After the Shock: Risks for the Global Economy and Markets
August 20, 2007
By The Global Economics Team
The Fed’s aggressive action to restore market liquidity will avert a financial crisis, but investors still must focus on threats to global growth and their implications for risky assets. The Fed’s massive provision of liquidity, a 50bps cut in the discount rate and allowance of term financing at the discount window have alleviated intense strain in money and credit markets. Additional steps — possibly unconventional ones — may be needed to achieve the first objective, but there is no mistaking the Fed’s and the community of central bankers’ resolve to respond in size (see “Unconventional Policy Options: Footnotes in the Fed’s Playbook”, Global Economic Forum, August 17, 2007 for a menu of unconventional options).
Despite these Fed actions, however, tighter financial conditions do imply downside risks to both US and global growth for now, and our global economics team here offers a rough calibration of them. More importantly, as we see it, we assess the nature of those risks and focus on their investment implications. Global recession not likely Our assessment of an ‘alternative’ — not a ‘bear-case’ alternative — suggests slower growth but hardly a recession. In this alternative scenario, we assume a 3-6-month period of significantly reduced liquidity and market access, together with a further 5-10% slide in developed-market equity prices, and a 10-20% drop in emerging markets. In this case, the hit to global growth would amount to roughly 0.5-0.75 percentage points and the outcome might trim global inflation by about 0.5%. The shock of tighter financial conditions likely would mainly affect US housing, the broader US economy and those levered to it. But a severe US and therefore a global downturn are still unlikely. As we detail below, in our view, the US consumer will skirt retrenchment thanks to strong global growth and its benefits for US job and income gains. But four other critical issues affect our assessment of global economic risks: First, this shock is economic decoupling’s first real test. We think that growth is more sustainable in Europe, Asia and Latin America than at any time in the past two decades. But those economies are not impervious to a US downturn, especially if consumer spending weakened. Indeed, globalisation has knitted economies closer and spillover from additional US weakness would affect those regions, and possibly feed back to US demand. Second, and related, commodities are levered to global growth. So, while the longer-tem supply-demand balance in commodity markets will remain favourable, in our view, any growth shortfall creates downside risks to commodity prices, including oil, for now. We guess that oil prices could average US$5-8/bbl lower in this alternative scenario than in our current baseline scenario. The distributional effects of lower oil and commodity prices for growth matter: Lower commodity prices would cushion growth shortfalls among commodity users, but spread those shortfalls to commodity producers. An OPEC response to rein in production, possibly triggered by a weaker dollar that reduces producers’ purchasing power, would obviously produce a higher path for crude prices (see “Strong Euro: A Shield from Higher Oil Price?” and “The Oil-Dollar Link: US Implications”, Global Economic Forum, July 16 and 23, 2007). Third, this shock is disinflationary for three reasons. First, if oil and commodity prices recede, headline inflation and any pass-through to overall inflation will ebb. In addition, we think that the financial shock itself is disinflationary, because it will make buyers hesitate and sellers worry that price hikes won’t stick. In fact, both market- and survey-based indications of inflation expectations have ebbed recently. Last, weaker growth will increase economic slack and thus crimp pricing power. As a result, with the level of inflation low, central banks likely will find latitude to respond to growth threats. Following their actions this week, the Fed will clearly be the first to ease, but others — like the Bank of Japan — may delay tightening now. Finally, while markets may decouple to reflect economic divergence, the recent price action is a reminder that markets are linked, and that financial globalisation transmits financial shocks quickly. The dispersion of risk resulting from financial innovation across financial markets and institutions is a double-edged sword: It diffuses credit risks across markets and may tend to reduce risk concentration by putting such risks in the hands of those who want and are better equipped to hold them. But the structure in structured subprime and other forms of credit makes it appear that such securities carry less risk than the underlying collateral, encouraging investors to increase leverage. That leverage provided the kindling for a liquidity crisis; deteriorating credit quality and a forced re-intermediation of credit to banks lit the match. Risks to growth: US-centric? The US outlook is clearly central to our assessment of risks to growth. Tighter financial conditions will likely deepen and prolong the housing downturn, by more even than our already-gloomy view of housing activity. In turn, such a sharper pullback will trigger additional weakness in construction and related employment and in home prices, challenging the resilient consumer. However, it’s worth stressing that we still rely on relatively vigorous non-US growth to be a cushion for a deeper housing recession and weaker consumer spending. The net of these could trim annualised real growth from 2.6% over the next five quarters by 0.5-1 percentage points (to about 2%, and year on year to 1.75% this year and 2% next year). We view these developments as disinflationary; in this scenario, inflation could fall next year by roughly a quarter of a point from our baseline to rates well within the Fed’s comfort zone (we have it edging lower over 2008 to 1.8%). Earnings growth would fall in both years to 0-3%. In this scenario, we would expect the Fed to continue to act to restore market liquidity through either conventional or other means, and formally to begin a gradual easing of monetary policy at the September FOMC meeting. It’s important to note that today, unlike in 1987 or even in 1998, when inflation was considerably higher, the Fed has ample latitude to focus on the downside risks to growth. Consequently, that ease might cumulate to 125bps by mid-2008 (75bps more than we envisioned in our baseline) if the growth shortfall amounted to half a point, or 200bps (150bps more than in the baseline) in the worst-case scenario. Regional spillovers Europe and the UK Elga Bartsch thinks that the threat of a credit crunch will likely be the main factor dampening growth in the euro zone economy. Two unknown factors will determine the impact: The size and distribution of European lenders’ losses, and their re-assessment of the credit risks associated with lending to euro area companies and consumers. Spillovers from market turbulence (and the uncertainty it creates for business sentiment and consumer confidence) and rising concern about US growth could dent investment spending. Resilient export and consumer demand would cushion the blow. Growth may slip below trend, primarily in 2008, and below our current baseline by 0.5-1.0 percentage points. Despite current inflationary pressures, which will likely push inflation above 2.5% by the end of this year, a more benign medium-to-longer-term outlook for inflation would keep the ECB on hold for now, and the ECB would lower the refi rate later this year or early next year. Government bond yields would likely benefit from a further flight to quality and should ease back towards 4% by year-end, possibly even below that level, in an environment of a bullish curve steepening. In the UK, David Miles believes that a further stock market sell-off (of another 10%) and a persistent tightening of credit conditions might bring consumption growth to zero for the next year or more. Assuming a halving of growth of exports and of investment, real growth likely would slip below 1% in 2008, implying two years of significantly sub-trend growth. Unemployment would be rising markedly, and household credit quality would slip sharply. Thus, inflation would likely sit consistently under the 2% level for 2008 and into 2009. In that environment, there would be rate cuts by the Bank of England, likely taking rates under 5% next year. This is not a central forecast; it is a scenario, and it remains more likely that much of the recent market turbulence recedes without substantial, persistent effects on the wider economy. Yet the downside risks to growth are clearly large and bigger than they seemed a month ago. And those risks come against a backdrop of an economy that we had anyway expected to slow. Japanand Asia For Japan, Takehiro Sato and Robert Feldman think that the main downside risks from continued market turmoil come from the impact of on capex, on foreign demand, and on consumption through wealth effects, with offsets from commodity price declines and lower bond yields. A higher cost of capital and fear about global demand will likely depress capex by about 100bps in 2008. A 50bps drop in US growth might shave about 0.2-0.3 percentage points from Japanese growth through exports, with the impact stronger this year than next. The stronger yen might depress wealth and thus spending, given Japanese investors’ holdings of foreign-currency denominated assets; that could curb GDP growth by 0.1-0.2%. Deflation might again be a risk, taking rate hikes off the Bank of Japan’s agenda. But rate cuts are equally unlikely; direct funding or government support for any financial instability is more likely than rate cuts. Gerard Minack expects that tighter credit and softer commodity prices would trim Australia’s real growth by about 0.6% in 2008. Inflation downside would be partly limited by the prospect of a sharply lower A$, with a resultant lift in import prices. He would expect a RBA response, in part to offset a prospective market-driven tightening in credit standards. The Australian equity market would fare poorly, given its heavy weight in two of the most at-risk sectors: financials and resources. Not surprisingly, Qing Wang expects the impact on China to come mainly through global growth and trade. He estimates that exports now account for over 40% of GDP, so the Chinese economy is vulnerable to a substantial weakening in external demand. The fallout would depend on the impact on other regions, however; a slowdown concentrated in the US will limit the impact, because the EU and Japan are now important export destinations. He estimates that 2008 GDP growth could slow to 9.5% from 11.0% in 2007, or 1.3 points lower than our baseline forecast. China’s relatively favorable fiscal outlook implies that authorities could offset a substantial weakening in China’s external demand through expansionary fiscal policy. Likewise, Sharon Lam thinks that the direct impact from a US slowdown on Korea’s economy is diminishing since the US is now its third-largest export market. She estimates that a 10% decline in export to US will cut Korea’s GDP by 0.4%. Of course, China (and Hong Kong) accounts for one quarter of Korea’s exports, so as China goes, so goes Korea. The decline in equity prices and soft exports would cut capex growth, but construction activity is picking up and the government could boost it further. Steady inflation and risks to growth would keep the Bank of Korea on hold. Taiwan is more exposed to a US slowdown, but domestic demand might get a boost from capital flows returning home and lower inflation resulting from a stronger TWD. Chetan Ahya believes that India’s growth acceleration in the past 3-4 years has benefited more from the globalisation of capital markets than from the globalisation of trade. Its balance of payments surplus (a key source of liquidity supply) has been driven by capital inflows. While the Rest of Non-Japan Asia (ROAXJ) has a current account surplus, India runs a current account deficit, the result of consumption and capex being leveraged to such inflows. As a result, India is more exposed than other emerging countries to a potential sharp reversal in global risk appetite. And if the current global risk aversion trend continues for more than three months, he believes that India could face a deceleration in growth of 0.4%. In the ASEAN countries, Chetan thinks that the tightening of liquidity conditions could be transmitted to the real economy through the reduction of risk capital and trade linkages from spillover onto global real economies. The impact of reduced capital flows would be most severe for Indonesia then the Philippines and least severe for Singapore then Malaysia. In contrast, the trade impact would be most severe for Singapore then Malaysia and least severe for Indonesia then the Philippines. Latin America Marcelo Carvalho does not think that the declines in local equity and credit markets will derail Brazil’s expansion. The local stock market is small as a share of the economy, leverage has declined to low levels, and interest rates will still decline. Instead, a weaker currency, lower commodity prices and softer global growth are the key threats to Brazil’s economy. Risk aversion would hurt capital inflows and the currency. A weaker currency might boost inflation to the 4-5% range, stall interest rate declines, and slow domestic growth. The negative scenario might trim 1% or a bit more from 2008 growth. For similar reasons, Gray Newman and Daniel Volberg don’t see tighter global financial conditions as a major threat to other economies in Latin America. Equity markets are small compared with GDP, and local leverage is low. Even in Chile, where leverage is higher, a fiscal surplus of 6% of GDP combined with a public sector that is already a net creditor limits the downside. In contrast, falling commodity prices would be a significant threat, hitting exports and income. LatAm currencies might weaken with the reversal in the terms of trade. In turn, that would erode the virtuous circle of lower inflation and interest rates. On balance, these factors would depress GDP by 0.2-1% in 2008. Central and Eastern Europe and South Africa Pasquale Diana believes that weaker Eurozone demand growth would hurt Central European exporters; Poland is least exposed and Hungary, where domestic demand is weaker, most exposed. Strong, sustained domestic demand dynamics have emerged in countries like Poland and the Czech Republic, which should help them sustain decent growth even in the presence of a euro area downturn. Central banks will be constrained to the extent that those factors weaken their currencies. Oliver Weeks thinks that Eastern Europe is relatively well protected by strong domestic demand growth and healthy government balance sheets, but tighter external financial conditions and further declines in commodity prices would hit growth and investment. While Russia today has a fiscal surplus of 7.5% of GDP and FX reserves of US$420 billion, declines in oil prices and external growth could trim 2-3% from 2008 GDP growth and put slight depreciation pressure on the currency. In South Africa, Michael Kafe and Andrea Masia note that growth has been predominantly consumption-led, although government spending, investment and net exports are playing an increasing role in the face of the 2010 World Cup and tabled government expenditure plans coming to the fore. Thus, while a US slowdown would undoubtedly affect the SA growth dynamic, the impact would be fairly limited, and occur only with a lag. However, a slowdown in the US would imply a pullback in the global pool of funds that are available for investment into South Africa, and so any weakening there would surely have an impact on the rand. Market implications Against this backdrop, we see five key market implications. First, global markets are still tender and investors cautious; while the glow from the Fed’s actions may inspire some dip-buying, a wholesale rally seems unlikely. Second, a month ago, we thought that higher volatility was here to stay, and we still do. Moreover, cyclical overshoots are possible. Third, the threat to earnings and volatility means that there is still more risk in equities and credit. Fourth, while yield curves have steepened, they likely will get steeper still. And finally, risk aversion, expectations of US weakness and Fed ease have promoted dollar weakness, so these factors will be critical for the currency in the context of a longer-term decline. We see two sets of risks, near-term and over a longer time horizon. Near term, global softening is in the price, but global recession is not. Therefore, near-term weakness in US consumer spending could ignite fears of global economic contagion. The Fed’s action may prove decisive in stabilising credit markets, and underpin a bounce in growth assets, including commodities and EM currencies. But as market functioning returns, and the fear of gloom dissipates, investors should not count on aggressive Fed action, much less succour from other central banks. Longer term, a period of softer global growth may create broader-based investor pessimism. But investors should not lose sight of the global economy’s underlying resilience, which could play an important role in reversing the downside risks for markets.
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Review and Preview
August 20, 2007
By Ted Wieseman/David Greenlaw | New York
Treasuries posted huge front-end gains in extremely volatile trading the past week. Market fears sharply intensified through midday Thursday before calming significantly Thursday afternoon and into Friday, with the reversal supported by the Fed’s surprise cut in the discount rate and extension of discount loan lengths from overnight to up to 30 days — moves we think could have a significant positive impact on the struggling CP and non-agency mortgage markets. In addition, the Fed clearly indicated that an official cut in the fed funds target, ratifying the de facto cut that had previously been implemented at least temporarily by the New York Fed’s trading desk, will follow if the extraordinary discount rate measures don’t work to restore functioning to faltering markets. After the broader worries about credit spreads, subprime mortgages, stocks and hedge fund blow-ups that had been the main focus of investor fears through the first stages of this financial market turmoil, attention in the latest week continued to shift much more specifically to the functioning of the commercial paper market and the financial health of mortgage lenders, who have been stuck holding on their balance sheets and funding a growing stock of non-conforming loans as the collapse in the non-agency mortgage securitization market showed no signs of abating. The brief breakdown in the asset-backed commercial paper market in Europe the prior week, which caused the temporary spike in overnight lending rates, globally spread in a big way to Canada early in the latest week and appeared to be moving to the US as the week progressed. At Thursday’s close, the average rate on asset-backed CP (at least according to official Fed data; actual conditions seemed as if they were significantly worse) had spiked to 5.93% from 5.35% a week-and-a-half earlier, and the spread between higher and lower-rated non-financial CP rates had blown out from 67bp from 20bp. And things were turning uglier Friday morning before the Fed’s announcement, with our desk reporting that most high-quality CP was trading above 6%. This unfolding breakdown in a key short-term funding market, in addition to its clearly highly worrisome possible implications for the financial and business sectors broadly, threatened to exacerbate an already increasingly precarious situation for mortgage lenders. With the non-agency mortgage securitization market having stopped functioning for weeks now, lenders who had made and are continuing to make these loans, which have been significantly curtailed recently and rationed through much higher rates, were being forced to hold them on their balance sheets, making ready access to financing increasingly important. So, the tightening of the CP market in general and, in many cases, reportedly for mortgage lenders in particular, raised major concerns about their financial positions. Countrywide Financial, as the nation’s biggest mortgage lender, was the clear bellwether for these worries and increasingly for the financial market turmoil in general. And the worst of the market panic/flight to safety that was reached in the early afternoon Thursday — with the 4-week bill yield trading at a crazy sub-2.5% at the worst of it and the 2-year yield below 4% — coincided with a huge blow-out in Countrywide’s 5-year credit protection towards 1,000bp from the 300bp level it had closed at the prior week. This reversed in a big way over the course of the afternoon Thursday, with Countrywide’s CDS tightening all the way back to near 500bp (around where it held through Friday), and stocks rallied back and Treasuries came well off their highs in sympathy. This initial move towards some possible stabilization was given a major boost by the Fed’s extraordinary actions. The Board of Governors cut the discount rate 50bp to 5.75%, extended the terms of the loans from overnight to up to 30 days, and attempted to use moral suasion to convince depository institutions to tap this lending facility at will and be assured that there would be no stigma attached. The FOMC also dropped its tightening bias and said that downside risks to growth had increased “appreciably”, setting the stage for an official rate cut at any time if the discount window actions do not succeed in getting key markets functioning better and taking pressure off mortgage lenders. We strongly disagree with many commentators who claimed that the discount window action was merely some sort of symbolic gesture on the Fed’s part. We believe it could have a major positive impact on liquidity in the CP market and help significantly in restoring financial stability to the mortgage lending industry, which would likely also help to stop the ongoing mortgage lending credit crunch outside of the still well functioning agency mortgage market. If so — and we think there is a reasonably good chance these steps could be effective in calming the market turmoil — no official rate cut will likely be needed. If not, the FOMC clearly stands ready to act officially to validate the effective cut in the funds rate engineered by the New York Fed in recent days (with the actual fed funds rate having traded on average near 4.75% in the week ahead of the Fed’s Friday announcements) and at any time, not necessarily waiting for the September FOMC meeting should conditions call for an earlier move. For the week, the Treasury curve saw a huge steepening move, with 2s-10s and 2s-30s moving to more than two-year highs as the 2-year yield fell 28bp to 4.16% (though pulling back significantly from the market peak of 3.965% in the early afternoon on Thursday), the 5-year 23bp to 4.34%, and the 10-year 11bp to 4.67%, while the long bond yield was unchanged at 5.00%. These moves among benchmark coupons were dwarfed by an astounding rally in bills, with the bond equivalent 4-week yield falling 143bp to 2.90%, the 3-month 79bp to 3.75%, and the 6-month 58bp to 4.20%. Demand for bills was so overwhelming and volatility so extreme at the worst of the market panic Thursday that bill trading essentially broke down, with dealers largely unable to make markets. TIPS performed relatively very strongly on the week — though they certainly still look quite cheap relative to nominals — with the benchmark 5-year and 10-year inflation breakevens each dipping just 1bp to 1.99% and 2.24%, respectively. There was massive dovish repricing of the Fed in the futures market on the week, though there was a modest move in the other direction Friday, showing some investor optimism that the Fed’s discount window operations might avert the need for as much action on the fed funds target. For the week, the August fed funds contract gained 17.5bp to 5.03%. Effective fed funds through Friday was averaging about 5.04% for the month, so this wasn’t pricing nearly as much immediate official Fed easing as it might at first suggest, but it did indicate that the market still sees some chance of either an official inter-meeting cut in coming days or it thinks that the NY Fed will continue to hold the actual funds rate well below the target. If the NY Fed were to hit the 5.25% target for the rest of the month, the August contract would settle at close to 5.14%. The October contract rallied 15.5bp to 4.85%, fully pricing one 25bp rate cut by the September FOMC meeting and a 60% chance of a second (or, probably more reasonably, fully pricing at least a 25bp cut and a 60% of a 50bp move instead at or before the September meeting). The January contract gained 28.5bp to 4.50%, fully pricing in 75bp of easing by year-end. Not much is expected next year beyond the fully priced in move to 4.50% by the December FOMC meeting. The low-rate June 08 eurodollar futures contract gained 26bp to 4.465%, leaning just barely in favor of one final 25bp rate cut to 4.25% next year. Gains in the reds ranged from 19bp to 4.57% by the Sep 08 contract to 12.5bp to 4.835% by the June 09 contract. Other interest rate markets were as wild as Treasuries. Swap spreads widened significantly on the week, but came well off their highs hit when Treasuries were peaking and stocks bottoming Thursday. The benchmark 10-year spread ended about 4bp higher on the week at 76bp, but came down from a high of 84bp Thursday, while the benchmark 2-year spread widened 8.5bp to 68.5bp, but well off highs above 80bp. Mortgages were similar, performing terribly into midday Thursday but seeing a good but partial recovery afterwards. It was a similar story across broader risk markets of major weakness into the worst of Thursday’s panic and then sizable, though for the week mostly partial, recoveries into Friday’s close. The S&P 500 ended down only 0.5% on the week after surging 5.5% from the trough hit Thursday at 1:00. Investment grade credit spreads widened, but improved notably late in the week, with the 5-year Hi-Vol CDX index up 9bp to 173bp after closing Thursday at 197bp and the IG index ending 5bp wider on the week at 73bp after closing Thursday at 82bp. The emerging markets index widened 27bp on the week to 198bp, but saw a huge improvement from Thursday’s 232bp close. After sharp recoveries Friday, high yield credit and leveraged loan markets actually improved on the week, with the HY CDX tightening 14bp to 412bp and the leveraged loan LCDX index rising to 95.21 (259bp) from 94.88 (270bp). In both cases, these were the second-best closes since July 19, just behind the recent highs hit August 8. In the subprime mortgage market, the ABX indices mostly ended a bit softer on the week after good recoveries Friday, but the AAA index did better, holding steady for the week. The Fed moved to deal with the unfolding financial market meltdown that was increasingly focused on CP and mortgage lenders’ financial positions in two ways in the past week, unofficial through the first part of the week and then official on Friday. The fed funds rate traded at an average of 5.41% on August 9 after the temporary breakdown in the European asset-backed commercial paper market had put extraordinary funding requirements on European banks that reverberated globally. It continued to trade well above target through most of the day August 10, before the heavy and unusual three rounds of Fed open market operations on the day finally led to a late collapse, with funds trading at the close that Friday near 1% and the effective rate for all of August 10 falling to 4.68%. Instead of easing back from Friday’s extraordinary actions, the NY Fed continued to leave the market oversupplied with reserves through the latest week. The fed funds rate averaged 4.81% Monday, 4.54% Tuesday, 4.71% Wednesday and 4.97% Thursday — a 4.74% average for the week ending Thursday taking just the trading days, or 4.72% including the Friday August 10 rate for the following Saturday and Sunday, which is relevant for fed funds futures settlement purposes and in judging bank reserve positions. In our view, this represented a temporary, unannounced and deliberate easing of monetary policy relative to the FOMC’s official target. A key reason why we see the move as deliberate was the NY Fed’s actions on Wednesday, the end of a two-week reserve maintenance period. The market seemed to be clearly oversupplied with reserves Wednesday, and we thought that there was even an outside chance that the NY Fed would conduct reverse repos to drain reserves if it really wanted to return the actual funds rate to target. But not only did it not do reverse repos, it did more repos, injecting additional reserves into an already oversupplied situation. This de facto temporary unannounced policy action engineered by the New York Fed was finally superseded by the strong official action Friday morning. There were two separate announcements by the Fed. First, the FOMC issued a statement indicating that the “downside risks to growth have increased appreciably” and that therefore the Committee “is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets”. This effectively removes the inflation bias that had existed previously and provides the flexibility to announce a cut in the official target federal funds rate at any time. Second, the Board of Governors announced a 50bp reduction in the discount rate from 6.25% to 5.75% and an extension in the maturity of discount window borrowings. This action was taken “to promote the restoration of orderly conditions in financial markets”. Obviously, these steps were aimed at restoring investor confidence. But if the Fed is successful in what we believe it is aiming for, this will be much more than just a symbolic gesture. We believe that the Fed is trying to implement a plan that will provide a viable intermediate-term financing option for troubled depository institutions and also possibly provide immediate support to the commercial paper market and the mortgage market. The discount window is typically used to provide overnight financing to banks, but Friday’s announcement included an important change that allows an extension in the term of borrowing for up to 30 days. Moreover, the loan is renewable by the borrower. By doing this, the Fed is essentially allowing banks to lock in a financing rate for a considerable period of time. Also, because the range of collateral that can be used to borrow at the discount window is very broad — and specifically includes all types of mortgages (securitized products as well as straight mortgage loans) and CP — this would allow banks to lock in a 5.75% rate and buy other assets whose value has deteriorated in recent days due to liquidity concerns. For example, according to our trading desk, most of the high-quality paper in the CP market was trading at 6% or above early Friday, so 30-day financing could be acquired on a large variety of collateral at a 5.75% rate and potentially profitably invested in high quality 30-day paper. Also, banks, thrifts or dedicated mortgage lending firms organized to loan through bank or thrift subsidiaries (the discount window is open to any ‘depository’ institution) could begin originating jumbo mortgages and financing them via the discount window until the securitization channel reopens. They could also move towards financing their existing books of jumbo and other non-conforming mortgages that they have been forced to hold on their balance sheets because of the collapse of the non-agency mortgage market at potentially much more attractive rates than reports were indicating the troubled CP market was offering many borrowers. Consider in this regard the following statement from Countrywide made Thursday after tapping bank lines of credit: “Importantly, in addition to the significant liquidity which we have accessed from our bank lines, the company’s primary strategy going forward is to fund its production through Countrywide Bank, FSB. We are already originating in excess of 70% of our total origination volume through the bank, and expect to accelerate our strategy so that nearly all of our volume will be originated in our bank by the end of September.” So, it’s conceivable that the Fed’s actions Friday could go a long way towards restoring liquidity to the markets. There is a potential roadblock here, however. Historically, banks have been somewhat reluctant to visit the discount window, especially during times of financial distress. This stigma is associated with past periods — such as the banking crisis in the 1980s — when investors quickly learned the identity of institutions that were regularly tapping the window and punished them in the marketplace. In the current environment, we strongly suspect that the Fed will use moral suasion to encourage institutions to tap the window. A significant step in this direction was taken Friday afternoon with a statement from The Clearing House signed by a number of major financial institutions applauding the Fed’s steps and saying that they “both encouraged use of the discount window and recognized such use as a sign of strength”. If enough institutions choose to tap the discount window going forward, any remaining stigma should rapidly disappear. In sum, Friday’s actions signaled a very high degree of concern at the Fed, coupled with an ongoing reluctance to announce an inter-meeting cut in official target. However, in expressing newfound concern about the outlook for economic growth, the Fed is clearly leaving the door open for a formal cut in the target rate — either at or before the September meeting — if the measures announced Friday are not successful in forestalling a credit crunch. We are optimistic that Friday’s actions could be a significant help in easing the mounting the financial market crisis, making an actual near-term Fed rate cut unnecessary, but the FOMC is clearly ready to act at any time if things do not improve. In the meantime, with the Fed having taken strong official actions, it appears that the unofficial de facto easing engineered by the New York Fed may be coming to an end, with actual fed funds trading much closer to target through the bulk of the day Friday (though being quoted softer late), averaging 5.17% on the day through 5:00 according to ICAP. There was a lot of economic data the past week, but it was of minimal market interest. To briefly summarize the main reports, inflation ran a bit on the high side in July, with the core CPI gaining 0.24% to keep the year-on-year pace steady at +2.2%. Translating this result into a core PCE inflation estimate (due out August 31), we look for a 0.22% rise, which would lift the year-on-year pace to +2.0% from +1.9%. Better-than-expected retail sales and trade reports pointed to stronger growth in 2Q and early in 3Q. Retail sales rose 0.3% overall in July and 0.4% excluding autos and there were upward revisions to prior months. The key retail control category — sales excluding motor vehicle dealers and building materials — that feeds into GDP gained 0.5% in July, better than the 0.3% we estimated, and June (+0.1% versus -0.2%) and May (+1.4% versus +1.3%) were both revised higher. Incorporating these results, we boosted our 3Q consumption forecast to +2.9% from +2.1%. In addition, based on the revisions, we see 2Q consumption being bumped up to +1.5% from +1.2%. Meanwhile, a further sharp gain in exports (+1.5%) and a surprisingly small rise in imports (+0.5%) caused the June trade gap to reach a four-month low of US$58.1 billion. This result was much better than BEA assumed in preparing the advance GDP estimate, and May was also revised in a positive direction, pointing to a further upward revision to 2Q growth. Combining the retail sales and trade results, we now look for 2Q GDP to be revised all the way up to +4.2% from +3.4%, compared with our forecast coming into the week of +3.7%. Looking to 3Q, the better starting point provided by the June trade surprise pointed to a somewhat larger positive contribution from net exports to growth. We now see a 0.3pp positive on top of the huge 1.2pp add in 2Q (which should now be revised even higher), up from our prior +0.1pp estimate. Combining the trade and retail sales implications, we upped our tracking estimate for 3Q GDP growth to +2.7% from +2.2%. Finally, the factory sector showed strength in July that, based on early reports, continued into August, while the housing market continued to tumble in both months. The key manufacturing gauge in the industrial production report rose a solid 0.6% in July for a second straight month, the best two-month showing since March and April 2006. Looking to August, the headline sentiment measures in the Empire State and Philly Fed manufacturing surveys were sharply mixed, but underlying details of both reports were strong, with ISM comparable weighted averages of the key activity measures we calculate coming in at 58.5 for the former and 54.3 for the latter. On the other side, housing starts plunged 6.1% in July to a 1.381 million unit annual rate, low since January 1997. Single-family starts tumbled 7.3% to 1.070 million, while multi-family starts, likely supported by healthier rental markets, dipped 1.6% to 311,000. Things continued to get worse into August according to the National Association of Homebuilders. Its composite housing market index fell to 22 in August from 24 in July, the lowest reading since the record low (in the period since 1985 that this survey has existed) of 20 hit in January 1991. All three components were down, with the assessment of present sales falling to 23 from 24, low since January 1991, expectations for future sales falling to 32 from 34, matching a record low, and traffic of prospective buyers tumbling to 16 from 19, also matching a record low. The economic calendar is very light in the coming week and essentially empty until Friday. The Fed’s Thursday evening release of its weekly H.4.1 report — ‘Factors Affecting Reserve Balances’ — could be the week’s key report. This release contains figures on discount window borrowing. Previously, heavy discount window borrowing might have been seen as a negative indicator of market stress, but just the opposite is the case now. The greater the amount of discount window borrowing reported Thursday for the week ending Wednesday the better, as more borrowing would indicate greater success in the Fed’s effort to inject liquidity into troubled markets. Economic data releases due out include leading indicators Monday and durable goods and new home sales Friday: * The index of leading economic indicators should rise 0.5% in July, its sharpest advance since March, with positive contributions from consumer confidence, claims, supplier deliveries and money supply. Indeed, the only negative influences that we see this month come from building permits and a relatively flat yield curve. * We look for a 0.6% rise in July durable goods orders. Another strong month at Boeing is likely to help boost the headline orders reading. Otherwise, we look for modest rebounds in categories such as high-tech and electrical equipment. This should help lead to about a 0.5% rise in the key core orders category — non-defense capital goods excluding aircraft. Finally, core shipments are expected to post a similar gain. * Based on the sharp fall-off in homebuilders’ assessment of current sales over the past couple of months, we expect July new home sales to fall another 4% to an 800,000 unit annual rate. Keep in mind that the recent tightening of mortgage credit to prime borrowers will probably have a very limited impact on July sales, but this factor should become more of a headwind in the coming months.
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Normalization Strategy on Hold
August 20, 2007
By Takehiro Sato | Tokyo
Rate normalization opportunity slipping awayThe Fed’s reduction of the ODR last Friday sought an announcement effect in response to a widespread credit crunch in US and European money markets, and this move itself was not the policy rate cut. However, the accompanying Fed statement mentions risk of weaker economic activity and adds to the possibility of an FF rate cut prior to the FOMC meeting on September 18. The BoJ is obviously unlikely to proceed with a rate hike at the August policy meeting and we doubt that it would act even at the September policy meeting (September 18-19) if the FRB cuts rate by September 18 or the ECB delays its planned rate hike at the council meeting on September 6. The BoJ might have trouble raising the policy rate at the two policy meetings held in October (October 10-11 and October 31) if it postpones action at the September meeting, since headline numbers from the September Tankan Survey due out on October 1 are likely to drop for both manufacturing and non-manufacturing sectors judging from the leading indicator such as the Reuters Tankan data and the like, and business plans disclosed in the survey typically do not contain significant information, given the timing just before interim results announcements. Therefore, we expect emphasis on weak headline results. There is also a possibility of the BoJ lowering its main scenario in the Outlook Report issued at the end of October based on a softer outlook for overseas economies. These conclusions would diminish chances of a rate hike at the November meeting (November 12-13). So, the BoJ’s normalization campaign could be suspended until at least November. Our scenario revision may not have been necessary We think that the December policy meeting (December 19-20) after the release of the December Tankan Survey (December 14) would be the earliest timing for a rate hike if the above events unfold. Key criteria for rate action at that point are confirmation of firm corporate sentiment in the December Tankan and only modest downward revisions of F3/2008 business plans even after 1H results. Yet, business plans from the June Tankan used a ¥114/$ forex rate assumption and a continuation of recent yen market conditions through the end of 2007 could weigh on export revenue for manufacturers. Thus, the above assumptions result in difficult hurdles. The more natural course, in our view, would be an interim assessment of the BoJ’s scenario from the October Outlook Report, which is likely to be revised lower, at the January policy meeting (January 21-22) and a decision on a rate hike in light of these conclusions. The next rate hike hence might not come until Jan-Mar 2008. This resembles our ultra-conservative scenario until June. The long-term interest rate (10yr JGB yield) has temporarily moved below 1.6% following the sharp decline in stock prices through the end of last week. We attribute last week’s stock market setback to a technical reaction to overseas weakness. Corporate earnings had an excellent start in 1Q (Apr-Jun), even exceeding our bullish estimates, with strong momentum in the manufacturing sector. The market plunge during the second half of last week therefore does not coincide with economic fundamentals, and we expect an autonomous recovery. Meanwhile, Japan’s long-term and short-term rates should reach limits even if they rebound, given uncertainty surrounding the BoJ’s normalization campaign. Otherwise, investors are coming to the phase where they should be ready for market rates trading too low again since the BoJ might be forced into a rate cut that reverses the normalization process if the risk scenario described below unfolds. Price improvement also unclear We anticipate limits to any rebound by long-term and short-term rates since sharp forex rate changes could affect the outlook for Japan’s prices. Our scenario projected that the core CPI rate would turn positive again, even if only temporarily, in November 2007 based on a $71.5/barrel WTI oil price and ¥118/$ forex rate in Oct-Dec 2007. Yet prices might not reach this level during 2007 depending on the forex rate, since the prospect of weaker demand from a possible US economic slowdown would adversely impact crude oil prices. We have already questioned the BoJ’s stance of putting less emphasis on negative CPI data and raising the policy rate when prices are dropping, and price trends should be even more important amid growing uncertainty about economic fundamentals. The following simulation, however, shows that the crude oil import price would need to fall 30%+ from the current level for Japan’s negative CPI rate to continue throughout 2007-08. This seems unlikely right now. So, we cannot rule out the possibility of a rate hike from Jan-Mar 2008 if the CPI rate might turn positive at some point in 1H08. Risks The main risk for the above scenario is an increased likelihood of the US economy slipping into a recession from a credit crunch and consecutive rate cuts by the Fed to address this threat. The Fed has substantial room for policy rate cuts, and the US economy should ultimately avert a recession through aggressive rate cuts. However, the BoJ might be forced to cut rates in this environment, and Japan’s policy rate could return to 0%. Yet, we advise against this type of excessive pessimism. US corporate fundamentals are solid and the job market is firm. So, we do not expect the risk scenario to materialize. US companies still enjoy healthy profit margins that provide a buffer against unexpected external shocks. The current shock might lead to modest inventory adjustments, but should not cause deeper adjustments such as scaling back capex plans or job cuts. It could be argued that US companies have reduced leverage even more than Japan’s case in some sense and are well prepared for a credit crunch. Job conditions remain tight, with upbeat corporate fundamentals. We hence expect a shift in the quality of US personal consumption away from spending driven by home equity gains to more reliable activity reflecting income upside from stronger employment and wages. Market concerns should retreat as this change shows up in the incoming economic data. The suspension of Japan’s rate normalization campaign could be relatively short.
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