UK
Where Next for UK Rates?
December 07, 2007

By David Miles | London

This week the Bank of England cut rates by 25bp to 5.5%. Just a few months back, the overwhelming consensus was that by the end of this year the BoE would be increasing rates to a level of 6% or higher.  That view was an over-reaction to temporarily high inflation in the first half of this year. There are signs now that many analysts and commentators – and maybe also investors – are already extrapolating too much into the change in the direction of rates from the BoE. The conventional wisdom has become that rates will fall two or more times next year. The consensus seems now to be that rates will be at 5% – and very likely lower – by the middle of next year.

A reading of the BoE’s statement accompanying the rate decision yesterday – and a cool look at the economic horizon – suggest to us that this view may somewhat exaggerate the likely slope of the downward trajectory in rates.

In the statement accompanying the decision, the MPC points to signs that growth is now beginning to slow and to deteriorating conditions in financial markets and a tightening in the supply of credit to households and businesses. But it also flags that upside risks to inflation remain, even though slowing demand growth should ease pressure on supply capacity. 

We had felt that a rate cut at this meeting was more likely than an on-hold decision, but that the decision would be close and tough.  We will get more sense of whether that was the case with the minutes of the meeting (published on December 19).  Some MPC members may have voted for rates to remain on hold – factors including elevated inflation expectations and the spectre of upcoming private sector wage rounds may have made some MPC members cautious of loosening monetary policy.  Further, the signs of a current slowdown are welcome, to a degree, since the MPC felt that a slowing economy was necessary to contain inflationary pressure. All in all, we suspect the decision to cut rates was a fairly close one. More important, several of the majority that voted for a rate cut will not – we think – be expecting now to push for consistently lower rates at the next few meetings.

Certainly, there are clear risks of a sharp slowdown in the UK and that domestically generated inflation pressures will recede so fast that the BoE will want to take rates very clearly into accommodative territory next year – that is to levels sub 5%. But we are sceptical that this should be a central forecast. Our own, long-held view is that the single most likely outcome is that the BoE will want to take rates to a neutral level quickly, and yesterday’s cut was the first leg of that. Another rate cut to 5.25% would put monetary policy on a neutral reading, in our view. If growth slows significantly next year to around slightly under 2% – but with inflation likely above target in the first part of the year – the BoE may well feel dis-inclined to cut rates further than 5.25%,  at least so long as the growth prospects for 2009 seem even marginally brighter. And that is the scenario we reckon to be the single most likely one.

Around that scenario, the risks are not symmetric though. We believe that the chances of a much slower downturn in the UK are significant. It is that judgment that drives our assessment that the probability of rates falling further than 5.25% by the middle of next year is greater than that they stay above it. Because of the downward skew in the distribution of rates around our single most likely outcome (of 5.25%), the mean rate for mid-2008 is a bit under 5.25%, as is the median.

But the risks are not all one way – we reckon that there is almost a 15% chance that rates may actually have moved back up from today’s level of 5.5% by mid-summer. As we said back in June – when our call for a rate cut by year-end looked to most people pretty bizarre – six months is a long time.

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Currencies
The US S&L Crisis, 1991 Recession and the Dollar
December 07, 2007

By Stephen Jen | London

Summary and conclusions

The US economy is facing a real shock from the deepening housing recession and a nominal shock from the full-blown credit crunch.  There are no exact historical parallels, but the S&L Crisis that plagued US policy makers from the mid-1980s to the mid-1990s and the recession of 1991 may be related historical benchmarks worth examining.  In this note, we take a first look at these two episodes, with a view to formulating an opinion on how the dollar might be affected by the current crisis.

The US Savings & Loans Crisis was serious

The US S&L Crisis was, back then, the single-most severe financial crisis faced by the US since the Great Depression.  The US housing market weakened steadily in the 1980s.  Interest rates were high and volatile during the late 1970s and the early 1980s, which exerted considerable pressure on the US S&Ls.[1]  In 1986, the FSLIC (Federal Savings and Loan Insurance Corporation) – the deposit insurance scheme funded by the thrift industry but guaranteed by the government – first reported being insolvent (incidentally the main reason why 1986 is remembered as the beginning of the S&L Crisis).  The FSLIC eventually worked through some US$125 billion-worth of bad S&L assets.  In 1989, the RTC (Resolution Trust Corporation) was established, which resolved an additional US$394 billion worth of assets.  As a result of the S&L Crisis, in the decade since 1986, the number of federally insured thrift institutions in the US fell by approximately 50%.[2]  When the dust settled, the cost of the clean-up of the US S&L Crisis reached US$153 billion, in ‘current’ terms equivalent to some 2.6% of US GDP in 1991.[3] 

While the US S&L Crisis is very different from the Sub-prime Crisis of 2007, in terms of the net clean-up cost, the total losses associated with the Sub-prime Crisis will need to reach US$350 billion to rival that of the S&L Crisis (and reach the same percentage of current GDP).  

USrecession of 1991

Though the US S&L Crisis did not directly cause the recession of 1991, it did restrain somewhat the availability of bank credit and impair banks’ capacity to expand their balance sheets.  However, the impact from the former to the latter was not evident.  In fact, there is still no consensus on what exactly caused that recession.  What we do know is that, in contrast to the recession of 2001, the 1991 recession was consumption-led.[4]  Consumer sentiment deteriorated sharply before the leading indicators began to deteriorate in earnest, as if the US consumers had anticipated a slowdown, due possibly to their realization that their debt levels were not sustainable or, more generally, that economic growth was not sustainable.   

During this growth slowdown, inflation actually accelerated from 1988 to 1990 and reached a high of 6.4% in October 1990.  A sharp deceleration in inflation ensued, with inflation (both headline CPI and PCE) declining to around 2.75% by late 1991.  In the ensuing three years, headline inflation hovered within the range of 2.25-3.25%.   

Interest rates during this time were sharply reduced.  In nominal terms, the FFR was cut from 9.75% in spring 1989 to 3.0% by 1993.  From 1991 to 1994, real short-term rates continued to fall (real FFR becoming negative for much of this period, and the 2Y real interest rate reaching 1%), while the 10Y yield held steady at around 3%, leading the 10Y-2Y yield spread to reach around 2.5% by 1993.  It is widely appreciated that this steep yield curve in the early 1990s facilitated the recovery of the US banking system. 

Lessons for the current situation

We have the following thoughts:

1. The risk of a recession in the US has risen[5].  To minimise the fallout from a recession, as the experiences from 1991 and 2000 suggest, the Fed may need to cut the FFR aggressively.  In the 1991 episode, the Fed lowered the FFR from, as we mentioned above, 9.75% in 1989 to 3.0% by 1993.  Similarly, in the early 2000s, the FFR was reduced from 6.5% in 2000 to 1.0% by 2003.  The 10Y-2Y yield spread also widened (steeper yield curve) in both episodes.  The key question here is whether the US will fall into a recession in 1Q and 2Q of 2008, or whether this will turn out to be mostly a ‘liquidity’ issue with little implications for the real economy, i.e., similar to what happened in 1998.  In 1998, following the Russian Crisis and LTCM, the Fed eased by ‘only’ 75bp and has been widely criticised for fuelling the IT bubble that ensued.  Thus, essentially, the Fed is trying to come to a conclusion on whether what we are about to experience will be more reminiscent of the recession of 1991[6] or the credit event in 1998.  With the risk of the former scenario rising, the Fed could incrementally adopt an easier stance; lingering inflationary risks will make this move a gradual and controlled one. 
2. Thought 2.  Similarities and differences with the S&L Crisis.  The S&L Crisis, as mentioned above, did restrain the availability of credit in the economy, as a result of the impairment of the capital position of financial institutions.  But the magnitude of the impact on economic activities in general was unclear.  If anything, the causality ran from the latter to the former.  The current credit crunch may very well turn out to be less costly for taxpayers, but the ‘blockage’ in the credit system could have a more direct impact on the real economy. 
3. Thought 3.  The RoW slowed with the US in 1991.  Per capita world growth was slightly below 2% before the US entered into recession in 1991.  It bottomed at around 0.5%Y in mid-1991, as the RoW was dragged down by a slowing US.  The Buba, the Bank of Japan and other major central banks eased with the Fed.  This was the main reason why the dollar did not fall despite Fed rate cuts:  the dollar did not show any material weakness against the DEM or the FRF.  Against the JPY, the USD weakened for JPY-specific reasons.  In short, the global economy was tightly coupled back in 1991.  As a comparison, per capita world growth was at 4% in 2006 – a much higher starting point.  While we suspect that the global economy will be less coupled this time around, most of the RoW will almost certainly experience some slowdown, which will help limit somewhat the downside for the US dollar. 

Bottom line

We examined the US S&L Crisis of the 1980s-1990s, and the 1991 recession.  The direct cost of the Sub-prime Crisis could possibly reach 2.5% of GDP (US$350 billion), as with the S&L Crisis.  The Fed is contemplating whether what we are confronting is more akin to the 1991 recession or 1998 credit event.  If it is the former, the probability of which has risen recently, the Fed may need to ease significantly further.  The consequences for the dollar will be a function of the extent of economic coupling.  In 1991, the dollar did not depreciate despite aggressive Fed cuts, because of economic coupling.  To the extent that consumption-centred recessions tend to last longer than investment-led recessions, the decoupling thesis is about to undergo a stress-test.

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[1]Essentially, the S&Ls were squeezed by ‘negative carry’ as the mortgage interest payments were not high enough to compensate for the high market deposit interest rates.  There were other reasons cited for the S&L Crisis, including the phasing out of Regulation-Q (which led to a significant wave of withdrawals as other depository institutions were no longer restricted on how high an interest rate they could offer on deposits), deregulation of state and federal depository institutions (which permitted thrifts to enter riskier loan markets), and procrastinated policy reaction, which allowed many insolvent institutions to continue to operate and incur greater losses (through the so-called ‘supervisory goodwill’).  In turn, regulatory forbearance permitted some S&Ls to take more risk and ‘gamble their way’ out of insolvency.  A problem that was triggered by high interest rates and the oil shock of 1979 eventually snowballed into a massive systemic problem that lasted until the mid-1990s.  

[2]T. Curry and L. Shibut (2000), The Cost of the Savings and Loan Crisis: Truth and Consequences, FDIC Banking Review, December. 

[3]Ibid.  Of this amount (US$153 billion), tax payers paid out US$124 billion and the thrift industry itself absorbed the rest. 

[4]In a paper by Prof. O. Blanchard in the American Economic Review, Consumption and the Recession of 1990-91, he states, “In contrast to its predecessors, this recession does not have an obvious proximate cause”.  However, he argues that the main proximate cause was a ‘consumption shock’, i.e., a decrease in consumption relative to its normal determinants. 

[5]See our piece in this week’s FX Pulse, “The Odds of a US Recession Within a Year Are Now 1 in 2”.

[6]The recession of 1991 may be a closer analogy to today’s situation, given that it was centred on a consumption slowdown.  The 2000 recession was an investment slowdown, from which the recovery was relatively rapid.

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Currencies
The Odds of a US Recession Within a Year Are Now 1 in 2
December 07, 2007

By Stephen Jen & Luca Bindelli | London

We have updated our recession predictor models with the latest financial data.  The main points worth noting are as follows:

1. The pure bond market-based models’ probabilities are still declining, in line with the ongoing Fed easing policy. 
2. On the other hand, our preferred model, Model 10 (which accounts for credit and equity markets conditions, in addition to bond markets), is assessing the chances of a recession as being roughly one in two within the coming year (the figure is 48%).   Model 1 and Model 10 have converged.
3. The main drivers of this increase in recession risk were: (i) A fall in equity market performance (from nearly +13%Y in October to +5%Y in November). (ii) The Sr. Loan Officer Survey suggests tightening credit conditions going into year-end. (iii) A drying up of the commercial paper outstanding market (-3.4%Y). (iv) The credit spread widened further, although only marginally.
4. These developments have more than compensated for the decrease in FFR and 3m-10y spread, so that the overall risk of recession has increased considerably. In other words, the current Fed easing and the associated lower perceived risk of recession in bond markets (alone) were not enough to decrease the overall perceived risk of recession when accounting for equity and credit market developments.
5. A Fed cut to 4.25% is expected by our US economists this month. All things being equal, this would lower the probability of our preferred model to 42%. If furthermore the yield spread narrows by the same amount, this probability would be 33% (back to October levels). However, if we suppose that credit conditions deteriorate slightly and that the current S&P futures contract for end-December is reached (both arguably incorporate future expected Fed cut(s)), the model probability would remain broadly unchanged from its current level.  Everything else being equal, a 25bp Fed rate cut would ‘offset’ a 1% decline in the S&P or an 8% rise in the credit spread.

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Currencies
CHF: SNB – the Only One in Control?
December 07, 2007

By Luca Bindelli | London

SNB monetary strategy helped ride the storm

While European and US markets risk premiums (as measured by 3M Libor over the Official Target Rate) are still hovering between 60 and 90bp, the SNB has managed to achieve a zero premium in the Swiss money market: Libor now matches the middle of the target set by the SNB.   In response to the surge in Libor in early August (about 10bp), the SNB immediately lowered the 1-week repo rate from 2.43% to 2.29%, and below 2.1% more recently.

Contrary to most other G10 central banks, the SNB decided in 1999 not to target a policy rate. Instead, it opted to use the 3-month Libor market rate as its policy objective. The main reasons were twofold:

(i) The SNB did not want a rigid operational objective and preferred a rate able to fluctuate in response to market tensions and absorb temporary shocks. Moreover, the importance of the exchange rate fluctuations for the Swiss economy required a policy framework flexible enough so that any eventual FX tensions would not dictate changes to or be interpreted as a change in policy orientation.

(ii) The Libor defines a monetary policy that is reflective of true credit market conditions and limits the risks of divergence between the official rate and the market rate.

The effectiveness of monetary policy itself is closely linked to the operational objective of a central bank. In fact, what we have witnessed since August is reminiscent of the fact that actual credit market conditions (as reflected by interbank lending conditions) may not be dictated by the official rate, and that their disconnect reflects a lowering of the effective control central banks may have on market credit conditions (point (i) above).

But will this be enough?

Renewed global funding pressures still challenge the SNB, and with the global growth outlook becoming more uncertain, next week’s policy decision is a close call.

The overall importance of the financial sector for the Swiss economy (15% of GDP, 6% of total workforce), and the possibility of abrupt swings in the CHF, especially in EUR/CHF, are clearly sources of risk for the SNB (see below on the latter risk). But we do think that risks are limited on both fronts.

While we do believe that there are only minimal chances that the SNB cuts rates (this would be related to a sudden and abrupt worsening of funding pressures in Switzerland), the choice between remaining on hold and implementing a rate hike is not trivial, and will probably be a source of intense internal debate.

We still believe that the SNB will raise next week

First, fundamentals are still strong. Growth in 3Q has surprised on the upside (2.9%Y), as did inflation in November (up 1.8%Y). The actual data will likely ‘overshoot’ the September SNB forecasts for the year-end (in terms of both inflation and growth). Considering energy/food price developments, and the AXJ region likely turning into an inflationary force, risks on inflation are definitely tilted to the upside going into next year, in our view.

Second, we think that the exchange rate is still undervalued (this is especially true against the EUR, for which we calculated a close to 20% undervaluation), and it provides a welcome buffer to any moderate global slowing activity.

Third, and related to the second point, the pass-through from past exchange rate weakness is increasingly feeding through imported prices (in November, imported prices accelerated to 3.6%Y from 1.8%Y the previous month).

Third, as discussed above, a stable and normalised money market is important for any central bank in conducting monetary policy effectively (especially in a period of changing policy stance and market turbulence). We think that the SNB has undoubtedly been successful in achieving this.

For these reasons, and as we argued in the past, it would make sense for the SNB to raise rates to a neutral level before any eventual slowdown materialises next year (which we indeed think is likely). This would give the SNB useful ‘extra’ ammunition next year if borrowing costs needed to be cut so as to accommodate a slowdown. If global credit conditions worsen or US economic conditions deteriorate more than expected, such a hike would not be possible in March (the next SNB meeting). Also, the lags in policy transmission would make it more adequate to raise rates now (as the economy is still strong).

What is the most likely CHF path?

We still think that the CHF will appreciate in the coming weeks and into next year. The most obvious trades remain long CHF against late cycle economies. The US, the UK in particular, and probably Canada represent the most obvious candidates. Despite the recent sharp appreciation of the CHF against these economies, we think there is room for further gains. In the case of Canada, the recent BoC decision and the possibility that the market may price in more ‘re-coupling’ with the US going forward make this a good relative value trade. The pace of this strengthening will also likely depend upon the Swiss Libor path, not necessarily because of the narrowing carry (although it should matter a bit, even in the current context), but mainly because of the signals the SNB would give in terms of underlying fundamentals amid global uncertainty.

In simple terms, these signals would be: (i) The economy is resilient as a whole, and growth may slow from a higher level than expected back in September; (ii) Inflation is a medium-term concern; and (iii) The financial sector is able to cope with a 25bp increase in the 3-month Libor rate.

EUR/USD is important for the SNB

The resilience of the euro area is not only important for Swiss external growth, but also from a EUR/USD perspective. If Europe does not show signs of strong weakness and the EUR/USD accordingly remains relatively supported, the EUR/CHF, while likely decreasing, would do so in an orderly fashion, so that the risk of sharp EUR/CHF depreciation would be less of a threat to the SNB.

Bottom line

It is a close call, but the SNB will likely raise rates next week. This will make a difference to the pace of CHF appreciation going forward. Our bias remains for the CHF to appreciate against late cycle economies.

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India
What Is Driving Headline Inflation Lower?
December 07, 2007

By Chetan Ahya | Singapore

Sharp deceleration in headline inflation

Over the last few weeks, headline inflation has moderated well below the central bank’s comfort zone. The more widely followed Wholesale Price Index (WPI) slowed to 3.2% during the week ended November 17, 2007, from the peak of 6.7% during the week ended January 27, 2007. The inflation-based Consumer Price Index (Industrial Workers) has also moderated, to 5.5% in October 2007 from the peak of 7.9% in June 2006. Three key factors driving inflation lower are: (i) a moderation in the pace of price rises for commodity products; (ii) a deceleration in food price inflation; and (iii) a delay in the price hike for domestic oil products. In addition, a higher base-effect factor has helped to contain headline inflation within the 3-4% range.

Global commodity-linked products: Inflation for the global commodity product basket, which has a weighting of 29.9% in the WPI, decelerated to 1.8% during the week ended November 17 from 7.3% during the week ended January 27.  This deceleration was primarily due to the rupee’s appreciation and softening in the pace of the year-on-year rise in commodity prices.

Food products: Normal output growth for the summer crop has helped to contain food inflation over the last three months. Moreover, global food prices have also moderated over the last few months. The moderation in food price inflation is the major factor behind the softening in the Consumer Price Index inflation. For instance, inflation in the food component of Agricultural Laborers’ (AL) CPI slowed to 7.8% in October 2007 from 11.8% in February 2007.

Domestic oil prices: While international crude prices have risen 60% over the last 12 months, the government has yet to pass the price increases on to the domestic market. Indeed, as per our Oil and Gas analyst Vinay Jaising, the current weighted average realization of oil products in the domestic market implies an average crude oil price of US$60/bbl (WTI). Even if the government were to set the domestic oil product price at US$75/bbl, we believe that headline inflation would rise by about 1.7% (excluding the pass-through impact on other products).

Softening in domestic demand has also helped

Aggressive monetary tightening pursued by the central bank since 4Q06 has caused a meaningful slowdown in aggregate demand, particularly consumption growth. Corporate revenue growth for a broader basket of 1,850 companies decelerated to 11.6% during QE-September 2007 from 32% during QE-September 2006. This softening of domestic demand is reflected in WPI Inflation, excluding food and global commodity-linked products (core inflation), which has decelerated to 4.7% during the week ended November 17 from 6.7% during the week ended March 31, 2007.

Slowing consumption, strong capex improving underlying demand-supply imbalance

The RBI’s policy measures have successfully engineered a soft-landing in the growth cycle. More importantly, we believe that these measures should gradually improve the demand-supply imbalance, which was at the heart of recent overheating of the economy. While consumption spending has significantly moderated, investment growth has remained strong. The interest- rate-sensitive segments such as automobiles and consumer durables have reported an extremely weak trend over the last two quarters. However, growth in capital goods production has remained steady at high levels. Although a higher cost of capital and slowing consumption demand will result in some moderation of capex growth, we expect it to remain relatively high.

Yet policy rate cut is not likely in the near term

We do not expect a policy rate cut in the near term. First, while investment growth has picked up, a long gestation period, particularly for infrastructure, implies that effective supply (commissioning) of new capabilities will take longer. Hence, we believe that the RBI would like to keep aggregate demand growth at current moderated levels before it reverses its monetary policy stance. Second, the RBI remains concerned about higher global oil and food prices weighing on inflationary expectations. Our Oil and Gas analyst estimates that if international crude prices stay around current levels of US$88/bbl for the next 12 months and the government leaves domestic oil prices unchanged, the oil subsidy burden will rise to 1.8% of GDP in this period. The longer oil prices stay at current levels, the higher the pressure on the government to hike domestic fuel prices. Similarly, while international food price inflation has moderated recently, absolute levels remain elevated. We believe that the RBI would prefer to see a meaningful correction in international oil and food prices before officially signing off on a loosening of monetary policy. Meanwhile, market forces will ensure that banks continue to pursue a moderate reduction in lending rates. This will be inevitable, as credit growth is now lower than deposit growth, resulting in a fall in the credit-deposit ratio.

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