United States
Review and Preview
August 07, 2007

By Ted Wieseman & David Greenlaw | New York

Treasuries posted significant gains across the curve in the latest week as the risk-reduction/flight-to-safety trade continued to roil markets.

Gains were significantly smaller than the huge rallies over the prior two weeks, however, as stocks, corporate credit and leveraged loan markets all traded better on the week through Thursday (the mortgage default swap market, on the other hand, was still collapsing), before significant weakness resumed Friday. Net losses on the week for key risk markets aside from mortgages were much more muted than the collapses of the prior week, though intraday volatility remained extreme and fears about the functioning of some markets appeared to be as bad as it’s been at the end of the week after Friday’s losses. The Treasury gains were accompanied by a major further repricing of the Fed, with the futures market now almost fully pricing in a rate cut by the October FOMC meeting and a second cut no later than the January meeting.

Interestingly, though, the market still only anticipates two rate cuts in total, just expecting them significantly earlier now. Even when credit markets and stocks were doing better through most of the week, fear still gripped investors, giving rise to a steady stream of rumors about various companies or investors being in trouble on top of the actual problems reported by some financial and mortgage firms. The speculation got so out of hand in a couple cases that the companies involved had to issue press releases specifically denying the market chatter, with homebuilder Beazer Homes denouncing “scurrilous and unfounded” rumors on Wednesday that it was on the verge of bankruptcy and mortgage finance giant Countrywide strongly denying that it was facing any general liquidity or commercial paper issuance problems on Thursday. Most economic data continued to be ignored, but a weaker-than-expected employment report Friday did actually provoke the first market response to an economic report in quite a while. Overall, the week’s economic news for early 3Q was softer, though a sharp rise in consumer confidence made clear that Main Street isn’t feeling nearly as dour as Wall Street at this point. While the downside in headline employment relative to recent trends appeared to be entirely a result of seasonal adjustment problems with the massive exodus of teachers from payrolls that occurs in July, some of the underlying details were a bit softer, notably the average workweek and unemployment rate. Both ISM surveys, while remaining comfortably in growth territory, posted good-sized pullbacks in July, and motor vehicle sales were much weaker than expected. More backward-looking data, on the other hand, were stronger, with upside in the details of the June construction spending and factory orders report pointing to an upward revision to 2Q GDP growth to +3.6% from +3.4%. We look for a moderation to about +2 1/4% in 3Q, which received some initial confirmation from the softer run of key early data for July.

Benchmark Treasury yields fell 8-9bp over the past week, with all the gains at the front end coming in a big rally Friday that was about half driven by the employment report and half by renewed flight-to-safety buying, reversing what had been a decent curve flattening move through Thursday’s close. On the week, the 2-year yield fell 9bp to 4.46%, the 3-year 8bp to 4.44%, the 5-year and 10-year 9bp each to 4.51% and 4.70%, and the long bond 8bp to 4.86%. The significant gains in the nominal market combined with a decent pullback in energy prices after oil traded to a record high mid-week contributed to continued significant underperformance by TIPS, with the benchmark 5-year inflation breakeven falling 7bp to 2.03%, a new low since the revival of the 5-year TIPS in 2004, and the 10-year breakeven falling 5bp to 2.26%, a low since mid-2005. Odds of near-term Fed rate cuts priced into futures markets were sharply raised. The August fed funds contract held at 5.225%, pricing about a 10% chance of a rate cut as early as Tuesday’s FOMC meeting. The October contract gained 3bp to 5.135%, pricing just slightly less than even odds of a rate cut by the September FOMC meeting; the November contract surged 7bp to 5.04%, just about fully pricing in a rate cut by the October meeting; and the February contract spiked 14bp to 4.795%, almost fully pricing in a second 25bp rate cut by the January meeting. While the market thus sees Fed action coming imminently, this mostly reflected a timing adjustment, as not much additional total rate-cutting is expected. The red (Sep 08 to June 09) eurodollar futures contracts posted comparatively modest 6.5-8.5bp gains, with the low rate Sep 08 contract gaining 8.5bp to 4.75%, moving in the direction of pricing a possible third cut to 4.50%, but still favoring a trough at 4.75% after the January FOMC meeting.

Key risk markets that have dominated investors’ attention the past month saw some continued extreme intraday volatility and mostly tanked Friday, but for the week as a whole were relatively more stable except for a continued collapse in the mortgage market. Still, sentiment across most markets certainly seemed to be as grim as it’s been heading into the weekend after Friday’s renewed turmoil ended the previous signs of stability. After plunging 5% the prior week, the S&P 500 ended the latest week down a more muted 1.8%. Swap spreads narrowed slightly from the multi-year highs at the end of the prior week, with the benchmark 10-year spread in 1bp to 74.75bp and the 5-year 1.75bp to 68bp.

After the prior week’s horrendous performance, credit spreads were more mixed in the latest week even after significant weakness Friday. The 5-year Hi-Vol CDX index widened 5bp on the week to 189bp and the IG index 4bp to 81bp, but the EM index tightened 25bp to 181bp and the HY index 48bp to 480bp. Tracking that relatively strong showing by high yield credit, the leveraged loan LCDX index had a very good week, rising to 93.80 (307bp) from 92.11 (370bp). The mortgage default swap market remained in turmoil, however, as one mortgage lender (American Home Mortgage) almost entirely shut down its operations after being unable to meet margin calls and another (Accredited Home Lenders) warned in a regulatory filing that it was at risk of following a number of its former competitors into bankruptcy. All the ABX indices fell significantly on the week — AAA (90.63 versus 95.61), AA (83.14 versus 90.18), A (60.43 versus 68.36), BBB (42.18 versus 44.74), BBB- (38.94 versus 39.97) — though the higher-quality indices continued the recent trend of performing relatively much worse, and the BBB- index actually rose slightly Friday amid the broader market carnage.

The key early round of economic indicators for July was mostly weaker than expected. Non-farm payrolls rose a relatively soft 92,000 in July, but all the downside relative to expectations and recent trends reflected weakness in education jobs that appeared to reflect seasonal adjustment problems, with combined government and private education payrolls down 24,000 after gains averaging 21,000 in the first half of the year. On a non-seasonally adjusted basis there is a huge drop in education jobs every July — 1.4 million this year between the private sector, state government and (mostly) local government components — as the summer break arrives, so the seasonal adjustment factor is massive and hard to get just right. Overall private sector payrolls gained 120,000, the same as the first half average, with upside in finance, healthcare and business services leading the gain, while manufacturing, construction and retail remained weak. Other details of the report were softer overall. The unemployment rate rose a tenth to 4.6%. The average workweek fell to 33.8 hours from 33.9, leading aggregate hours worked to fall 0.1%. On the positive side, average hourly earnings gained 0.3% to hold at an elevated +3.9% year-on-year pace. Although the headline payroll number was slightly disappointing and some of the underlying details a bit softer, there were other indications the past week that labor market conditions remain solid. Bucking the broader trend of mostly softer July data, the Conference Board’s measure of consumer confidence surged to its best reading in six years, with much of the upside accounted for by a substantial improvement in views of the current job market to the best net opinion since August 2001. And the weekly jobless claims report came in significantly better than expected for a fourth straight week, with the 4-week average of initial claims dropping to its lowest level since late May and continuing claims the lowest level since mid-June.

Both ISM surveys posted significant declines in July, though both remained comfortably above the 50 boom/bust line. The composite manufacturing diffusion index fell to 53.8 in July from 56.0 in June, a four-month low after the 16-month high hit last month. The drop was concentrated in a significant pullback in the production index (55.6 versus 62.9), a surprising result given the strong advance in motor vehicle assemblies industry sources reported for the month. The orders (57.5 versus 60.3) and employment (50.2 versus 51.1) gauges posted smaller pullbacks. The prices paid index dipped two points to 65.0, extending the gradual moderation from the recent peak of 73.0 hit in April. Some metals and food products were reported up in price this month, while, in a shift, a couple of energy inputs — gasoline and natural gas — were reported lower in price. Meanwhile, the headline business activity index in the non-manufacturing survey dropped to a four-month low of 55.8 in July from the 14-month high of 60.7 hit in June. Note that this headline index, unlike the manufacturing version, is not a weighted average of key activity measures but a separate question considered most comparable to the manufacturing survey’s production measure.

Finally, rounding out the softer July results, motor vehicle sales were much worse than expected, falling to an estimated 15.2 million unit annual rate (note that BEA released revised seasonal factors on Thursday that reduced this number a couple of tenths from initial estimates based on the old seasonals), from 15.6 million in June. This was the worst month since October 2005 and second worst since 1998. While this outcome will clearly hurt July consumer spending results, to what extent it will have a negative impact on overall 3Q growth remains unclear at this point, as GM reaffirmed its 3Q production plans and Ford did not announce any changes. It appears that the major producers are moving towards significantly stepping up incentives to try to get sales back on track in coming months.

While 3Q activity seems to have gotten off to a softer start — in line with our expectations for a moderation in GDP growth to +2.25% — growth in 2Q appears to have been a bit better than BEA’s +3.4% advance estimate.

Overall construction spending dipped 0.3% in June, significantly worse than we were expecting but a good bit better than the very pessimistic assumptions BEA made in preparing the advance estimate of 2Q GDP growth.

Overall residential spending fell 0.7%, with the key single-family and multi-family new homebuilding components combining for a 1.1% drop. This was worse than we expected after the surprising 2.3% gain in June housing starts. Still, over the past four months, drops in homebuilding spending have averaged 1.2% after monthly drops averaging 2.4% over the prior year. This slowed pace of decline has exacerbated the inventory imbalance in the housing market, and we expect the downturn to significantly re-intensify going forward, contributing to the expected moderation in 3Q growth. Non-residential spending ticked up 0.3% in June, though this followed an annualized spike of 30% over the prior four months, while government spending was unchanged, flattening out after a 2.3% surge in May. BEA was quite pessimistic in its construction assumptions in preparing the advance GDP report. Non-residential spending in particular was much stronger than it assumed, and government spending also surprised to the upside, with a partial offset from softer residential activity. Meanwhile, though overall factory orders rose a less-than-expected 0.6% in June on some softness in non-durables, key underlying details of the report were better, with non-defense capital goods ex aircraft shipments revised up to -0.1% from -0.4% in June, pointing to better capital spending in 2Q, while overall May factory inventories were revised up to +0.4% from +0.3% and June came in as expected at +0.3%. Combining the positive impacts of the better construction spending, capital goods shipments and factory inventory numbers, we see 2Q GDP growth on track for an upward adjustment to +3.6% from +3.4%.

Aside from what will clearly be continued intense focus on developments in the risk-repricing trade, the main investor attention in the coming week will mostly be on Tuesday’s FOMC meeting. While we expect that policymakers will acknowledge the tightening in financial conditions driven by the repricing of risk spreads and tightening of lending standards and suggest that these developments have incrementally increased medium-term growth risks, we don’t expect significant changes in the key risk assessment section of the statement. With the market already pricing in a high probability of a near-term Fed rate cut that FOMC members probably consider unlikely at this point, we doubt that the Fed wants to inflame further what it likely considers to be already overdone market expectations by striking a meaningfully more dovish tone in its statement. So, we expect that upside risks to inflation will continue to be cited as the main risk to the economic outlook. St. Louis Fed President Poole, who has been the only Fed official publicly responding in a significant way to the recent market turmoil as Chairman Bernanke remains conspicuously quiet, laid out clearly in a speech the past week how the FOMC is viewing these developments and what it would take to prompt the response the market now expects. He emphasized that the Fed should allow markets to set prices without interference unless there is evidence that market developments have significantly altered the growth and inflation outlook. He described recent events as a “typical market upset”, most of which “stabilize on their own, but some do not”. Unless the recent market problems “change the probable course of economic growth and inflation, then the fed funds futures market will reverse course and the expected policy easing will disappear”. On the other hand, “if evidence accumulates that the inflation picture remains benign but the outlook for the economy next year appears likely to be significantly weaker than the current best guess, then the market will deepen its conviction that the Fed will be cutting its fed funds target”. In Poole’s view, the “Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment, or when financial market developments threaten market processes themselves. The Fed should not try to substitute its judgments for the market’s judgment on appropriate security prices”.

There’s a light data calendar in the coming week, with nothing that seems likely to attract much interest from investors. The Treasury refunding auctions will take place Wednesday with US$13 billion in 10s and Thursday with US$9 billion in 30s. With only US$22 billion in new issues against US$63 billion in maturities plus a US$20 billion interest payment, a ton of money will be flowing to the market from the Treasury when the refunding settles on August 15 (though a good part of this will likely be soaked up by a big expected 1-day cash management bill we estimate will be needed to bridge the gap between this huge outflow on the 15th and the settlement of the weekly bills on the 16th). As for data, the wholesale trade report on Wednesday will continue to fill in missing data the BEA had to make assumptions for in preparing the advance 2Q GDP report, and monthly sales reports from most retail companies on Thursday will help set expectations for the retail sales report in the subsequent week (our preliminary forecast is -0.4% overall and +0.2% ex autos). Other releases due out include productivity Tuesday and the Treasury budget Friday:

* The GDP data pointed to a solid 2.4% gain in 2Q productivity following several quarters of more subdued growth. Indeed, the previously reported 1% gain in productivity over the four quarters ending in 1Q07 is expected to be revised all the way down to +0.5%. Meanwhile, unit labor costs appear to have posted only a modest 1.4% rise in 2Q, but upward revisions to prior quarters should be quite sizable. Indeed, as a result of the somewhat slower productivity gains, combined with sharper growth in compensation, the rise in unit labor costs over the four quarters ending in 1Q07 is expected to be pushed up by 1.5 percentage points — from +2.2% to +3.7%.

* We estimate that the federal government ran a US$36 billion budget deficit in July, US$3 billion wider than in the same month a year ago.

However, this largely reflects some minor timing quirks, and we still appear to be on track for about a US$165 billion deficit for the fiscal year as a whole — down from US$248 billion last year.

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United States
Not Ready For Neutral
August 07, 2007

By Richard Berner & David Greenlaw | New York

Key Points

		2006E	2007E	2008E
Real GDP		2.9%	1.9%	2.6%
Inflation (CPI)		3.2	2.8	2.6
Unit Labor Costs		2.9	3.8	2.4
After-Tax “Economic” Profits		12.2	3.0	7.5
After-Tax “Book” Profits		13.9	2.8	3.0

Source: Morgan Stanley Research    E = Morgan Stanley Research Estimates

The balance of risks in the US economic outlook is shifting: Upside risks to inflation have ebbed and downside risks to growth have increased.  But at their policy meeting this week, the Fed is unlikely to shift to neutral, much less to ease.  While incoming data have been soft, we believe that officials will need further evidence that inflation risks are tame and economic headwinds are strengthening to tip the balance for change.  The Fed’s statement following their meeting this week likely will acknowledge some of these risks, but is unlikely to move away from inflation as the Fed’s predominant concern. 

Certainly, market turmoil and tighter lending standards are playing an important role in changing the balance of risks in the outlook.  But the Fed appears to think that these developments, while painful, still amount to a repricing of risk and a more appropriate credit-granting process, rather than a credit crunch, and it is thus premature to make a shift. 

Based on the evidence so far, we agree.  In our view, the signposts for comparison with past credit events — as in 1998, 2001 or 2002 — indicate that the current situation is quite different from those periods.  For example, in the week leading up to the Fed cutting rates in September 1998, the 30-day A1/A2 commercial paper (CP) yield spread widened by 21 bp (from 23 bp to 44 bp).  Following the terrorist attack of 9/11, this spread widened by 33 bp (from 19 bp to 52 bp).   But in the week ended this past Thursday, the A1/P2 spread had moved by just 3 bp (from 10 bp to 13 bp).  This may understate pressure in the market, as overnight CP spreads widened by 7 bp in the past week.  Still, after 9/11, overnight rates on AA rated asset-backed CP went up by 50-75 bp.  According to Fed data, the rate on both 30-day and overnight AA asset backed paper rose by only 2-5 bp last week. 

Market participants and the Fed will monitor several other indicators that could signal a drying up of liquidity, changes in term premiums or the ability to roll out the curve in money markets, or financing access and market stress.  So far, none has signaled more than mild strain.  Among them: Spreads in the market for repurchase agreements (repos); spreads on collateralized vs. uncollateralized lending in money markets; the Treasury-Eurodollar (TED) spread; bid/offer spreads in Treasuries; the number of specials or fails in the repo market; pressure in overnight repo or fed funds markets suggesting hoarding of collateral or cash by broker/dealers or banks; junior/ senior subordinated debt spreads, and the spread between overnight funding and term funding rates. 

Two other factors suggest that it is too soon for a shift.  A Fed shift to neutral would likely ease market pain and refresh risky asset markets as investors reprice the future path for monetary policy.  But markets already discount a significantly easier future path, and officials might be reluctant to inflame expectations for more.  More fundamentally, policy action will depend on evidence that the risks continue to tip away from higher inflation and towards weaker growth.  While the main risk to our view is that monetary policy will ease sooner than our current baseline reflects, the evidence for doing so is absent for the time being.

There are three key uncertainties facing the Fed: How much have financial conditions tightened and do they threaten growth?  Do fundamentals and incoming inflation data hint at a further deceleration?  And are recently softer economic data the start of a slide toward something more dire?

The evidence for tighter financial conditions is everywhere on Wall Street and increasingly so on Main Street, but in our judgment not by enough seriously to threaten growth.  Buyout bond deals planned in an era of easy credit have been pulled, lenders are turning cautious, and spreads have widened dramatically.  According to press reports, 46 leveraged financing deals globally representing about $60 billion in M&A funding have been pulled from the bond market since June 22, and dealers hold a much larger total of uncompleted deals.  While there is little hard evidence of lender restraint, the Fed will have the results of the latest Senior Loan Officer Survey at their meeting this week; that canvass should show a further significant tightening in mortgage lender standards and the first signs of tighter standards for corporate loans.  Risk spreads, of course, have doubled in many cases, and already evince the repricing of risk and tiering reflecting credit quality that Fed officials consider desirable.  But this pricing could also reflect disruptions and dislocations in markets.  And there’s no question in our mind that whatever the current state of play, a further tightening of financial conditions is likely.

Meanwhile, core inflation peaked last year in our view; the key issue has been whether it would stay tame.  So far, it has continued to move lower; measured by the personal consumption price index, at 1.9% in June, it was within the Fed’s presumed 1-2% comfort zone.  Yet the Fed and we thought several factors could push inflation higher again.  Labor markets have been tight, and operating rates are still high.  A looser and less-certain relationship between slack and inflation than in the past implies that inflation will decline only slowly.  Moreover, higher energy, food and import prices, a potential surge in protectionism, and slowing productivity growth each pose upside risks to our baseline inflation view.  Measured by the University of Michigan’s canvass, 5-10 year inflation expectations ticked up to 3.1% in July.  The acceleration in non-auto consumer import prices to a 1.5% rate in July (although down from 1.9% in April, up from negative territory in 2006)has just started to show up in consumer inflation gauges, and more is coming, especially if the dollar weakens further.

The good news for the Fed is that some of those factors are fading.  Labor markets are beginning to evince more slack, with the unemployment rate edging up to 4.6% in July, and operating rates are unlikely to rise significantly.  Compensation and wage growth by any measures have flattened.  As a result, our own forecasts for core PCEPI inflation have moved slightly lower over the past month, to 1.8% in 2008.  It’s worth noting that we are a bit more optimistic about trend productivity growth than is the Fed, based on forecasts for growth and employment; such higher productivity growth would help dampen inflation. 

Concurrently, the combination of tighter financial conditions, soft incoming data, and somewhat higher energy prices has prompted us to scale back our forecasts for second-half 2007 real GDP growth by 0.1% to 2.3%, and by a more-significant 0.4% in 2008 to 2.7%.  The coming further tightening in financial conditions, and the fact that they influence the economy with a lag, imply that their maximum impact will occur next year.  

But there’s no mistaking the soft tone to incoming data.  Consumer spending, durable goods bookings and home sales softened appreciably in June.  Nonfarm payrolls rose a relatively soft 92,000 in July, although seasonal quirks likely promoted a decline in public-sector education employment.  Private payrolls gained 120,000, in line with the 2007 first half average.  But a dip in the average workweek produced a decline in hours worked of 0.1%.  Both ISM surveys posted significant declines in July, though both remained comfortably above the 50 boom/bust line.  Finally, motor vehicle sales fell to an estimated 15.2 million unit annual rate from an already-soft 15.6 million in June.  We assume that Detroit will have to put more money on the hood to ramp up sales in order to maintain current production plans.  On the positive side, wage income still appears solid, consumer confidence is holding up, and weekly jobless claims have fallen to a three-month low.

In our view, there’s no smoking gun in the data compelling an immediate reappraisal of the Fed’s outlook and thus a shift in the policy stance.  Rather, the case for a shift lies in risk management.  Here’s the essence: The risk for the Fed of making a mistake by shifting to neutral now seems small.  Even if growth rebounds and financial conditions stabilize, inflation now seems less likely to rise than a couple months ago.  In contrast, if officials stand pat now and growth weakens further, the Fed could find itself behind the curve and might have to scramble to head off a downward slide.  A shift to neutral would give the Fed the flexibility it needs to respond to coming developments, just as the Fed used the pause in monetary policy a year ago to take stock and decide they had done enough.  While those arguments are sensible, in our view they aren’t decisive.

Beyond the fundamentals, moreover, the Fed does not want to alter policy simply to soothe troubled markets or bail out investors who made bad bets, although some suspect that Ben Bernanke will follow Alan Greenspan’s example.  The upshot is that the downside risks to the economy of sticking to an inflation bias seem small — smaller than the moral hazard resulting from a perceived market bailout.

Against this backdrop, the Fed may make three changes to its post-meeting statement.  First, they may soften their description of inflation risks.  They could drop the adjective modestly from the statement that “Readings on core inflation have improved modestly in recent months.”  They could describe the outlook by replacing “a sustained moderation in inflation pressures has yet to be convincingly demonstrated” with January’s “some inflation risks remain.”  The second change would acknowledge that market turmoil and tighter lending standards have tightened somewhat financial conditions, but we think officials will affirm their forecast of moderate growth.  Finally, if the Fed softens their description of inflation risks, they will have to soften their inflation bias in the policy paragraph, while still indicating that their predominant concern remains that inflation will fail to moderate as expected. 

Even if it is less hawkish than before, a wary Fed stance will likely translate into additional caution among lenders and risk managers, lower-quality risk spreads will widen, and risky assets will come under further pressure.  Market participants will continue to have difficulty distinguishing a bumpy repricing of risk from a credit crunch. 

Risks for investors and the Fed may continue to escalate.  The call for the Fed is close and tough.  If we are wrong and officials do shift their language, markets would instantly discount additional and faster easing.  And at least for a while the yield curve would likely steepen significantly further, the dollar would weaken, the worst-quality risk spreads might stabilize and riskier assets rally.  Conversely, if the Fed and we are too optimistic about the outlook and the economy weakens considerably further, risk spreads would widen and tier significantly.

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Turkey
The Case for Gradualism
August 07, 2007

By Serhan Cevik | Istanbul

Consumer price inflation declined to 6.9% in July — the lowest reading in the last four decades. The consumer price index posted a 0.7% drop last month, significantly lower than our and consensus estimates. As a result, the annual inflation rate declined from 10.9% at the end of the first quarter and 8.6% in June to 6.9% last month. This is in fact the lowest reading in the past four decades and confirms the steady correction in inflation after the global volatility shock weakened the lira and pushed consumer price inflation to 11.7% last summer. Furthermore, the quality of disinflation has also improved beyond base effects and the lira’s strength, as non-tradable price inflation eased from 12.2% at the end of last year to 10.2% in July. In our view, this gradual breakdown of inertia is an encouraging development that has already helped to lower the annualized inflation rate over three months from 12.8% in April to 6.1% in June and 2.4% last month. Therefore, we expect consumer price inflation to be 6.2% (or possibly lower) at the end of this year and then reach below the 4% mark in the second quarter of next year. However, despite the secular nature of disinflation, there is still a good case for avoiding aggressive monetary easing at this stage.

Exogenous risks like the volatility in energy and food prices threaten the disinflation trend. Higher energy quotes have already slowed the pace of disinflation in the last couple of years, even though the lira’s appreciation limits the fallout on domestic fuel prices. Consequently, the Turkish economy remains exposed to the risk of a further increase in energy prices. Likewise, the extreme volatility in (unprocessed) food prices presents a significant challenge. For example, after surging from 12.9% at the end of last year to 20.7% in January, the year-on-year rate of increase in unprocessed food prices declined to 16% in March and 8.9% last month. Unfortunately, we are skeptical about the sustainability of this correction, as climatic anomalies and increasing global demand for soft commodities push food prices higher all around the world (see Heat Wave, June 20, 2007). In addition to exogenous risks that remain a source of inflation volatility, base effects will become less favorable in the coming months, especially with regards to price adjustments before and during the month of Ramadan.

It would be unfair to dismiss the latest inflation data as seasonal quirk. The drop in food and clothing prices made a significant contribution to the July reading, but the extent of disinflation reached beyond seasonal adjustments, in our view. Take, for example, the CPI excluding seasonal products, which recorded a year-on-year increase of 7% in July, down from 8.5% in June and 10% at the end of last year. Likewise, inflation excluding unprocessed food prices eased from 9.2% in December to 6.6% last month. More importantly, the widely watched ‘core’ inflation measure improved from an annual rate of 8.9% at the end of last year to 7.6% in July. This is of course still inconsistent with the central bank’s target, but there is an emerging trend shift in the latest figures that points to steady disinflation over the medium term.

Underlying economic fundamentals support the secular disinflation trend. In a country suffering high and volatile inflation for decades, it is not surprising to find inertia in price-setting behavior. Unfortunately, occasional bursts of financial volatility have also worsened the degree of price stickiness and thereby resulted in a disconnection between inflation and the correction in consumer demand over the past year. However, there are now encouraging signs of change. For example, durable goods prices (excluding gold) recorded a year-on-year drop of 2.2% in July, down from 3.1% in January and 5.7% last summer. Even non-tradable prices are showing a gradual improvement, with the annual inflation rate easing from 12.2% at the end of last year to 10.2% last month. In our view, tighter monetary conditions that helped to rebalance the composition of growth are the key to Turkey’s improving disinflation prospects. Despite the inertia in certain sectors, the moderation of consumer demand — from an annual growth rate of 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 — is bringing inflation dynamics in line with underlying economic realities (see What Marx Knew about Inflation, July 30, 2007).

The future state of the economy calls for gradual normalization of interest rates. The latest economic indicators and inflation data may justify an immediate reduction in short-term interest rates, but we argue that the central bank needs to focus on the future state of the economy. While the high degree of slack in the labor market and productivity gains limit inflation pressures, the Turkish economy is now operating with a limited output gap that cannot accommodate the accumulated energy in domestic demand. In our view, consumer spending will show a robust recovery in the coming months, as risk aversion recedes and credit growth accelerates. That means the pace of disinflation will be slower in the remainder of the year, compared to the correction in the past couple of months. Therefore, we expect the Central Bank of Turkey to remain on hold until October and then adopt a measured easing mode. It looks possible to start with a 50bp reduction in October and keep lowering short-term interest rates in a gradual, data-dependent fashion that would also allow better management of liquidity conditions.

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Euroland
Don’t Bet on a Trichet Put
August 07, 2007

By Eric Chaney | London

The consequences of the US housing market correction on Europe cannot be ignored anymore.  The sub-prime housing loans crisis has spilled over into most European asset classes: equities, swap spreads, corporate bonds including investment grade, and even ‘peripheral’ government bonds.  In the latter, usually highly liquid markets, liquidity appeared quite poor these last few days.  The ripple effect of US events is also hitting European financial institutions.  Not only are several European hedge funds exposed to the US sub-prime market in trouble, but also some commercial banks.  While some market participants, including institutions, may suffer badly from the current turbulence, it does not follow automatically that there will be a significant macro impact on European economies.  I see three main transmission channels: liquidity; credit standards for loans to households and companies and exchange rates.  I will not elaborate on the latter, since recent spread volatility has had little consequences on the main exchange rates: the effective exchange rate of the euro has even eased (-0.8%) since mid-July.

This is not (yet?) a liquidity crisis

The liquidity issues that have appeared recently are not early signs of a liquidity crisis, in my view.  Rather, they show that, in the context of high volatility and conflicting news, investors are not convinced that prices have corrected enough.  A liquidity crisis would happen only if a chain reaction was ignited by the default of a large financial institution.  In this regard, that a large Chicago-based hedge fund bailed out a smaller one, that a large European fund manager did the same with some European funds exposed to the sub-prime market and that financial institutions such as KfW immediately bailed out subsidiaries in trouble is good news: the financial system is strong enough to cope with sub-prime fallouts on its own.

Credit conditions are tightening

The euro area bank lending survey released by the ECB on August 3 paradoxically indicated that commercial banks had recently “eased credit standards for loans to enterprises”.  However, the cut date was July 10 and things have probably rapidly changed since then.  Some large European commercial banks have already announced that they had or intended to increase provisions for bad debts.  Although this does not imply a tightening of credit standards per se, banks would not behave consistently if they didn’t raise the hurdle when approving a loan or a credit line. 

Mind non-linearity and sector heterogeneity

If, as I think, European banks tighten credit standards going forward, this would be a good illustration of the non-linear nature of the monetary policy transmission mechanism.  The ECB started normalising monetary conditions in late 2005 but so far only the currency and some property markets (Spain for instance) have reacted to rising interest rates.  The shockwave coming from the US and the re-pricing of risks on European assets are now suddenly extending the transmission to other economic agents.  In the real economy, credit-sensitive sectors such as housing and consumer credit should be increasingly hit.  Interestingly, the ECB’s senior loan officer survey is showing that banks do anticipate a sharp deceleration in housing loans and consumer credit.  Regarding corporate investment (capex), the case is less clear-cut.  Companies are cash-rich and profits are at a cyclical peak.  Although capex is usually highly sensitive to interest rates and credit conditions, expected demand is probably more important than credit spreads in current circumstances.  As Richard Berner has argued for the US economy, capex could paradoxically benefit from the rise in risk aversion from lenders and investors, inasmuch as companies’ investment projects are less risky than LBOs and other private equity operations.

Listen to the ECB, but do not bet on a Trichet put

Since the end of 2005, ECB officials warned that risks were not correctly priced across asset classes.  No wonder then that President Jean-Claude Trichet and other ECB officials have expressed some satisfaction about the re-pricing of risks.  However, President Trichet made clear at the press briefing that unexpectedly followed Thursday’s Governing Council teleconference that the ECB is watching liquidity fluctuations very closely.  Even though fundamentals such as corporate default rates are sound, one of the bank’s missions is to guarantee a smooth functioning of money markets and access to liquidity for credit institutions. Since we do not really know what could be the consequences of a large-scale financial accident in Europe, the ECB is certainly on alert.  Yet, being on alert does not mean being pushed into action, all the more so considering that, provided that systemic risks do not materialise, the current circumstances in the markets are providing a unique opportunity for the ECB President to demonstrate that his job is not to bail out reckless investment strategies that have turned into heavy losses; in other words, there will not be nothing like a Greenspan put in Europe.

In conclusion, as long as the real economy indicators do not show a sudden loss in business confidence and monetary data (corporate spreads, new credit to non-financial institutions, M3, etc.) do not point to a risk of credit crunch, we will remain close to our baseline scenario for the real economy, i.e., an ‘orderly slowdown’, itself the consequence of previous monetary and fiscal tightening.  Since President Trichet used the coded word “strong vigilance” at the press briefing, meaning that the refi rate should go to 4.25% in September, it seems that the ECB came to the conclusion that, in the short term, the orderly slowdown scenario was the most likely.  However, because of the non-linear side of credit tightening, I suspect that the ECB may want to take the time to monitor the consequences on the real economy of its past actions before going for another rate hike.  This is probably why Jean-Claude Trichet, while insisting on the perils of inflation, avoided qualifying the current monetary policy stance.

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Taiwan
Upside Risks to Interest Rate
August 07, 2007

By Sharon Lam | Hong Kong

CPI fell in July, on food prices again: Consumer inflation fell in July, again because of lower food prices.  CPI growth fell 0.3% YoY, as prices of fruit and vegetables tumbled amid a good harvest in unusually warm weather.  The other volatile component, fuel, also climbed in line with higher international oil prices, but the growth is not outrageous, as the base is already high.

But highest core inflation since 2004:  Core inflation actually increased 1.1% YoY, the highest since mid-2004 (excluding the Lunar New Year-affected January/February).  Meanwhile, wholesale price and import price growth decelerated in July, but remained solid.  Inflationary pressure does exist.  In fact, we believe that even headline inflation will be on an upward trend in the coming months, as oil prices are breaking record highs and anecdotal evidence points to rising food prices.  Warm weather only advances the harvest, putting upside pressure on agricultural prices later.

Indeed, we see upside risks to the interest rate outlook:  We believe that this is positive for the Taiwanese economy, by normalizing the interest rate level, which should help ease pressure on capital outflows seeking higher yields and discourage formation of NT$-funded carry trades that could only bring volatility to the economy.  Meanwhile, raising rates should not hurt the economy, as the current rate is still below neutral, in our view, while sluggish loan growth stems from confidence issues, not interest rate levels.  In fact, we believe that higher rates and gradual NT$ appreciation can help raise confidence in NT$-denominated investment.  Currencies of other countries in the region have been appreciating sharply, so we believe that it will be a long time before NT$ appreciation hurts Taiwan’s export competitiveness.  However, external uncertainty may hamper rate hikes.  Therefore, we believe that the central bank may want to push forward rate hikes before uncertainty rises further.   We should watch for either greater-than-expected rate hikes (25bp) in the central bank’s September meeting or, in the extreme, a hike between the quarterly meetings.

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