United States
Housing: Enter the Bear Scenario
October 31, 2007

By Richard Berner | New York

Over the past year and a half, many seers have looked for an end to the ongoing US housing recession, only to be frustrated by continued bad news.  For example, just a year ago, former Fed Chairman Alan Greenspan cautiously opined that the “worst [of the housing downturn] may well be over.”  Although we’ve been consistently more bearish than most on housing for more than a year, we’ll count ourselves in that myopic group.  A year ago we thought that single-family housing activity would decline by 16-18% before it hit bottom (see “Is the Housing Recession Over?” Global Economic Forum, October 20, 2006). 

That was then.  Over the intervening period, single-family housing starts plunged by 30.8%.  And since then, we’ve pared our outlook for housing activity three times, to the point where we have the lowest projection of any in the Blue Chip Survey for both 2007 and 2008.  But more is likely coming, because tighter lending standards are depressing demand by more than we thought just a month ago.  Builders may need to slash up to another 40% from single-family construction activity from September levels to balance supply with demand, or about 10% more than we thought last month.  And real home prices likely will have to decline by 10% to make housing more affordable.  Neither that construction decline nor its potential effect on economic activity seems to be in any forecast.  Details follow.

There’s no mistaking the signs of weakness in housing demand.  New one-family home sales bounced by 4.8% in September, but statisticians dramatically revised down the level of sales in prior months.  For example, the sales pace in August was recorded last month at a 795,000 annual rate; now it stands at 735,000, testifying to more underlying weakness than previously thought.  Such downward revisions have been common over the past year, undermining any sense of a bottoming in either the pace of decline or the level of demand.  With new and existing 1-family home sales down 41.6% and 29.8% from their peaks of more than two years ago and no sign of a bottom, how should one calibrate where, if not when, that bottom might occur?

Some analysts are looking to the homeownership rate — the share of occupied houses that is occupied by owners — as a gauge for housing demand.  Their reasoning: The rise in that rate added to the demand for housing overall, not just the split between those owned and those rented.  Researchers formerly at the Federal Reserve Bank of Atlanta argue in a recent paper that between 56-70% of the rise in the homeownership rate between 1995 and 2005 can be attributed to the use of ‘piggyback’ or ‘combo’ mortgages.  Such aggressive lending reduced needed downpayments in many cases well below the 20% needed to qualify for mortgage insurance on the first lien (see Matthew Chambers, Carlos Garriga, and Don E. Schlagenhauf, “Accounting for Changes in the Homeownership Rate,” FRB Atlanta Working Paper 2007-21, September 2007;  http://www.frbatlanta.org/filelegacydocs/wp0721.pdf).  Presumably, therefore, the homeownership rate must fall to 67% or so from the current 68.1% — implying a reduction in ownership of about 1.1 million — before balance emerges. 

As we see it, however, a better gauge of underlying demand might be the share of occupied housing units (owner- and tenant-occupied) relative to the population 20 years old and over (as measure of potential household formation).  That ratio has been essentially flat over the past 14 years at 51-52%.  But the number of vacant homes (either for rent or for sale) has risen steadily as a share of the 20-year-old+ population from 6.5% in 1994 to 8.3% in the third quarter of 2007.  Until 2005, all observers agree, rising home prices and easy credit supported the housing market and promoted a rising level of vacant homes that were easy to carry and seemed to appreciate whether they were rented, lived in, or empty. 

Changes to the tax code in the past decade likely added fuel to the fire.  The Taxpayer Relief Act of 1997 changed the tax treatment of capital gains on a primary residence.  Previously, homeowners were allowed a lifetime exemption on $125,000 of capital gains; the new law allowed a married couple filing jointly to exclude up to $500,000 of capital gains on the sale of a home if they live in it for at least two years.  Effectively, that brought the tax on realized gains in housing wealth to zero for all but the wealthiest homeowners and reduced significantly the prospective after-tax cost of homeownership.  And even the wealthy few now pay only 15% on the gain above $500,000.  Likewise, for investors, the reduction in the tax rate on capital gains in the Jobs and Growth Tax Relief Reconciliation Act of 2003 made speculating in housing more attractive.  Indeed, 2006 HMDA (Home Mortgage Disclosure Act) data indicate that the share of home sales for investment peaked at 17.3% in 2005, nearly three times the rate of a decade earlier.  But soaring prices and tighter financial conditions made housing less affordable for both owners and investors, ultimately unmasking vacancies too expensive to carry. 

Looking to the vacancy rate for owner-occupied homes as a barometer of excess, we estimate that the rise of about 600,000 vacant homes over the past two years must be reversed to bring supply and demand into balance.  That can occur on the demand side through a combination of lower interest rates and lower prices.  Housing demand is not highly sensitive to price, so a price decline in real terms of roughly 10% might be needed to increase demand by the extra 300,000 units (about 0.4% of the stock of owner-occupied houses) that would reduce vacancies by half over the next year or so.  On the supply side, we calculate that as much as a 40% further decline in single-family housing starts from current levels might be needed to reduce the other 300,000 vacancies — consistent with a reduction in the inventories of unsold new homes from the current 523,000, or 8.3 months’ supply, to just under 5 months.  That could push our 2008 prognosis for overall housing starts well below 1 million units, compared with the 1.054 million we forecast in early October.

There’s little doubt that such adjustments would be painful.  The resulting further decline in housing activity would likely knock a quarter percentage point off our already below-consensus US growth forecast over the next year (in early October, we expected just 1.8% real growth over the four quarters ended in Q3 2008), leaving the economy a bit more vulnerable to unexpected shocks.  Together with the collateral damage from the spillovers in housing-related industries and the drag on spending from the declines in home prices, this analysis suggests that the odds of a recession are currently about one in three. 

Fed officials are acutely aware of these risks and the resulting uncertainty surrounding the outlook.  Indeed, in a paper he delivered at the Kansas City Fed’s Jackson Hole symposium in early September, Fed Governor Mishkin argued that policymakers can offset the negative impact of a large home price shock with early and aggressive action (see “Housing and the Monetary Transmission Mechanism,” FEDS Discussion Paper 2007-40 http://www.federalreserve.gov/pubs/feds/2007/200740/200740abs.html).  In hindsight, his conclusions foreshadowed the Fed’s action in mid-September, and recent speeches by Chairman Bernanke, Vice Chairman Kohn, and Chicago Fed President Evans reinforce that logic for the Fed’s 50 basis-point move. 

But it’s still unclear just how big a move the Fed would need to mitigate the downside risks in the current circumstances.  In the paper, Mishkin offered a number of alternative response functions in an attempt to quantify the required response.  As my colleague David Greenlaw points out, even in Mishkin’s most extreme example, the Fed’s optimal response appears to be a good deal smaller than the market is currently anticipating.  As we have long argued, a key reason is that the wealth effects associated with home price changes are relatively small — the impact of a 10% swing in prices corresponds to about a 70-cent move in gasoline prices.  Thus, only a major move in home prices will prompt a significant policy response.

For example, using Mishkin’s models, including a standard Taylor rule reaction function, the Fed would need to ease by about 40 bp over two years to offset the macro spillovers from a 10% real decline in home prices.  Of course, that is less easing than the Fed did in September in one stroke.  What’s more, the model calls for 25 bp of tightening as the headwinds fade.  An alternative model — involving "magnified channels” of spillover — prescribes some 90 bp of cumulative easing over the next couple of years, followed by 75 bp of tightening.  Finally, even if real home prices were to decline by 20% over the next year, as some are now mooting, Mishkin’s optimal policy model does not call for 100 bp of cumulative easing until around Q2 2008. 

We hasten to add that there are significant uncertainties surrounding any of these calculations.  Vice-Chairman Kohn recently provided a useful framework for assessing them.  He agrees that such policy rules and models are extremely helpful for crosschecking policy decisions.  But he also points out that uncertainty about the measurement of inputs to the models, factors the models overlook (i.e., other dimensions of financial conditions such as stock prices, the dollar, credit spreads and credit availability), and a risk-management approach to the probabilities and costs of various outcomes might dictate deviating from their prescriptions. 

For their part, investors must also cope with the uncertain implications of these scenarios.  Housing appears to be at the crossroads of the disconnect between equity and fixed-income investors.  Even if the Fed’s actions will ultimately do the job, as many hope, we suspect that the damage from such a downturn in housing activity is not reflected yet in equity prices for either housing or housing-related industries such as building materials and supplies, and furnishings and appliances.  In contrast, fixed-income market participants seem to be anticipating broad spillovers into the rest of the economy.

Risks thus abound.  The overhang of unsold new homes in inventory is now a major factor in the housing outlook.  Ironically, an aggressive response from builders would clear the air and the market faster.  Conversely, the longer that builders defer the adjustment, the more would-be buyers may wait for more attractive deals, putting home prices and activity at further risk.

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Japan
Room at the Top? Not Such an Outlandish Scenario
October 31, 2007

By Takehiro Sato | Tokyo

Governor and Deputy Governors seats could fall vacant

When we floated the idea that the Bank of Japan could find itself rudderless we were exploring the possibilities, but scarcely believed it could happen. Now we are not so sure, and here is why.

When the budget for F3/09 passes the Lower House in late February, the constitution stipulates that it automatically becomes effective within 30 days, regardless of deliberations in the Upper House1. So from March on, a dissolution mood spreads through the Diet. Even so, since the government must get budget proposals for its tax code and other changes passed, our own view is that the Lower House will only be dissolved after budget-related proposals have been re-approved by an absolute majority of at least 2/3 in the lower chamber by late March2. In any event, we are set up for a chaotic round of Diet business after March.

The problem would surface if the terms of office of the Governor and Deputy Governors expire on March 19 at a time when negotiations are going nowhere and confusion in the Diet is expected. As is well known, the BoJ’s executive posts are political appointments, and must according to Article 23 of the BoJ Law be approved by both chambers. And unlike most bills, the wishes of the Lower House do not take precedence. This gives the Democratic Party of Japan, which has an Upper House majority, an effective veto over the appointments, and it seems that the DPJ is maintaining that the decision on the top brass at the BoJ should be a matter for the next government to decide after the next general election. Terms last five years, so it would in a sense be unfair for the appointments to be in the gift a Fukuda Cabinet which may prove to be short-lived. To this extent we can understand the DPJ’s position.

But if the selection of the next BoJ leaderships is postponed because of a general election, the Bank would inevitably face its own form of political vacuum. It would have to conduct the MPMs in April (8th-9th, 30th) and May (19th-20th) without a sitting Governor or Deputy Governors (i.e., with a six-person board), or under Article 23 it is possible that the Cabinet would extend the terms of the incumbents in the interim.

Note that if the executive posts at the Bank are unfilled, it has already been laid down by the policy board that Miyako Suda, the longest serving non-secretariat member, would stand in for the Governor and Deputy Governors (under provisions for a stand-in in the event of an accident3). Whether or not this would be triggered in the event that the posts are vacant because terms have expired (not an accident) is open to question as a contingency not foreseen by the law. The BoJ’s interpretation appears to be that the provision applies in cases of physical accidents befalling the Governor or Deputy Governors, and does not stretch to appointing a stand-in chairperson at MPMs. The actual interpretation of the law would be made by the Cabinet (or Cabinet Legislation Bureau), however, which would presumably prevent an interpretation being made that favors the BoJ’s special interests. Regardless of these details, the bizarre situation above – unthinkable at central banks in most developed countries – has become an unexpectedly realistic possibility.

Policy implications

How would policy change if the posts do remain vacant, or are filled only on a provisional basis by the incumbents? The short answer is that it shouldn’t change at all, as changing policy under a provisional or stand-in chairperson runs counter to common sense. That eventuality would mean policy gridlock spills over from the government and bureaucracy to the BoJ as well. Also, there is a real possibility that headline GDP for the October-December quarter due out in mid-February will drop to near zero growth as the fall-off in housing starts in July-September linked to revision of the Building Standards Law feeds into plunging housing investment. This would scotch any prospect of a rate hike at the MPM in February (14th-15th) or March (6th-7th). There is then the possibility that the April and May MPMs will be held for form’s sake, neutered in the absence of BoJ leadership or with the current leaders temporarily extending their terms. So if the opportunity to hike is passed over in December and January, and a snap election is on the cards for the spring, the next rate hike would probably have to be postponed till the middle of next year.

Market implications

With concerns about the sustainability of the US economy plaguing stock markets at home and abroad, markets are already factoring for no further rate hikes this year and acclimatizing to a new policy duration. But the scenario we outline above does not still comfortably with recent pricing in the Overnight Index Swap (OIS) market, which appears to reflect a probability of a rate hike that rises with the passage of time.

We are still not abandoning the prospect of a rate hike in either December or January. GDP for July-September (due out on November 13) is likely to give a respectable showing, admittedly driven by external demand, with annualized growth in the upper 1% to 2% range. The headline December Tankan number (on the 14th) should also be solid, reflecting the health of manufacturing, and a move into positive territory for the core CPI in January-March 2008 is looking probable too. Meanwhile, for the reasons given earlier the chances of a rate hike between February and around May are lower. The trade in this scenario would be to pay for OIS until January, and be on receiving side from February to around May.

Risks

If there is a leadership hiatus, Miyako Suda would take over as the stand-in chairperson at the MPM, and voting would take place among the six non-secretariat members. Three or four of these including Suda herself appear to have hawkish leanings, so the possibility of an opportunistic hike under these circumstances, while remote, cannot be entirely dismissed. The risk for the Bank is that if this happened and the economy then hit the rocks, moves to restrict its independence by amending the BoJ Law could be set in motion. We hope that the six remaining board members would have the sense to avoid this.

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Japan
Japan: Outlook Report or ‘Wish Report’?
October 31, 2007

By Takehiro Sato | Tokyo

Outlook Report’s basic view generally in line with expectations

The BoJ’s Outlook Report was in line with expectations. While the median value of GDP forecasts from policy board members dropped for F3/08, the F3/09 outlook assessment calls for a recovery to 2%+. Policy board members lowered the F3/08 price outlook even further from the April report that lowered the estimate more than expected, and are still projecting a modest rebound in F3/09. Meanwhile, the risk assessment simplified the reference to IT adjustments, but emphasized downside risk from overseas economies.

Although the Outlook Report generally retains a more bullish stance than the extent to which investors are currently discounting for a rate hike, there are signs of uncertainty in the details and diminished resolve from the bank secretariat.  For instance, the BoJ has for the first time since October 2005 during quantitative easing uttered the word “latitude” regarding its stance on policy measures.  Yet Mr. Fukui reiterated that the BoJ has not altered its basic stance at the regular press conference, in contrast to the report’s uncertainty. However, eight months have already passed since the previous rate hike and we believe that investor confidence in the BoJ will suffer without some action, similar to the boy who cried wolf.

Some media sources are treating the Outlook Report as simply a ‘Wish Report’. Although this has partial validity, the situation has improved in Japan and abroad compared to the summer, with support from bold policy measures by the Fed. The BoJ might be cautiously laying the groundwork for a rate hike at the December or January meetings with this Outlook Report in order to avoid a reputation for crying wolf. We hence cannot completely rule out a rate hike at the December or January meetings, though the possibility is remote. But if it passes on this opportunity, we think that a rate hike would likely be skipped until the middle of next year.

Optimistic growth rate outlook

The BoJ’s growth rate outlook is fairly optimistic, in contrast to growing uncertainty about where the global economy is headed. Economic contraction in Apr-Jun forced policy board members to lower the F3/08 forecast. Furthermore, although robust external demand probably lifted the Jul-Sep growth rate, we anticipate a sharp drop in residential investment and a backlash decline for external demand from Oct-Dec. The +1.8% bank forecast hence appears bullish amid growing uncertainty in the external environment. Residential investment, which is headed sharply lower, should be a major limiting factor for near-term GDP growth. Yet the BoJ is focusing on future upside potential, since recent weakness reflects a supply-side bottleneck. In fact, the BoJ predicts a restoration of growth above Japan’s latent growth rate at +2.1% in F3/09, even though international entities and overseas central banks are reducing their outlooks.

The BoJ outlook envisions healthy overall growth, driven by upbeat momentum in the manufacturing sector, which reflects strong Asian demand even with recent sluggishness in the household sector for personal consumption and residential investment. However, the household sector has steadily underperformed the BoJ outlook thus far, and widening discrepancies between large companies and smaller businesses are showing up in not only executive sentiment but also in employment trends. These factors raise questions about the feasibility of the BoJ’s existing scenario. Yet it has continued its emphasis on a forward-looking view.

Still the risk of a shortfall for the price outlook

The price outlook still faces shortfall risk. The Outlook Report lowered its outlook again for core CPI growth, to +0.0% YoY in F3/08. The outlook for a +0.4% increase in consumer prices during F3/09, meanwhile, requires +0.03pp YoY improvements by the ‘core of core CPI’ each month from November, even assuming that oil prices remain at current highs. This is still an aggressive goal with the recent stabilization of ‘core of core CPI’ at a low level. We think that there is a possibility of core CPI not increasing much in 2008. Incidentally, our updated core CPI outlook for F3/09, based on the most recent September nationwide CPI data, is +0.2%.

The output gap pass-through to prices could weaken in F3/09, even with a somewhat faster growth rate, if the output gap has an impact on prices with a lag as asserted by the BoJ, given the flat trend for Japan’s output gap in F3/08 with real growth at +1.8%, or roughly on par with the potential growth rate. Investors are unlikely to accept the bank’s policy tone, which over-emphasizes higher price risk considering the upward bias in the bank’s price outlook and the reality of prices remaining below the low end of the “understanding of price stability”.

Positive and negative deviations and our view

The previous Outlook Report outlined various positive and negative risks for economic activity such as global economic trends, supply and demand conditions for IT-related goods, and larger swings in financial and economic activity; and for prices, risk related to uncertainty about changes in the sensitivity of prices to the output gap and commodity price trends.  

The October Outlook Report largely mirrors the style of the previous report, but supply/demand trends for IT-related goods were not covered as an independent risk, and combined into overseas economic trends.  Regarding prices, as a downside risk the Report underscored a case where “wages have been somewhat weak, reflecting labor cost restraint by firms, especially small firms, in the face of greater exposure to global competition and capital market discipline, and increased materials prices”, and where “the change in the composition of the workforce due to the retirement of the high-salaried baby-boomer generation and increases in part-time workers have also contributed to the weakness in wages”, in which the BoJ put an emphasis on the case where certain factors have a strong effect in controlling wage increases. 

Policy/market implications

The Report also maintaining portions of the conclusions of the previous April Outlook Report, saying that the BoJ will adjust the level of interest rates gradually in accordance with improvements in the economic and price situation.  However, regarding heretofore policy measures, the bank noted that weak inflationary pressures have given it latitude in conducting monetary policy, and that the actual interest rate adjustments have therefore been slow, based on a thorough assessment, under the two policy perspectives, of the future path of the economy and prices and its likelihood, as well as both upside and downside risks. Thus it plans for justification of the policy stance so far in the situation where prices have reacted quite sluggishly to the economy. However, our position is that the BoJ erred in its outlook on prices, and thus was late in adjusting the policy rate.

We think that the probability of a rate hike at the December or January meetings is likely to rise somewhat, reflecting the bank’s forward-leaning stance. Nevertheless, taking a subjective probability distribution, the chances of action from February 2008 to mid-year are likely to fall enormously. The former view assumes a rebound in Jul-Sep GDP data, firm results in the December Tankan survey, a price recovery, and that further receding of the credit turmoil keeps short-term money market rates (LIBOR) down. The latter view takes into account the possibility of the headline GDP growth rate for Oct-Dec due out in mid-February dropping to nearly 0% on a setback in residential investment. We doubt that the BoJ could proceed with a rate hike at the February or March meetings after the release of Oct-Dec GDP data. Political disruptions might prevent it from having more than a nominal leadership team at the April and May meetings (led by Miyako Suda as a stand-in chairperson or with the existing governor and deputy governors on temporarily extended terms). The next rate hike hence could be delayed until at least mid-2008 if the BoJ misses the near-term opportunity at the December or January meetings, and assuming a general election in spring 2008.

A new policy timeline is taking shape, with investors already projecting no rate action for the rest of 2007. However, we are uncomfortable with current pricing in the OIS market that suggests a steady rise in the probability of a rate hike over time, given the scenario explained in the previous paragraph.

Risks

The main near-term risk is a housing shock in Japan. Residential investment could make a substantial negative contribution to Jul-Sep GDP due out on November 13. Yet we expect a similar setback for residential investment in Oct-Dec that might even reduce GDP growth to nearly 0%. This will make it very difficult for the BoJ to raise the policy rate from mid-February when Oct-Dec GDP data is released, including pressure from political disruptions.

While some bank officials view the decline in residential investment as merely a technical factor, a prolonged supply-side bottleneck (even if it is caused by a technical factor) could hurt economic activity by squeezing cash flow at construction firms and reducing mortgage loans. Investors should not underestimate the impact of a housing shock on the Japanese economy.

 

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Euroland
Alert -- Risk of manufacturing recession
October 31, 2007

By Eric Chaney | London

The devil is often in the details, as the saying goes. This might be true for the euro area economy: while the widely scrutinized headline Ifo index posted only a modest slip in October, one key detail of its manufacturing section sent a much gloomier message: production fell from a cliff in Germany, the powerhouse of the recovery so far. In fact, production dipped in almost all other euro area countries, although less heavily. Because this was not anticipated by companies, our Surprise Gap Index dropped below the deceleration line for the first time since June 2005, and our Compass moved straight to the 'decelerating, risk of recession' zone. Of course, one single month is not enough to establish a new trend and production might rebound in November: Companies say that demand is decelerating, but only incrementally. Yet, we take the warning seriously, because it comes from several countries and, above all, from the leader of this recovery that started in the summer of 2005. Also, it is about what companies know best: their own recent output.

 

Production took a hit in Germany and the Netherlands

 

Current production dropped to 0.3 standard deviations above the long-term average (sd) from 0.8 in September. Back in December 2006, this index was roaring at 1.4, matching the May 2000 peak. The drop in Germany was even more dramatic, from 1.2 to 0.0. Even if a rebound is almost guaranteed in November (this is what the dynamics of the time series are strongly suggesting), something has happened: production also slowed in the Netherlands, in France and in Belgium. Italy was an interesting exception but even in the Peninsula, the trend is weakening.

 

Demand is slowing incrementally, so why this fuss?

 

Companies’ assessment on demand went down only marginally, from 1.2 sd to 1.1. Even though demand is less robust than in April, when the indicator peaked at 1.6 sd (its all-time record), its deceleration is not enough to justify the magnitude of the expected slowdown. We believe that a combination of two negative factors is at work. First, tighter credit conditions (already reported by companies) are raising the opportunity cost of inventories and reducing companies’ appetite to spend. Second, the global macro outlook is becoming clouded: a series of bad news from the US and UK housing markets, crude oil on its way to $100/bbl and the euro heading to $1.45 if not higher. This combination has probably reversed managers’ risk assessment, as the inventory index extracted from the surveys is showing: only four months ago, it was indicating that inventories were dramatically insufficient. It is now very close to neutrality, showing that managers are now anticipating much slower demand. Against this backdrop, the marginal rise of the production plan index, from 0.6 to 0.7, looks surprising. It is probably announcing a short lived bounce back, rather than a re-acceleration.

 

Stall speed in 1Q 2008?

 

Sensitive to current production but also to the trend in demand and to past construction orders (which improved in 2Q), our GDP indicator did not correct much for the current quarter (4Q 2007), at 0.41%Q (or 1.7% annualised rate) vs. 0.46%Q (1.9% annualised) after last month’s round of surveys. Thanks to still positive production plans, the GDP indicator anticipates a further slowdown in 1Q 2008, at 0.32%Q (1.3% annualised), significantly below trend, and not far from what we would call ‘stall speed’ by European standards, i.e. a pace of growth around 1%.

 

Back-testing the ‘risk of recession’ signal

 

If our models are correct, the balance of risk is clearly on the downside, not only for our current GDP forecasts (0.4%Q in 4Q 2007 and 1Q 2008) but even for our less rosy GDP indicator. We have back-tested the Compass model over the last 15 years. The ‘decelerating, risk of recession’ mode occurred 31 times over the 192 months of the series. The call was a good call (i.e. followed by a contraction of the quarterly manufacturing production index in the next three months) 17 times and ‘almost a good call’ (followed by at least two months of contraction in the next four months) 6 times. Overall, the Compass has predicted a manufacturing recession correctly in 74% of the cases over the last 15 years.

 

Policy makers should listen to producers

 

Three weeks ago, we wrote that tighter credit conditions, as they were reported by the ECB bank lending survey, were implying downside risks to growth and rates. This time, the warning is coming from the real economy and it is serious. However, it is about risks, not yet about the actual outcome. Nevertheless, if confirmed, it would probably convince the ECB to re-think its risk assessment on the real economy. Then, the option of a rate cut, which was recently demonized by several hawkish comments from executive board members, would resurface.

 

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United States
Review and Preview
October 31, 2007

By Ted Wieseman & David Greenlaw | New York

Treasuries posted modest further front-end-led gains over the past week on top of the massive surge of the prior week. The market continued to benefit from general investor anxieties even as Fed easing expectations, while remaining very aggressive, were scaled back slightly, stocks posted a good rebound, money market healing continued, a continued weakening in the dollar pointed to further support for the already booming export sector, and heavy Treasury supply was met with very little interest by final investors. On the somewhat market-supportive side, credit spreads didn’t show much improvement after the substantial widening seen late the prior week. The underperformance of credit relative to equities was in large part led by financials in the wake of Merrill Lynch’s big write-downs. The generalized anxieties this helped stoke, providing a continued solid underlying flight-to-safety bid in Treasuries that has taken yields way beyond even currently very dovish Fed expectations, was also reflected in major further losses in the mortgage default swap ABX market. These fears were not evident, however, in the performance of the asset-backed commercial market, which extended the improving trend that has been underway since the market began in early September to look ahead towards the first Fed rate cut. A light economic data calendar over the past week produced mixed results and had a negligible market impact. Housing remains a disaster, with weak results for existing and new home sales. And initial jobless claims posted a second straight elevated reading, leading us to reduce our forecast for Friday’s jobs report to +65,000 from +100,000. On the other hand, key underlying details of the durable goods report were better than expected, leading us to boost our 3Q GDP forecast to +3.5% from +3.1%.

On the week, 2’s-10’s moved another 4bp higher on top of the prior week’s 13bp move to +63bp and 2’s-30’s rose another 4bp on top of the prior week’s 20bp surge to +92bp, both just below the cycle highs that were hit in late September and mid-August, respectively. The 2-year yield fell 5bp to 3.76%, the 5-year yield was flat at 4.04% (rolls on the new 2-year and 5-year issues were very small), and the 10-year and 30-year yields each dipped 1bp to 4.39% and 4.68%. After performing extremely well on a relative basis during the prior week’s market surge, TIPS had another very good week. The outperformance was helped by a surge in energy prices -- December oil surged nearly $5 a barrel to $91.86, November oil jumped $0.11 a gallon to $2.27, and November natural gas rose $0.18 per MMBtu to $7.22 -- that looks like it could prevent what is normally a seasonally negative period for TIPS carry, with non-seasonally adjusted CPI usually falling over the November/December period. The benchmark 5-year inflation breakeven rose 7bp on the week to 2.21% and the 10-year 5bp to 2.35%, highs since July. The huge dovish repricing of the Fed over the course of the prior week only saw a marginal reversal in the latest week. The November fed funds contract lost 1.5bp to 4.48%, largely pricing out the possibility of a 50bp rate cut. The January contract fell 2.5bp to 4.295%, the February contract 3.5bp to 4.18%, and the April contract 2.5bp to 4.075%. The biggest eurodollar futures losses were towards the longer end, with 8bp drops starting with the Dec 11 contract. The reds (Dec 08 to Sep 09) fell 4 to 4.5bp on the week, with the low rate Dec 08 contract ending at 4.105% as the market moved back towards pricing a 4% trough in the funds target instead of 3.75%.

After the partial set back of the prior week, financial market healing mostly either continued or resumed in the latest week, which certainly made the failure of Treasuries -- except at the very short end -- to correspondingly give back some of their prior week spike puzzling. For some reason, interest rate market investors are apparently a lot more anxious and gloomy than their counterparts in other major markets.

Stocks posted a good rebound on the week, with the S&P 500 gaining 2.2% to climb back to just 2% below the record close hit October 9. Credit markets improved as well, but much less than stocks. In late trading Friday, the 5-year Hi-Vol CDX index was being quoted near 158bp, little changed on the week, while the broader investment grade index was trading near 59.5bp, 2bp stronger on the week. High yield and leveraged loan markets also improved modestly. Through Thursday’s close, the high yield CDX index was 12bp better on the week at 419bp and the index was trading slightly stronger Friday afternoon. The leveraged loan LCDX index was 5bp better on the week at 262bp, with good progress in funding the TXU deal helping sentiment in that market. On the negative side, Merrill Lynch’s big write-downs and fears of more to come across the Street along with ratings agency downgrades kept the mortgage default swap ABX market in complete freefall. All the ABX indices – AAA (86.25 v. 91.81), AA (58.07 v. 70.06), A (35.86 v. 43.25), BBB (23.14 v. 25.50), BBB- (20.18 v. 23.28) -- were down big again on top of the massive losses of the prior week.

Improvement in the money markets continued. In Treasuries, most of the huge flight to safety into the very short end seen the prior week was reversed, with the 4-week bill’s bond equivalent yield up 55bp on the week to 3.97% after having hit a recent closing low of 3.16% two Thursdays back. Term interbank lending rates moved significantly lower on the week. While this partly reflected the expected imminent Fed rate cut, the improvement for the week exceeded by a good amount the Fed repricing seen since the London fixings early on Friday, October 19. On the week, 1-month Libor fell 16bp to 4.79%, 3-month 17bp to 4.98%, and 6-month 17bp to 4.83%. Conditions in the asset-backed CP market continued to normalize. Fed data through Thursday showed average term ABCP rates moving to new lows over the course of the week, with the average 30-day rate down 10bp on week through Thursday to 4.93%, the average 60-day rate steady at 4.97%, and the average 90-day rate down 7bp to 5.01%. Our CP desk observed good activity in term ABCP funding through most of the week, before month-end considerations and a desire to wait for the expected rate cut led to a shift back towards more overnight activity Friday. They also noted that well established domestic ABCP programs were funding term issuance at Libor give or take a fewbp through the week, moving back towards historical norms.

The small number of key economic releases over the past week showed continued weakness in housing and some deterioration in labor market conditions, but stronger than expected capital spending and inventory accumulation that further boosted our estimate of Q3 GDP to +3.5% from +3.1%.

Existing home sales plunged 8.0% in September to a 5.04 million unit annual rate, low in the period since 1999 that single family and condos have been reported. Single-family sales fell 8.6% to 4.38 million, low since early 1998, and condo sales fell 4.3% to 660,000, a five-year low.

The months’ supply of unsold homes jumped to 10.5 months from 9.6, with single-family inventories hitting an almost 20-year high of 10.2 months.

According to the National Association of Realtors, the broadening mortgage credit crunch in August had a big impact on sales, with particular weakness seen in higher priced areas where jumbo loans predominate. Meanwhile, new home sales rebounded 4.8% in September to a 770,000 unit annual rate but only from substantially downwardly revised results for August (735,000 v. 795,000), July (798,000 v. 867,000), and June (797,000 v. 835,000). Homes available for sale declined 1.5% in September, a sixth straight modest decline. Combined with the uptick in the selling rate, this caused the months’ supply of unsold new homes to fall to 8.3 months from the more than sixteen-year high of 9.0 hit in August. September’s inventories, however, remained well above the 5 to 6 months that would be consistent with a balanced market, pointing to significant further pressure on new home construction and pricing going forward.

Also negative was the latest jobless claims report. Initial unemployment claims posted a much smaller than expected pullback in the week of October 20 after spiking higher last week, dipping to 331,000 from 339,000, causing the 4-week average to rise 7,750 to 324,750, high since the end of August. On the positive side, continuing claims the prior week, the survey week for the employment report, were little changed at a relatively low 2.53 million. Still, based on the failure of initial claims to reverse the survey week spike, we cut our forecast for October nonfarm payrolls to +65,000 from +100,000.

On the positive side, a strong underlying durable goods report pointed to a second straight quarter of strong GDP growth in Q3. Overall durable goods orders fell 1.7% in September but only because of a 38% plunge in the volatile defense category. The key core gauge, nondefense capital goods ex aircraft, rose 0.4% on top of an upwardly revised reading for August (-0.1% v. -0.5%), with the September gain led by a surge in machinery bookings (+4.3%) that offset some softness in electrical (-0.4%) and telecom (-0.3%) equipment. Nondefense capital goods ex aircraft shipments gained 1.0% in September on top of an upwardly revised 1.8% surge in August, pointing to solid growth in business investment in equipment and software in the third quarter. We boosted our E&S forecast to +6.7% from +4.5%. In addition, overall durable goods inventories rose 0.4%, the biggest gain since January, pointing to a smaller inventory drag on Q3 growth. We now see inventories subtracting 0.7 percentage points from Q3 GDP growth instead of 0.8pp. Combining the upside in investment and inventories implied by this report, we boosted our Q3 GDP forecast to +3.5% from +3.1%. Coming on top of the 3.8% gain in Q2, this would represent the best six months of growth since the second half of 2003. The trend in capital goods orders still remains weak and investment is likely to soften going forward, but the modest upside in September capital goods orders combined with the surge in capital goods shipments at least reduces downside risks in the same way that the surprising gain in September ex auto retail sales reported a couple weeks ago lowered the downside risks to Q4 consumption. At this very early point, we see Q4 GDP on track for about 2% growth, a bit better than our +1.5% estimate at the beginning of the month.

The upcoming week has a hectic schedule of key data and events. Focus in the first part of the week will be on the two-day FOMC meeting, which will conclude Wednesday. We don’t see much reason for a further rate cut at this point so soon after the front-loaded 50bp cut last month, but the market seems to be forcing the Fed’s hand, and policymakers have offered minimal resistance. The trigger for the recent swing in Fed expectations is not entirely clear. Negative earnings reports and weak housing data appear to have played a role, but with the exception of some softening in jobless claims the overall economic picture actually appears to have brightened a bit in recent weeks. The September employment report was encouraging, and our tracking estimates of GDP growth have drifted higher. At the time of the September FOMC meeting, we had Q3 tracking at +2.3% with Q4 at +1.5%; we now project +3.5% and +2.0%. And while there is still reason for concern, there has been meaningful healing in various previously strained markets. Asset-backed CP rates and spreads have plummeted since early September as have, to a lesser extent, interbank lending rates. Even with the partial recent backtracking, equity and credit markets are also significantly better now than they were in early September when markets began to rally in anticipation of the September 18 rate cut. But having offered negligible pushback against overexcited market rate cutting expectations, the Fed has apparently allowed itself to be bullied into cutting rates anyway this week. We would be shocked, however, if the Fed cut the 50bp the market has moved towards pricing some chance of over the past week. Such a move would establish in investors’ minds the existence of a Bernanke put that would dwarf the old Greenspan put and be terrible for Fed credibility. Beyond this week’s meeting, we expect the Fed to pause in December and to cut a final 25bps at the January meeting. Thus, we still anticipate a funds rate trough of 4.25% in this easing cycle, and look for the Fed to remain on hold for most of 2008 before moving to take back most of the easing over the course of 2009 as the economy sees a solid cyclical pick up.

After the past week’s heavy issuance, more supply news will also be on tap in the coming week, with the Treasury refunding announcement on Wednesday and announcement of Treasury’s revised Q4 and preliminary Q1 borrowing announcements on Monday. We look for a $13 billion 10-year and $5 billion reopening of the 30-year to be announced, which would be unchanged sizes for both. On top of the $2 billion increase in the 2-year size this month, we expect to see some small additional coupon size increases over the course of this fiscal year to help fund what we expect to be a modest widening in the budget deficit to $200 billion from $163 billion and less support from non-market sources of funding.

We don’t expect the next round of size increases until February, however, when Treasury faces its highest financing pressures of the year from the combination of the peak of the tax refund season and a seasonal low point for tax receipts. As far as additional announcements at this refunding, Treasury queried dealers this quarter about possible changes to the timing of auctions, and there may be discussion of moving auctions to earlier in the day to encourage more participation by European investors. Otherwise, we don’t expect any structural changes to the issuance calendar any time soon after the recent elimination of the 3-year. The main financing problem the Treasury faces at this point is that the size of the quarterly refundings has become so small relative to the maturing issues and interest payments that refunding settlement days will see a large cash outflow each quarter going forward. In our view, it would make sense for Treasury to move towards issuing regular large and relatively long-dated cash management bills along with the refundings to address this financing gap instead of attempting to deal with them entirely through big temporary boosts to regular bill issue sizes.

In addition to the FOMC meeting and Treasury refunding, the upcoming week sees a number of key data releases, highlighted by the employment report Friday. Other key releases include consumer confidence Tuesday, GDP, ECI, and construction spending Wednesday, personal income and spending, ISM, and motor vehicle sales Thursday, and factory orders Friday:

* We look for a slight improvement in the Conference Board’s measure of consumer confidence to 102 in October following the drop-off recorded in September. Media focus on the (initially reported) lousy August employment report seemed to have a much greater impact on the Conference Board survey than on the University of Michigan confidence gauge. So the improvement in the September jobs data is expected to have at least a mild positive impact on this month’s Conference Board index.

* We look for another solid gain in GDP growth during the third quarter of +3.5%, with a rebound in consumer spending and a further improvement in net exports leading the way. In fact, consumption is expected to be up 3.5% as lower gasoline prices provide some noticeable stimulus. The strength in consumer spending, together with a better than previously anticipated gain in capital spending in the wake of the latest shipments data, is expected to help push overall final sales up 4% -- which would represent the best advance seen in the past six quarters. Of course, residential construction will remain a powerful headwind, knocking an estimated 0.8 percentage points off growth in Q3. And an outright drawdown in inventories is expected for the first time in more than four years. Finally, the core PCE price index is likely to match the 1.4% rise seen in Q2.

* We expected the employment cost index to rise 0.9% in Q3, matching the gain seen in four out of the past five quarters, with the wage component showing a very slight acceleration tied to the recent hike in the federal minimum wage, while the benefits category posts a trend-like increase of a little better than +1.0%. However, it’s worth noting that a significant portion of the rise in the benefits component of the ECI these days reflects skyrocketing pension and health insurance costs for state and local government workers. Finally, on a year/year basis, the ECI is expected to tick up slightly to +3.4%.

* We look for construction spending to fall 0.4% in September, which would mark the third decline in the past four months. The starts data point to another sharp drop in residential activity, which is likely to be only partially offset by gains in the nonres and pubic categories.

* We expect September personal income to rise 0.5% and spending 0.4%.

The labor market report pointed to a rebound in income growth during September following on the heels of a subpar advance in August.

Meanwhile, the retail sales figures imply a modest rise in spending.

Finally, based on our translation of the CPI results, the core PCE price index is expected to be 0.19% in September, with the yr/yr rate just barely rounding up to +1.8%.

* The regional manufacturing reports that have been released to date point to some modest deterioration in the national results. Thus, we look for the headline ISM index to be down about a half point in October to 51.5, reaching the lowest level since March. Some slippage in the key orders component is expected to be responsible for the bulk of the dip.

Finally, the price gauge -- which has been drifting lower in recent months -- is likely to post a slight uptick in October.

* With automakers continuing to push incentive offers in an attempt to clear out the leftover 2007 models, October sales appear to have held steady at 16.2 million units annualized. Year-to-date, sales have averaged 16.1 million units. The mix of activity during October is expected to remain tilted toward the light truck category.

* We look for a 65,000 rise in October nonfarm payrolls. Trends in withheld tax payments, along with survey results covering both hiring intentions and layoff announcements, suggest that labor demand remains reasonably firm. However, the recent elevation in initial jobless claims points to some moderation in payroll growth during October. We expect to see another drop-off in the construction category as well as further slippage in the temp help sector. Interestingly, while swings in temp jobs are often viewed as a leading indicator of overall employment demand, it appears that the retrenchment in construction activity has been an important driver of the 100,000 decline in temporary help employment that has been seen since the start of 2007. In fact, according to BLS statistics, about 7% of the roughly 2.5 million of all temp workers are tied to the construction industry. Finally, while the unemployment rate is likely to drift up a bit incoming months, it is expected to hold steady in October.

* The drop in the durables component – tied to slippage in the defense and motor vehicle categories – points to a 0.8% pullback in overall factory orders in September following a couple of months of sizeable gains

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Russia/Ukraine
Emerging Inflation
October 31, 2007

By Oliver Weeks | London

(This is an extract from a wider note: CEEMEA: Emerging Inflation in this week's EM Economist)

In the former Soviet Union double digit inflation is once again the norm.  Headline CPI reached 14.4%Y in Ukraine and 11.2%Y in Kazakhstan in September.  From preliminary data we expect around 10.7% in Russia in October.  Richard Berner has argued that global inflation fears are overblown (Global Inflation: False Alarm).  Morgan Stanley's Asia economics team is also sanguine (AXJ: End of Disinflation Cycle?).  In this region we think inflation may prove more persistent.  Certainly much of the pick up is food driven, with food accounting for 59% of the Ukrainian CPI basket and 40% of Russia’s.  In Kazakhstan a credit crunch will ensure that inflation concerns recede over the next few quarters.  However in Russia and Ukraine we expect renewed capital inflows, domestic capacity and labour supply constraints and relatively weak policy responses to keep inflation a major challenge over the next few years even given lower food prices and tighter credit.  As in several other EM countries nominal FX appreciation looks the most likely policy response. 

Capacity constraints in Russia  In Russia the recent acceleration in inflation puts an end to steady disinflation since 2005.  Official core inflation, excluding administrative and seasonal factors, has jumped from an all time low of 6.7%Y in May to 8.6% in September.  Our own measure, excluding all food and petrol, has been stable and close to 9.0% for most of this year.  In the near term we would not be surprised to see headline inflation falling slightly.  As expected and widely reported the government has concluded agreements with many large food producers and retailers to fix retail prices of bread, sunflower oil and various dairy products at October 15^th’s levels at least until the end of the year.  Less public pressure on petrol retailers is likely.  Output growth has slowed significantly in August and September and tightening credit conditions are likely to continue to slow money supply growth over the next couple of quarters.  The long term outlook is less rosy we think.  Administrative limits are only likely to work temporarily.  Competition is not particularly intense, and less so after the government’s ban on non-Russians selling at food markets.  Many retailers are likely to raise other prices to compensate.  A continuing decline in the current account surplus will tend to reduce excess liquidity but with much of the current surplus automatically sterilised by the Stabilisation Fund, we expect a persistent capital account surplus to be instrumental in driving strong money supply growth.  Meanwhile the economy continues to come up against significant capacity constraints.  Fixed investment has at last begun to accelerate, but still accounts for just 21.5% of GDP and is showing recent signs of renewed weakness as credit conditions tighten.  Also in contrast to most of Asia are increasing labour shortages.  US Census Board projections have the labour force falling 4.5% over the next decade, yet policy and popular feeling remain relatively hostile to immigration.  Unemployment is at 6.0% and real wage growth still averages 16.5%Y this year. 

 

Policy still stimulative  Apart from price controls policy looks unlikely to address this before March 2007’s presidential elections.  Monetary policy remains closely focused on excluding the possibility of a bank failure before the elections.  Fiscal policy is also firmly in pre-election mode, the government having just revised down the 2007 federal surplus target from 4.8 to 2.8% of GDP.  Under the three year budget framework fiscal expansion will continue as the government continues a strategic shift from saving oil revenue to spending on domestic infrastructure.  Also set into law are retail gas and electricity price rises of 26.8% and 15.5% pa respectively in 2008-10.  In the longer term the solution will be in a shift to formal inflation targeting, with a clear inflation priority, deeper domestic markets and positive real interest rates.  With the government looking unwilling to delegate the necessary authority to the CBR in the short term, continued high inflation looks likely, and early next year a resumption of nominal RUB appreciation.  We do not however expect a return to capital controls given the government’s strong interest in foreign inflows and investment. 

FX revaluation increasingly likely in Ukraine  Ukraine is suffering a more severe inflation shock but looks more likely to attempt a monetary policy response in the near term, given its different electoral cycle.  Inflation excluding food and petrol has actually declined this year, from a peak of 24.4%Y in March to 13.3%Y in September.  However the degree of suppressed inflation is higher even than in Russia given informal pre-electoral restrictions on food prices and the failure to pass on large imported gas price rises to households.  The labour force situation is also worse than Russia’s given massive emigration and growing demand for Ukrainian workers in central Europe.  The UAH peg to the USD has both kept the currency weaker on a trade weighted basis than Russia’s USD-EUR basket arrangement, and encouraged a boom in household USD borrowing.  Balance of payments pressure for FX appreciation is less obvious than in Russia, given a current account deficit at 3.0% of GDP and widening.  Another large rise in imported gas prices for 2008 – we currently expect a hike from USD 130 per thousand cubic metres to around USD 180 – is likely to widen the deficit to around 5.5% of GDP next year.  However we expect a still larger capital account surplus as capital flight slows while FDI and long term foreign borrowing grow.  (See also Ukraine: Still afraid of floating? September 3^rd.)  We expect the new government to be slightly bolder both in passing on gas price hikes to the population and in allowing FX flexibility.  Recent comments from previously conservative members of the National Bank management suggest that many have picked up on the political case for flexibility and tighter monetary conditions.  We continue to expect UAH appreciation towards 4.9 to the USD, most likely in January.  Nevertheless inflation looks unlikely to return to single digits before 2009 at the earliest. 

 

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Singapore
Inflation Risks Revisited
October 31, 2007

By Deyi Tan & Chetan Ahya | Singapore

Underlying inflation has continued to move up, with the latest data showing it (ex private transport and accommodation) picking up further to 3.0%YoY in September from about 1% earlier this year. The central bank has already responded by tightening monetary policy and steepening the pace of appreciation of the NEER.  Moreover, our current base case forecast assumes that global growth will slow, weighing on Singapore’s outlook, thereby reducing potential inflation pressures. Indeed, we expect GDP growth to moderate to 6.1% in 2008 from 7.7% in 2007. However, recent global and local developments imply that inflation risks persist.

Inflationary Sources Are Both Global and Local

As highlighted in our note Overheating risks: Implications for Monetary Policy, dated October 3, we believe inflationary pressures are rising from global as well as local factors. Global factors include the rise in oil and food prices, while local factors include property reflation and wage pass-through. The higher oil and food prices are likely a result of the robust growth in emerging markets driving the incremental demand for energy and higher income there driving the demand for protein. This same strong global growth has translated nicely to above-trend momentum for Singapore as the economy diversified itself over the years to better ride the global tide (financials - liquidity and wealth growth; transport - oil demand and ageing rig supply; and property – tourism and population growth). In turn, this has helped drive asset price reflation and wage pickup.

For Singapore, a services-oriented, high-per-capita-income economy, the risk from local factors in the form of rise in non-tradables could be a more important factor to watch at the margin, particularly when domestic demand has stayed stronger for longer. Though our long-term growth forecasting model indicates that the structural growth path in Singapore has been lifted by the government’s reforms, we believe supply bottlenecks appear to be emerging, which could add to such pressures. Indeed, our analysis of the trend in components of inflation indicates the following:

1) Non-tradables inflation has risen to a 16-year high: Prices of tradables (excluding private transport), which are typically determined by global markets, have risen lately to 2.6% YoY in September largely due to food prices, but still stayed within the historical range of below 3%. On the other hand, prices of non-tradables (excluding accommodation), which are typically determined by local conditions, have risen to a 16-year high of 3.8%YoY. Also, such inflationary pressures were on the back of discretionary spending items such as education and holiday expenses.

2) Non-tradables inflation is now significantly higher than tradables inflation: To be sure, non-tradables inflation, at an average of 1.9% from 1990 until now has traditionally been higher than tradables inflation (1.3%), perhaps reflecting the effectiveness of the exchange rate in combating imported inflation as well as global competitive forces in keeping tradable inflation manageable. However, seldom has the disparity between tradables and non-tradables been this wide. Had the current property reflation been fully captured in CPI, we believe the divergence would have been even bigger. 

More Cost-Push Non-Tradables Inflation To Come?
We believe non-tradable inflation could face further upside risks, particularly amid wage and real estate price pressures. The two would constitute a bigger share of costs for the services industry as compared to the goods industry. To that point, the labour shortage in the services industry is getting more marked. Services employment has risen but job vacancies have risen even more and this is driving a wedge between services and goods industry wage growth, which could spur further cost-push pressures on non-tradables. On the other hand, while home property reflation is understated in the CPI, the pass-through from higher retail space or office space costs could pick up if the economy remains in strong cyclical health beyond the global softlanding. 

Would the Recent Exchange Rate Tightening Be Enough?
In our view, the recent development of non-tradables inflation being higher than tradables could be an issue for the central bank’s monetary policy effectiveness. The rationale behind the 1981 inception of the managed exchange rate has been due to the openness of the economy and its exposure to trade and capital flows. However, the effectiveness of the policy appears to be asymmetric. Indeed, the impact of exchange rate movements on tradables has been traditionally much stronger than that on non-tradables. This is because exchange rate movements on tradables inflation is direct through the change in prices while its impact on non-tradables is indirect and works through the more convoluted route of the exchange rate impact on money supply and interest rates. With non-tradable inflation now being the bigger concern of the two, the risk is that the degree of exchange rate tightening would have to be higher to achieve the same effect on inflation, compared with in the past. 

 

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Asia
Indian Monetary Policy: Don’t Expect Immediate Cut in Policy Rate
October 31, 2007

By Chetan Ahya (India)|

Monetary policy measures in line with our expectations

The RBI today announced a 50bp hike in the cash reserve ratio (CRR) to 7.5% but left policy rates unchanged. This move was in line with our expectations. However, consensus did not expect a hike in the CRR. The RBI has also maintained its monetary stance, implying that it will not cut policy rates immediately. More importantly, the RBI has reduced its medium-term inflation target to 3% from the earlier stated 4.0-4.5%. The monetary policy measures and policy stance indirectly convey the dilemma facing the central bank when higher rates are attracting capital inflows but rising oil and food prices pose risks to the inflation outlook, making it difficult to cut policy rates.

Monetary policy reaffirms reduced concerns regarding overheating

Over the last few months, clear signs of a slowdown in growth have emerged. Aggregate revenue growth for around 3,000 companies has also decelerated to 17% during the quarter ended June 2007 from the recent peak of 31% during the quarter ended September 2006. A number of other indicators – including export growth in rupee terms, automobile sales, credit growth and railways freight traffic growth – corroborate this trend.

More importantly, as we have been highlighting, overheating concerns have also been reducing. WPI-inflation has decelerated to 3.0-3.5% from the peak of 6.4% (average) in March 2007. Inflation, excluding food and global commodity-linked products (core inflation), has also decelerated to 5% for the week ending October 13 from the peak of 6.5% (average) in April 2007. Property purchase transactions have also declined significantly, with some pockets already witnessing a decline in prices. Weakening property demand is also reflected in the low growth of just 3% YoY in mortgage disbursement of the three large players (ICICI Bank, HDFC and LIC Housing). These three lending companies combined account for about 42% of the all-India mortgage loan portfolio. The current account deficit (excluding remittances), though high, has also stabilized at around 4%. Credit growth has moderated to 23.3% in the fortnight ending October 13, 2007 from the peak of 33.1% in June 2006. Credit growth is lower than deposit growth.

What is holding the RBI back from cutting policy rates?

We believe that there are three key issues weighing on the central bank’s relatively cautious approach to monetary policy. First, while headline inflation is at 3.1%, core inflation (non-oil non-global commodities) is at 5%, as of October 13, 2007. 

Although both core and headline inflation are within the RBI’s comfort zone of 5%, the recent rise in oil and the CRB foodstuff index has raised concerns. According to our Oil and Gas analyst Vinay Jaising, domestic oil product prices are marked to US$54/bbl (WTI equivalent) compared with current international price of US$93/bbl. Indeed, food price pressure has lifted the consumer price index (industrial workers) for the past consecutive months to 7.3% in August 2007 from a trough of 5.7% in June 2007. CPI for agricultural labourers has increased to 7.9% in September 2007 from 6.3% in July 2006. Moreover, the RBI has also highlighted its concerns regarding the potential risk of sharp inflation in China getting transmitted to its trading partners. Second, while there are clear indications of a decline in property purchase transactions, prices remain at unusually high levels. A big drop in lending rates could quickly revive euphoria in the property market. Third, the RBI is also concerned about elevated levels of asset prices, driven by less stable capital inflows. The RBI has highlighted that “these pools of capital, which are private, often opaque, highly leveraged and largely unregulated, have the potential for heightening risks to the domestic financial system and posing a threat to financial stability”. The RBI remains concerned about the risk of potential reversal in these inflows.

No change in our view on the lending rates outlook

We believe that the most important indicator for assessing the ‘effective’ monetary policy environment will be banks’ lending rates. The RBI has been pursuing different types of measures to influence banks’ lending rates. These include adjusting the repo rate (the rate at which the RBI injects liquidity into the banking system), the reverse repo (the rate at which the RBI absorbs excess liquidity), the cash reserve ratio, risk weighting for bank loans, and issuing market stabilization scheme bonds. The combined impact of these measures on banks’ lending rates determines the ‘effective’ monetary policy environment. As we highlighted in Interest Rates – On a Clear Downtrend, July 26, 2007, we believe that evolving banking system dynamics will force a cut in lending rates. Over the last two months, banks have already reduced their lending rates by 50-75bp. 

In our view, lending rates have peaked and are likely to decline going forward. The RBI’s measures aim only to prevent a sharper fall in lending rates. In other words, we believe that monetary policy is on a path of gradual ‘effective’ easing. The pressure to cut lending rates would be necessitated by credit growth decelerating further below deposit growth. We maintain our view for lending rates to fall by 75bp by March 2008.

Risks of unconventional policy measures

The RBI has included an additional line in its monetary policy statement indicating that overall monetary policy will continue “to be in readiness to take recourse to all possible options for maintaining stability and the growth momentum in the economy in view of the unusual heightened global uncertainties, and the unconventional policy responses to the developments in financial markets”. While there are no specific indications of the potential measures being considered, we believe that the RBI may consider measures to reduce capital inflows. Based on FX reserves increase data, it appears that India is likely to have received capital inflows of US$29 billion during the five-week period ending October 19, 2007. This represents annualized inflows of US$300 billion compared with India’s current absorption rate of about US$50 billion. This sharp rise in capital inflows is a key concern for the policy makers.

While the recent participatory notes-related measures are likely to weigh on equity inflows, debt inflows continue unabated. India is estimated to have received about US$95 billion of capital inflows over the last 12 months. We estimate that, out of this, about US$30-35 billion has been external debt inflows, US$25 billion has been FII equity investments (cash plus derivatives), US$10 billion is net FDI investments and the balance includes other inflows (which are in form of complex financial instruments).  Hence, external debt has been the largest source of capital inflows. We believe that the policy makers will wait to see the impact of the PN-related measures on capital inflows. If capital inflows remain high, we do not rule out the possibility of fresh capital control measures, with external debt-related inflows being the next target. 

 

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