the 5-year benchmark inflation breakeven fell 10bp to 2.10% and the 10-year 4bp to 2.32%, a combination that lifted the 5-year/5-year forward breakeven 3bp to 2.54%. Though Thursday’s panicked expectations of an imminent Fed rate cut were ratcheted back slightly Friday, for the week a hugely more dovish Fed path was still priced into futures markets. In the near term, the October fed funds contract surged 6bp to 5.165%, putting about 33% odds on a rate cut by the September FOMC meeting. A 13.5bp rally in the January contract to 5.025% just about fully priced in a rate cut by year-end. Looking beyond this year, eurodollar futures gains were led by 24.5-25.5bp rallies by the 2008 contracts. The low rate Sep 08 contract gained 25bp to 4.835%, more than fully pricing in a cut in the funds target to 4.75%.

Investors were completely focused through the week on continuing weakness across key risk markets that was particularly intense and panicked on Thursday, continuing to pay no attention at all to incoming economic data. After Thursday’s meltdown, activity was more mixed Friday, but all of the key risk markets that investors have been focusing on and that have driven the powerful Treasury flight-to-safety rally and accompanying repricing of the Fed in futures markets were off sharply on the week. Stocks had a bad week, with the S&P 500 down 5%; however, having hit a record high just over a week ago, they have only recently joined the risk-reduction trade that has been impacting other asset classes for some time. Thus, stocks have seen a comparatively small net correction so far. Credit spreads widened every day, with particular carnage Thursday — especially in emerging markets debt. The benchmark 5-year Hi-Vol CDX index widened 49bp on the week to 184bp, the IG index 24bp to 77bp, the emerging markets index a rather amazing 79bp to 206bp, and the high yield index 98bp to 528bp. Tracking the general weakening in credit and the flight-to-safety premium accorded to Treasuries, swap spreads blew out to their highest levels in five years, with the benchmark 10-year spreads up 7bp to 75.75bp and the 5-year 9.5bp to 69.75bp. The mortgage default swap market, where the whole risk reduction trade began months ago, remained in freefall, with all the ABX indices way down on the week — AAA (95.61 versus 98.03), AA (90.18 versus 96.14), A (68.36 versus 78.56), BBB (44.74 versus 55.44), BBB- (39.97 versus 47.86) — and all ending Friday at new lows except the AAA, which bounced slightly to end the week off Thursday’s trough. The leveraged loan LCDX index appeared to find some stability mid-week, rebounding Tuesday and then only dipping slightly Wednesday even after two major leveraged loan deals were shelved; however, it collapsed along with everything else starting Thursday, ending the week at a new low of 92.11 (370bp), down from 94.83 (271bp) at the end of the prior week.

Real GDP growth accelerated to +3.4% annualized in 2Q, marginally less than the +3.6% we expected, rebounding from the meager +0.6% reading in 1Q. In our view, some timing issues and quirks in the data artificially depressed 1Q and inflated 2Q, so the average over the two quarters of +2.0% is much more indicative of the underlying trend in the first half than the volatile 1Q and 2Q results. We expect a gradual pick-up from this towards +2.5% in the second half and then back towards what we consider to be the sustainable trend of +3.0% in 2008. Final sales advanced 3.2% in 2Q, with inventory rebuilding adding a much less than expected 0.2pp — a positive for growth going forward. Final domestic demand growth remained fairly sluggish at +1.9%, while net exports, as expected, were a substantial positive, adding 1.2pp, with exports up 6.4% and imports down 2.6%. Within domestic demand, a significant slowdown in consumption (+1.3%) was offset by a sharp pick-up in business investment (+8.1%) led by structures, the smallest drop in residential investment (-9.3%) in five quarters, and a pick-up in government spending (+4.2%) as the recently extremely volatile federal government component sharply rebounded from a big decline in 1Q. The slowdown in consumption in 2Q after gains averaging +3.8% over the prior two quarters reflected the impact of higher energy prices; growth in nominal consumption at +5.6% exactly matched the average over the prior year. Notably, the contribution from residential investment at -0.5pp — half the average drag recorded over the prior year — was more than offset by the positive contribution from business investment in structures at +0.7pp, so overall construction was a net positive for growth in the second quarter. The core PCE price index slowed to +1.4% in 2Q, consistent with our forecast for June (due out Tuesday) of +0.17%. There were some small upward revisions to prior quarters, however, so the June year-on-year rate may end up at +2.0% instead of the +1.9% we previously expected.

Annual benchmark revisions were released with this report, showing slower growth over the past few years. From 4Q03 to 1Q07, average annualized quarterly growth was adjusted down to +2.7% from +3.0%, which will be reflected in an even bigger undershoot in productivity growth, raising further questions about the economy’s potential growth rate. On the other hand, real disposable income growth was revised up significantly in recent prior years as a result of much higher dividend and interest income, lifting the personal savings rate into positive territory and potentially moderating concerns about the underlying state of the consumer.

After the much more moderate decline in residential investment in 2Q, we expect to see a major re-intensification of the downturn going forward, and the past week’s home sales reports starkly highlighted the problem.

The slowdown in rate of decline of new homebuilding in 2Q combined with still sharply falling home sales has left inventories at still sharply elevated levels. We expect that big further declines in housing starts and overall new homebuilding activity will be required to bring the housing market back into balance and that the moderation in the housing recession in 2Q just delays this inevitable adjustment. Existing home sales fell 3.8% in June to a 5.75 million unit annual rate, a low since November 2002. Sales of single-family homes (-3.5%) and condos (-6.3%) both fell substantially, and sales in all four regions were down, led by the Northeast (-7.3%) and West (-6.8%). In the West, overall sales hit their lowest level ever in the eight years the combined single-family and condo numbers have been released and single-family sales hit their lowest level since 1998. Homes available for sale fell 4.2% in June, but with sales down sharply, the months’ supply held steady at 8.8, the highest level on record for the period starting in 1999 when the combined single-family/condo numbers are available. Single-family supply rose to 8.7 months from 8.6, a 15-year high. Meanwhile, new home sales fell 6.6% in June to an 834,000 unit annual rate, and there were significant net downward revisions to prior months. Unsold homes on the market were flat, which, combined with the lower sales pace, led the months’ supply to jump to 7.8 from 7.4, not as bad as the 8.3 March peak, but well above the long-term average near 5.5 months. Regionally, sales plummeted in the West (-22.5%), Midwest (-17.1%) and Northeast (-27.1%), but a partial rebound in the South (+7.6%) mitigated the overall decline. As in the existing home sales report, the collapse in new home sales in the West — where affordability issues are dramatically worse than in the other areas — has been the worst of any region, with the June level of sales at a more than 12-year low.

There’s a lot of key data due out in the coming week, highlighted by the employment report on Friday, but investors have completely ignored all recent economic news, and there’s little reason to expect this to change until the risk-reduction/flight-to-quality trade stabilizes. The Treasury’s quarterly refunding announcement is Wednesday. With the elimination of the 3-year, the refunding now just consists of the 10-year and 30-year.

We look for unchanged sizes of US$13 billion and US$9 billion, respectively — making for considerably less in total issuance than the US$37 billion in 2-year, 5-year and 20-year TIPS supply the past week. With US$63 billion in securities maturing on August 15 plus a large interest payment, the Treasury will face a major cash outflow at the refunding settlement, necessitating some very heavy bill issuance throughout August. This should extend in a big way the gradual move back towards steadily more positive net bill issuance seen in July, finally alleviating the extended bill squeeze caused by the massive paydown in 2Q. We don’t expect any significant news from this refunding, but if the major improvement in the budget deficit in recent years continues, the Treasury may soon need to consider eliminating more issues in addition to the 3-year, with the 5-year TIPS and 10-year reopenings probably next on the chopping block. Key data releases due out in the coming week include personal income and spending (including core PCE inflation), the employment cost index, Conference Board consumer confidence and construction spending Tuesday, ISM and motor vehicle sales Wednesday, factory orders Thursday, and the employment report Friday:

* We forecast a 0.6% gain in June personal income and 0.2% rise in spending. The employment report pointed to a solid gain in wages during June, so we look for income to post its best advance since March.

Meanwhile, a pullback in auto sales along with softness in retail control points to a subpar advance in spending. Finally, based on our translation of the CPI results, the core PCE price index is expected to be up 0.17% in June, with some slight upward revisions to prior months leaving the year-on-year rate at +2.0%.

* We forecast a 0.9% rise in the 2Q ECI. Despite the fact that relatively tight labor market conditions have prevailed for quite some time now, the various measures of wage trends have been sending mixed signals for the past few quarters. The headline ECI has been drifting higher despite some recent moderation in the benefits component that has been helped by slowing growth in healthcare costs. Average hourly earnings have actually decelerated since the start of the year despite significant minimum wage hikes in several large states. Finally, non-farm business compensation has been bouncing around quite a bit — apparently as a result of volatility introduced by the exercise of stock options.

Of course, the definitional differences account for much of the recent divergence in the wage measures, but there also appear to be some unexplained gaps. In any event, the ECI is expected to tick up slightly relative to the 1Q advance as a result of an expected modest rebound in the benefits category. However, the key private wage component is actually expected to show a bit of moderation (to +0.8%), with the year-on-year rate holding at +3.5%.

* We look for a 0.8% rise in June construction spending, a second straight sharp gain, with the non-res and public components again likely to lead the way. Also, although we look for another decline in the residential category, the upside surprise in June housing starts points to a somewhat smaller dip than seen in prior months.

* We expect the Conference Board’s measure of consumer confidence to rise to 106.0 in July. Both the University of Michigan and ABC sentiment gauges pointed to a relatively sharp improvement in confidence during late June and early July. However, it appears that the swing may have been short-lived. So, we look for only a modest uptick in the Conference Board index, relative to the 103.9 reading posted in June.

* We forecast a 56.0 reading for the July ISM. Both the Empire and Philly gauges posted modest gains on an ISM-weighted basis in July, while Richmond was flat and KC down slightly. So we look for the ISM to hold at a relatively high level. We suspect that a pick-up in motor vehicle production is providing some support for the factory sector at this point. Finally, the price index is expected to continue to drift lower from the peak that was seen in April.

* Preliminary surveys point to a solid rebound in motor vehicle sales in July to a 16.4 million unit annual pace following a dismal performance in June, when the selling rate slipped to just 15.5 million units — the lowest since October 2005. The expected pick-up this month is largely a reflection of an aggressive industry-wide incentive war. Still, the Big 3 appear likely to continue to lose market share. We will update our estimate if the automakers offer additional guidance as the reporting date approaches.

* The durable goods data pointed to a solid 1.0% rise in overall factory orders, although much of the upside is attributable to the volatile aircraft category. Meanwhile, shipments are expected to post a slight decline, with the I/S ratio registering a fractional uptick.

* We look for a 150,000 rise in July non-farm payrolls. The recent divergence between initial and continuing claims is a bit perplexing, but at this point we look for the pace of job growth in July to be roughly in line with the year-to-date average. The construction category is expected to register a modest decline, but we actually look for a slight increase in manufacturing jobs for the first time in more than a year. This reflects the sharp jump in vehicle assembly plans for July, along with a possible overcompensation for the typical summer auto plant shutdowns due to the fact that there are 82,000 fewer workers (an 8% decline) in the industry than at this time last year. Also, a rebound is anticipated in the retail sector, which has been following a see-saw pattern in recent months. The hike in the federal minimum wage took effect at the end of July — too late to have any impact this month.

Moreover, because so many states already have minimum wage thresholds that are above the new federal mandate, the impact in coming months should be negligible. Finally, the unemployment rate is expected to register a fractional uptick (after rounding down to 4.5% in June).


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What Marx Knew About Inflation
July 30, 2007

By Serhan Cevik | from New York

The fundamental determinants of inflation will once again become more important. After the elections, it is time to turn our full attention to economic trends and focus especially on inflation. The latest figures were in line with our projections and showed a steady decline from 10.9% in March to 8.6% June. Although we expect further correction — lowering consumer price inflation to 7.5% in July and below 6.5% by the end of the year — disinflation is largely a result of base effects at this stage and remains closer to the upper bound of our forecast profile. In other words, despite the lira’s strength and slowdown in domestic demand, the extent of disinflation is not deep enough to bring the trend rate in line with the target. In our view, the disconnection between economic conditions and inflation reflects a range of factors that may persist in the coming months. The volatility shock leading to a sudden depreciation of the lira disturbed expectations and pricing behaviour. Anticipating another bout of currency weakness — due to global developments or domestic uncertainties — residents adopted a higher exchange rate assumption in asset allocations as well as in pricing decisions. This ‘just in case’ mark-up has of course created inertia in price-setting behaviour and delayed the pace of disinflation. The volatile rise in food prices is also a major problem, putting pressure on headline inflation. Likewise, although the lira’s appreciation limits the fallout from higher oil prices, the energy component is still a source of distortion. Nevertheless, the fundamental determinants of inflation will become more important and influence the future trajectory of interest rates.

The rise in energy and food prices is a global trend, but a greater risk for Turkey. With cyclical pressures and the pass-through from commodity prices, inflation is a global problem. One of the interesting developments is taking place in China. After functioning as a source of disinflation in the world, China is now experiencing higher inflation that may trickle down the supply chain. Meanwhile, with supply worries and the dollar’s weakness pushing the price of oil higher, Morgan Stanley revised its estimate from an average of US$63 a barrel to US$67.3 this year (see Eric Chaney and Richard Berner, Oil: Revisiting $80/bbl? July 9, 2007). Although this is bad news for energy-importing countries like Turkey, the lira’s strength has so far cushioned against higher oil prices (and imported inflation in general). A similar risk comes through the rise in food prices (which account for 28.5% of the CPI basket). Despite the recent tax cut on food products, the annual rate of increase in food prices is still moving higher. In our view, supply constraints — resulting from weather anomalies like high temperatures and low rainfall — and rising global demand for agricultural goods have increased food prices. Unfortunately, there is no sign of correction on the horizon and if anything we are likely to see further volatility (see Heat Wave, June 20, 2007). However, while exogenous factors present risks, the state of the Turkish economy has become more balanced and conducive for disinflation.

The behaviour of domestic demand will be the key to disinflation. Tighter monetary conditions have led to the rebalancing of growth over the last year. For example, the growth rate of consumer spending declined from 9.9% in the first half of 2006 to 1.3% in the second half and 1.6% in the first quarter of this year, largely because of a significant retrenchment in interest rate-sensitive demand for durable goods. Although risk aversion has also played role, recent developments validate the increasing influence of monetary transmission channels. The annual inflation rate in durable goods (excluding gold) declined from 3.1% at the beginning of the year to 0.3% in June. In our view, this is a result of fundamental changes empowering monetary policy. First, fiscal imbalances no longer have a dominant role. Second, despite the longest stretch of uninterrupted growth, the share of labour income declined from 30.7% of GDP in 1999 to 26.2% last year. In other words, employment and real wage growth lagging behind productivity gains led to a ‘demand gap’ in the economy (see Marx’s Ghost, July 17, 2006). Third, household debt increased from 4.7% of disposable income in 2002 to 25.2% last year. This is partly related to stagnating labour income, but also reflects greater access to the bank lending channel. As a result, the central bank now has greater control over the behaviour of domestic demand.

The accumulated energy in domestic demand does not allow aggressive monetary easing. The degree of slack in the labour market and stagnating labour income limit underlying inflation pressures. However, even with structural changes bringing higher productivity and potential growth rates, we believe that the output gap is no longer wide enough to accommodate the accumulated energy in domestic demand. Election economics (with measures like 10-35% increases in public-sector wages and agricultural support prices) have primed the demand channel and now, with a more stable political outlook, we are likely to see a robust recovery in credit growth. Indeed, the expansion in domestic liquidity is already underway and will pave the way for the return of pent-up consumer demand. This is why we do not expect aggressive monetary easing from the central bank. Even with our below-consensus inflation projections for the next two years, the room for interest rate cuts is limited — just about 75bp later this year and 150bp in 2008.


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No Inflation Let-up
July 30, 2007

By Oliver Weeks | London

Inflation heading towards 9.0%.  Full inflation data for July will not be released until the week after next, but as usual the direction is already clear.  Kremlin economic adviser Dvorkovich reported that CPI in the first 23 days of July was up 0.8%, a marginal slowdown from the last report of 0.6% in the first 16 days of the month.  Year-on-year inflation in July still looks on course for around 8.9% — up sharply from 7.4% in March.  M2 growth slowed slightly to 53.3%Y in June, and Gazprom and Rosneft have both postponed debt issuance, given market volatility, but so far the appetite of state-owned firms for foreign borrowing and the pre-election IPO calendar still look relatively firm.  The inflation targets of 8.0% for end-2007 and 7.0% for end-2008 remain well out of reach, in our view. 

Attracting Putin’s attention.  The government response remains slow.  The anti-monopoly service has unsurprisingly launched an investigation of the retail petrol market, following PM Fradkov’s recent complaints about this.  Further short-term administrative pressures in the run-up to election season look likely, but the medium-term outlook for government-controlled prices remains sharply upwards, in our view (see Russia: How to Spend it, May 7).  More importantly, President Putin has been paying increasing attention.  At his last meeting with economic ministers, he noted that he was “concerned about inflation – higher than we expected”.  At the last cabinet meeting, he noted the risk of rising fiscal spending disturbing macro equilibrium.  The public are also concerned.  The latest annual Levada Centre poll on the public’s view of what should be the government’s highest priorities puts corruption top for the first time with 45%.  However, the three next responses — lowering prices, inflation indexation of wages, pensions and deposits, and state price control — all relate to inflation, and received 40%, 39% and 39% of responses, respectively (people were allowed several choices). 

Stronger RUBUSD likely.  Fiscal tightening, ahead of the elections and just after revisions in the direction of higher spending, still seems unlikely to us.  Other government pre-electoral policies — notably the expulsion of foreign traders from retail markets — are also working in the direction of higher prices.  Further RUB appreciation still looks the most plausible policy response to us.  The Levada poll underlines that this would also be popular — 26% of respondents named strengthening the RUB as a top priority.  Manufacturing output data and the demand for investment imports underline the room for nominal appreciation — see EM Economists passim.  We continue to look for another 2.5% nominal appreciation against the basket this year.  Given the hike in our FX team’s year-end EURUSD forecast from 1.28 to 1.33, this now equates to 25.0 on RUBUSD.  The new 1.27 forecast for end-2008 implies RUBUSD at 24.4, in our view, again with no change to our basket view. 


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