Funding Pressures, Adverse Feedback Loops and Monetary Policy
April 15, 2008
By Richard Berner | New York
The Fed has taken aggressive steps to provide support to financial markets and to a broad range of financial institutions, and market pricing suggests that the financial crisis peaked in mid-March. Spreads on risky assets and in some money markets have narrowed. For example, spreads for investment-grade corporate CDX indexes have declined by about 60 bp over the past three weeks, while indexes for leveraged loans and commercial mortgage-backed securities have narrowed comparably, and quality spreads for commercial paper have turned down by about 30 bp. The flight to quality evident at the short end of the yield curve has abated, as effective yields on 1- and 3-month bills have backed up by 60-80 bp from rates previously ranging between 25-65 bp.
Money-market pressures remain uneven But financial market pressures are not over, and a contracting economy may yet promote an ‘adverse feedback loop’ as it weakens the value of collateral, forces lenders to deleverage and raise capital, and thus further tightens credit availability. While still narrower than three weeks ago, risk spreads widened by 25-30 bp over the past week. Likewise, funding pressures have resurfaced in money markets, with a continued widening in 3-month Libor-OIS spreads to 80 bp, and declines of 63 bp and 20 bp, respectively, in effective yields on 1- and 3-month bills over the past week. To be sure, some of these reversals corrected price action that may have moved too far and too fast. More fundamentally, however, we think that they reflect the pressure from ongoing losses on lenders’ balance sheets and the associated concerns about counterparty risk. Those pressures seem likely to prolong the credit crunch or even intensify it. As a result, we expect that the Fed will ease further and maintain an accommodative stance through late this year. Gauging the extent of those pressures on the price of credit and its availability is never easy, and that’s especially true because the sources of pressure in money markets remain uneven. The Fed has channeled its aggressive actions through five facilities — its regular open market operations, the discount window, and three new ones: the Term Auction Facility (TAF), the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF). Each of these addresses strains at different institutions and in different markets, so it’s hardly surprising that different money-market metrics yield different messages. For example, the discount window and the PDCF provide daily access to funding in amounts demanded by eligible depository institutions and primary dealers, respectively, at a penalty rate. In contrast, the TAF and TSLF auction set amounts of term funding on announced dates to depository institutions and primary dealers, respectively, but are aimed at improving liquidity and functioning in funding markets rather than the needs of individual institutions (for details, see “Understanding the Recent Changes to Federal Reserve Liquidity Provision,” Federal Reserve Bank of New York, March 2008). These differences were starkly evident in money-market spreads last week. The trigger for the reversal in some money markets came from the TAF stop-out (auction) rate exceeding the 1-month Libor rate last week. I agree with our interest rate and FX strategy teams’ view that stepped-up TAF demands and widening Libor-OIS spreads reflect broad concern over bank counterparty risks and precautionary demands for liquidity, especially from weaker institutions, as the reintermediation of bank balance sheets proceeds at home and abroad (see “Money Market Stresses Continue…” April 14, 2008). Unlike the discount window, the TAF is anonymous, so weaker institutions or the US affiliates of those abroad can get some funding while avoiding the stigma of borrowing at the window. Our strategy teams’ research suggests that funding pressures are a global, not just a US, problem. As quality tiering and overseas demand are growing among banks in interbank lending markets, term 1-month Eurodollar deposit and FX implied rates are better measures than Libor of the cost of borrowing for many institutions. In contrast, falling usage and low bid-to-cover ratios for the PDCF and TSLF and reduced tensions in repo markets reflect the success of the TSLF and PDCF in providing funding to primary dealers. The fundamental reason for the deleveraging process, of course, is the growing losses in subprime and other mortgages at both banks and other intermediaries. According to MS credit strategist Vishwanath Tirupattur, global losses from subprime mortgages alone last week stood at $260.7 billion, of which $245.3 occurred at banks and $15.4 billion at other institutions. At that pace, our estimate that US losses in mortgage lending will run at least $400 billion over the next two years may well be too low (see “David Greenlaw et al., “Leveraged Losses: Lessons from the Mortgage Market Meltdown,” US Monetary Policy Forum Conference, February 29, 2008). Likewise, our guess at overall credit losses of $750 billion might also be too conservative. MS large-cap bank analyst Betsy Graseck estimates that global banks, brokers and specialty finance lenders have raised $165 billion in new capital to offset this deterioration, and they will need to raise more, but such losses are still levering into a credit contraction. Erring on the side of ease Against this backdrop, Fed officials and market participants face enormous uncertainty over just what is the current stance of monetary policy and thus whether additional ease is appropriate. Measures to gauge the stance of monetary policy have always oversimplified reality; for example, the famous Taylor rule provides a description of how policy has adjusted the Federal funds rate in response to inflation pressures and slack in the economy. The reality is that a broad array of financial conditions affects the connections between policy, intermediaries and the economy. Such financial conditions include interest rates along the maturity spectrum, credit spreads and credit availability, financial asset prices, and the dollar’s value. Today the credit crunch has altered the relationships among those metrics in ways that remain uncertain. In my view, the credit crunch likely means that today’s 2¼% funds rate combined with the new term lending facilities is moderately stimulative. There is some empirical evidence to challenge that conventional view; a very recent paper by John Taylor and John Williams suggests that the TAF in particular has not reduced money-market spreads (see “A Black Swan in the Money Market,” Federal Reserve Bank of San Francisco Working Paper 2008-04). In contrast, preliminary empirical work at the New York Fed suggests that it has. The use of unconventional tools to address the credit crunch, such as direct relief for borrowers, may help take the burden off monetary policy. But even if such tools gain traction in the policy debate, as now seems increasingly likely, their timing, implementation and efficacy is uncertain (see “The Case for ‘Unconventional’ Tools to Fix the Credit Crunch,” Global Economic Forum, March 24, 2008). For example, the Foreclosure Prevention Act of 2008 (H.R. 3221) passed the Senate on April 10. The Administration opposes several features of the bill, including a $7,000 tax credit for buyers of foreclosed homes, to be claimed over two taxable years. In contrast, the Administration supports expansion of the FHASecure program that would help struggling borrowers refinance into FHA-insured loans. Democrats support a $300 billion expansion of that FHA insurance program, but the Administration opposes its scope. Given those uncertainties, and the downside risks to growth, it seems likely for now that the Fed will err on the side of ease. Consequently, we still expect that the Fed will reduce the funds rate by another 50 bp to 1.75% at this month’s FOMC meeting, and maintain that lower rate until late this year. Against that backdrop, the recent flattening of the yield curve likely will reverse. When the Fed does reach the trough in rates, that steepening is likely to be bearish, as inflation uncertainty and a temporary summer pickup in the economy boost yields. Risks for markets and the economy still seem pointed lower. Estimates of losses at leveraged lenders continue to rise, and with them the risk that the credit crunch and its effects on economic activity will intensify. Lenders are aggressively recapitalizing, however, and at some point — likely next year — the losses will slow, the Fed’s actions will get more traction, and the economy will start to recover. We think there are several reasons why that recovery will come later than many expect and be slow. However, the Fed has eased aggressively and is committed to maintaining the several facilities to add liquidity. Lenders are beginning to recognize losses and to recapitalize. And fiscal stimulus is coming. Consequently, we don’t want to overlook the chance that recovery could come sooner or more forcefully (see “The Eye of the Storm,” Investment Perspectives, April 10, 2008).
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Business Conditions: New Low
April 15, 2008
By Shital Patel and Richard Berner | New York
The Morgan Stanley Business Conditions Index declined five points in early April to an all-time low of 27%. The less volatile three-month moving average ticked down a point to 32%. And there’s scant sign of improvement. The expectations index edged down three points to 25%, matching January’s all-time low, and while the advance bookings index jumped seven points to 36%, that’s at the low end of its 5-year history. We’ve been bearish on earnings, and we think MS analysts’ 2008 earnings estimates remain too high given their assessment of business conditions. To their credit, however, MS analysts look more realistic at 6.1% growth compared with the 14.0% consensus. Indeed, our telecom services, consumer discretionary, and consumer staples analysts now expect declines. But more cuts lie ahead, and stock prices have yet to stop declining on bad news. Services Weak; Factory Bounce. Most of the April deterioration was concentrated in the services sector, which represents nearly two-thirds of our sample. Our services sub-index plunged nine points to an all-time low of 17%, putting it at odds with the Institute for Supply Management’s (ISM) non-manufacturing index, which has jumped five points over the past two months to 49.6 in March. The MSBCI manufacturing sub-index rebounded seven points to 46% mainly due to continued improvement in the materials sector. Forward-looking indicators mixed. Our key leading indicator, the business conditions expectations index, edged down three points to 25%, matching the all-time low recorded in January. The consumer discretionary, financials, healthcare, industrials, IT, and telecom sectors expect business conditions to deteriorate over the next six months. Only 11% of groups expect conditions to improve, mainly in the materials and energy sectors. Another leading indicator, the advance bookings index, jumped seven points to 36%. While this represents improvement, the level of the index is still low relative to its 5-year history. Hiring plans worsened with 28% of groups planning to cut payrolls over the next three months, versus 23% in March. Economic uncertainty has also affected capital spending plans, as only 33% of groups have plans to increase capex over the next 3 months, down from 46% last month and the lowest percentage since November 2004. Credit conditions improving slightly. Our credit conditions index, which looks at the ability to get financing compared to three months ago, increased five points to a still-low 31%. Not surprisingly, no groups reported that financing was easier to obtain. Over the past month, 59% of borrowers in our survey faced tighter lending standards, down from 70% in March. Deteriorating economic outlook. While our 2008 real GDP growth estimates have remained virtually unchanged from the beginning of the year at 1.0%, consensus estimates as reported by the Blue Chip Economic Indicators have nearly halved from 2.2% in January to 1.4% in April. Moreover, according to the April 10 edition of their survey, 54.3% of respondents believe the US economy is in or will enter a recession in 2008. Survey-based indicators are also weak, with both the manufacturing and non-manufacturing ISM indexes remaining below the 50 break-even level and the NFIB small business optimism index hitting a 28-year low. Also, the University of Michigan’s measure of consumer confidence hit a 26-year low plunging 6.3 points to 63.2. It is clear from MSBCI survey results that MS analysts agree that we are in the midst of a subdued economic climate and expect poor conditions through at least the next six months. As we and our US equity strategist Abhijit Chakrabortti have noted for the past several months, MS analysts’ 2008 earnings estimates remain too high given their assessment of business conditions. However, MS analysts continue to slash 2008 earnings growth estimates to 6.1% from 7.0% last month, and 13.5% in January. Compared to Street analysts who are expecting an unrealistic 14.0%, MS analysts are relatively bearish, but we still think they have more cutting to do. That said, this month we looked at MS earnings estimates by sector now versus the beginning of January. All sectors with the exception of energy and materials have downgraded their 2008 earnings estimates. The biggest cuts have occurred in the telecom services, consumer discretionary, and consumer staples sectors, which have each moved into negative earnings territory. The good news is that analysts have not boosted 2009 earnings in response to downgrades to 2008. Telecom services, consumer staples, health care, industrials, and utilities have downwardly revised both 2008 and 2009 earnings. This is in stark comparison to Street earnings estimates, where only six of ten sectors have lowered 2008 estimates, and none see an earnings contraction. Remember, the Street stands at 14.0% for 2008 earnings versus 6.1% for the MS-coverage universe. Analysts were again bearish about risks to their earnings estimates this month. 68% of analysts believe there are downside risks to their earnings estimates, up from 62% in March. Of these, 61% are concerned about domestic growth while a growing percentage, 22%, believe there are downside risks from margin compression. Only 32% of analysts believe there are upside risks to earnings estimates, down from 38% last month. The dollar continues to have a positive impact on earnings, with 31% of analysts reporting that the dollar has contributed 1-3 percentage points (pp) to year-over-year earnings growth, and the dollar has contributed 3 pp or more to earnings growth for 19% of the groups. Pricing power and margins. Our pricing conditions index, which looks at the change in prices charged compared to a year ago, increased four points to 67% in April. While 53% of the industries covered in this survey were able to increase prices compared to a year ago, higher costs have been squeezing margins over the past three months. Fully 45% of groups noted that material and/or labor costs have increased faster than prices charged, compared to 37% in January. The outlook for margins in 2008 also worsened. A full 42% of respondents believe that margins will shrink, compared to 36% in March and 15% in January. The way we see it, with recession underway, this margin compression augurs poorly for earnings. This month we also asked analysts about companies’ plans to increase or decrease stock buybacks and dividends. 34% of groups plan to increase buybacks while 20% plan to decrease them. Only one group, large-cap banks, plans to suspend buybacks altogether. 40% of respondents plan to increase dividends, while the remainder are keeping dividends unchanged. This is not completely surprising, as companies may be stepping up dividends in anticipation of higher taxes if a Democrat gets voted into the White House. Most groups planning on increasing dividends are in the industrials, materials and energy sectors.
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Review and Preview
April 15, 2008
By Ted Wieseman | New York
Treasuries posted modest front end-led gains over the past week. It was a quiet week for economic news and trading mostly followed, in generally very light volumes, moves in credit and equity markets, which gave back a portion of the major rallies seen from the mid-March peak of the systemic meltdown fears through last week. With systemic and counterparty fears having significantly faded in the aftermath of the Fed’s backstopping of the primary dealer community with the primary dealer credit facility, investors are still left to deal with the unfolding recession and the credit crunch that is its key driver, and there were more worrying indications over the past week that the strains on the banking system continue to worsen. Both spot and forward spreads of term LIBOR over expected fed funds continued to move wider, with a particularly large move in the expected spreads out to June and September. The blowout in the forward spreads, with the market now pricing little improvement in the badly strained interbank lending situation any time soon, was in large part triggered by the latest TAF auction, which was awarded way above the minimum bid rate and even a decent amount above 1-month LIBOR. According to our financing desk, this highlighted that as bad as the spreads between officially posted LIBOR and OIS rates are, the underlying situation may actually be much more strained, as generally only the highest-rated and largely domestic banks are able to borrow at LIBOR at this point, leaving many other institutions stuck with even higher rates in the term interbank market. So, while the fears of a systemic meltdown that peaked around the Bear Stearns blow-up have greatly abated, the pressure on bank balance sheets remains intense, and the resulting credit crunch and recession continue to unfold. The economic data calendar the past week was light. Weak chain store sales led us to cut our March retail sales and 1Q consumption forecast, but this was more than offset by another surge in wholesale inventories, where inventories are starting to look bloated, boosting our 1Q GDP forecast to -0.2% from -0.5%. The likely weak start provided to 2Q by soft March retail sales and the prospect of an increasing big inventory correction point to more downside in 2Q, however. The headline results in the trade balance report were a lot worse than expected, but underlying details, while implying a different composition on growth (less of a positive contribution from net exports but a smaller decline in investment) were neutral for our first quarter growth outlook. Finally, the University of Michigan consumer confidence index for early April caught up with the March collapse in the Conference Board’s poll, hitting its lowest level since 1982. For the week, benchmark Treasury coupon yields fell 1-9bp, and the curve moved a bit steeper after what had been a major flattening reversal over the prior month. The 2-year yield declined 9bp to 1.74%, the 5-year 6bp to 2.57%, the 10-year 1bp to 3.47% and the 30-year 2bp to 4.30%. The squeeze in the very short end, which had eased a fair amount over the prior couple of weeks, sharply re-intensified, with the 4-week bill’s bond equivalent yield down 63bp to 0.85% and the 3-month down 20bp to 1.19%. Oil’s surge to another record high helped TIPS outperform, with the 5-year yield down 9bp to 0.25% and the 10-year 4bp to 1.15%. Swap spreads in the belly of the curve moved slightly wider on the week, and mortgages underperformed. Along with renewed worries about interbank lending strains, the main driver through the week for Treasuries was credit and to a lesser extent stocks, with a partial reversal of the big narrowing in spreads seen from mid-March through the end of the prior week sending yields lower. The investment grade CDX index, which had tightened about 80bp from the worst close on March 10 through the recent best close on April 4, was 20bp wider on the week at 129bp in late trading Friday. The high yield index was 35bp wider on the week through Thursday, and the index was trading down about a half point Friday afternoon. The S&P 500 ended the week down 2.7%, though almost all the losses came Friday. The highest-rated commercial mortgage CMBX indices also reversed some of their major recent improvement, but relatively much less so than the CDX indices, with the AAA index widening 12bp on the week to 143bp after having tightened 132bp over the prior three weeks and the AJ index widening 47bp to 425bp after having tightened 332bp over the prior three weeks (the lower-rated CMBX indices were mixed on the week, with the AA, BBB and BBB- showing further improvement). The leveraged loan LCDX index held in similarly well, with the now off-the-run series 9 index trading about 10bp wider on the week early Friday afternoon near 377bp after having tightened 111bp over the prior three weeks (the new series 10 LCDX index that started trading early in the week was at 408bp midday Friday). Meanwhile, the subprime ABX market, which never showed that much improvement to begin with, resumed weakening, with the AAA index down 1.55 points to 56.15. Near-term Fed rate-cutting expectations were scaled back a bit on the week, with the market moving towards pricing more of a toss-up on whether the Fed will cut 25bp or 50bp at month-end (we’re still leaning towards 50bp), but continuing to see 1.75% as the trough, whether it’s reached in April or June. The May fed funds contract gained 2.5bp to 1.885%, July 4.5bp to 1.775%, and low-rate September 7bp to 1.735%. Against a more dovish near-term Fed view, 3-month LIBOR only dipped about 1.5bp on the week to 2.71%, sending the 3-month LIBOR/3-month OIS spread up another 4bp to 80bp, just about back to the post-December high of 82bp hit March 14 when the Fed intervened to rescue Bear Stearns. And the TAF results contributed to a big increase in pessimism about the interbank lending mess being resolved any time soon. The Jun 08 eurodollar futures contract actually sold off 9bp on the week to 2.46%, versus a 5bp rally in the average of the overlapping June, July and August fed funds contracts to 1.79%, so the 3-month LIBOR/OIS spread is expected to still be near 70bp in mid-June. And the Sep 08 eurodollar contract lost 1.5bp on the week to 2.25% as the average rate on the September, October and November fed funds contracts fell 8bp to 1.74%, so a spread still near 50bp is seen in September. It was a light week for economic data. Weak chain store sales results pointed to worse retail sales results in March than we preliminarily estimated, with corresponding downside to 1Q consumption. Wholesale inventories rose much more than expected again, pointing to a bigger contribution from inventories to 1Q growth. The headline result in the trade deficit was much worse than expected, but the underlying details were neutral for our 1Q GDP estimates, with offsetting impacts on net exports (negative) and capital spending (positive). Combining these impacts, we raised our 1Q GDP forecast slightly to -0.2% from -0.5%. Chain store sales were significantly worse than expected overall in March, with particularly bad results at clothing and department stores. On top of the previously reported weak motor vehicle sales, these results pointed to a third decline in retail sales in the past four months. We cut our March retail sales forecast to -0.2% overall and 0.0% ex autos from 0.0% and +0.2%, respectively. We also reduced our estimate of the GDP input ‘retail control’ to 0.0% from +0.3%, which lowered our 1Q consumption forecast to +0.6% from +0.7% and would provide a much softer starting point for 2Q consumption. On the positive side for growth, though probably only temporarily as a future correction is likely, wholesale inventories surged another 1.1% in February on top of an upwardly revised 1.3% gain in January. The upside in February inventories combined with the January revision boosted our estimate of the inventory contribution to 1Q growth to +0.6pp from +0.2pp. This surge in wholesale inventories will be a major contributor to what is likely to be a big rise in the overall business inventory/sales ratio in February to its highest level in a year, pointing to an increasing likelihood of a sharp reversal in inventory accumulation in 2Q. The trade deficit widened much more than expected in February to US$62.3 billion from US$59.0 billion, with both exports (+2.0%) and imports (+3.1%) posting big gains. Export upside was led by food, which continues to show extraordinary growth (+47%Y), a broadly based advance in industrial materials and a surprising rise in autos given the slowdown in North American assemblies. The main offsetting weak area was capital goods – a positive for investment, as it indicates that more of February’s capital goods shipments went to domestic use. The import upside was led by surprising surges in consumer goods and autos. Capital goods also posted a significant advance, pointing to a further boost to domestic investment. A pullback in petroleum products provided some offset. Underlying details were not nearly as negative as the headline result. The real goods deficit widened in February, but by significantly less than the nominal figures, to US$51.5 billion from US$49.7 billion. Incorporating this result, we cut our estimate of the net exports contribution to 1Q GDP growth to +0.4pp from +0.8pp. This was offset, however, by the positive implications for investment from the capital goods imports and exports figures. We now see 1Q investment in equipment and software falling 4% instead of 7.5% and overall investment declining 4% instead of 7%. These impacts netted out, and had no further impact on our 1Q GDP forecast on top of the modest downside from the chain store sales results and upside from wholesale inventories that together boosted our estimate to -0.2% from -0.5%. The economic data calendar is very busy in the coming week after the past week’s lull. Main focus will be on retail sales Monday and CPI Wednesday. Initial estimates for the upcoming employment and ISM reports for April will also be guided by the weekly jobless claims report, which for initial claims covers the survey week for the employment report, and the Empire State manufacturing survey Tuesday and Philly Fed Thursday. On Wednesday, the Fed will release the Beige Book prepared for the upcoming April 29-30 FOMC meeting, and the Treasury will announce a new 5-year TIPS on Thursday for auction the following Tuesday. Other data releases due out include business inventories Monday, PPI Tuesday, housing starts and IP Wednesday, and leading indicators Thursday: * We forecast a 0.2% decline in overall retail sales in March and a flat reading excluding autos. The unit sales results pointed to a further pullback in the auto dealer category in March. In addition, the chain store sales results showed major weakness at clothing and department stores and relatively soft numbers at drug stores. Moreover, housing-related categories (furniture, building materials, and electronics and appliances) are expected to remain soft. On the positive side, the gas station component is expected to post a modest, price-related gain in March. And heavily weighted food stores are likely to rebound from a decline posted last month. Note that the unusually early Easter could cause significant problems with seasonal adjustment, potentially causing an unusual swing in either direction in this report, though any surprise of this sort would likely be reversed in April. * We look for a 0.5% increase in February business inventories. Another sharp rise in wholesale inventories (+1.1%) and a decent rise in manufacturing stockpiles (+0.5%) should be partially offset by a flat reading for the retail component on a pullback in auto inventories. The I/S ratio is likely to jump to 1.29 from 1.26, which would be the highest level in a year. * We expect the March producer price index to rise 0.8% overall and 0.2% excluding food and energy. A rebound in food prices, together with another sharp jump in quotes for energy-related items, should lead to a significant rise in the headline PPI. Meanwhile, the March core PPI is likely to be somewhat better contained than in the first two months of the year, mainly because we do not anticipate a repeat of the spike in drug prices. Also, the motor vehicle category is expected to settle down following some elevation in February. * We forecast a 0.3% rise in the overall consumer price index in March and a 0.2% increase excluding food and energy. Prices at the gas pump rose about 6.5% during the month, but this is only slightly more than is built into the March seasonal adjustment factor. So the energy component of the CPI should post only a modest rise. Otherwise, the core is likely to be near trend, following a very subdued result in February. Specifically, even though we look for further weakness in clothing prices, the medical care and education categories should rebound after showing some unusual softness in last month’s report. Also, the shelter component is not expected to be quite as weak as seen in February – although we continue to look for further underlying deceleration in this key sector going forward. Finally, on a year-on-year basis, the core is expected to hold at +2.3%. * We look for about an 8% drop in housing starts in March to a 975,000 unit annual rate. This reflects an expected continuation of the steady fall-off in the key single-family component, along with a likely reversal of the recent upside surprises in the multi-family sector. Indeed, multi-family starts are expected to be down 16% in March. Looking ahead, we still expect to see another 20% or so decline in starts over the balance of the year. * We look for industrial production to rise 0.4% in March, reversing almost all of the drop seen in February. Indeed, the employment report revealed surprising strength in manufacturing hours – especially outside of the automakers. So, we look for the IP data to show a 0.8% jump in manufacturing output excluding the motor vehicle sector, which would represent one of the sharpest gains seen in the past couple of years. The spillover effect of a strike at an important auto parts supplier is expected to contribute to a 2.5% drop in car and truck production. Also, relatively mild weather conditions should help to restrain utility output. So, the gain in overall IP is likely to be significantly less than the rise in non-auto factory output. * Based on currently available components, the index of leading economic indicators should rise 0.2% in March, breaking its run of five straight monthly declines – the first such string since the beginning of the 1990-91 recession. Significant positive contributions are expected from the money supply and vendor deliveries components, with more modest support coming from the yield curve and factory workweek. There is likely to be some negative offset in March from jobless claims, stock prices and consumer expectations.
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Take a Hike
April 15, 2008
By Marcelo Carvalho | Sao Paulo
Increasingly hawkish signals from the central bank appear to be paving the way for a monetary tightening cycle, as the central bank seeks to anchor inflation expectations. We have reversed our view of no hikes for the year and now expect the central bank to hike by 25bp this week. Before the hiking cycle is over, we expect the central bank to raise rates by a total of 200bp to 13.25% by end-2008. Let’s Take a Monetary Hike The Copom will hike rates. A couple of weeks ago, we changed our forecast in order to remove any remaining easing from the forecast horizon. We highlighted substantially increasing risks of monetary tightening, but we stopped short of calling for outright rate hikes. In retrospect, we believe that this call was wrong. We now expect monetary tightening, starting at the Copom meeting that concludes with a rates decision on Wednesday. What has changed? We would highlight three factors: First, the central bank has sent increasingly hawkish signs. The Copom minutes have already been cautious for a while, and the quarterly inflation report was particularly conservative. It highlighted a worsening balance of risks, and indicated that strong domestic demand is key for such balance, despite the global slowdown. It went out of its way to explicitly mention that other central banks around the world are tightening despite Fed easing. And it argued that the Copom should be ready for pre-emptive action. But a key tipping point was the subsequent statements by the central bank’s director of economic policy, who has gone beyond the report in painting a hawkish picture with even stronger colors. Second, possible divisions within the board have failed to transpire. The central bank’s director of economic policy is often seen as the most hawkish member of the Copom, and we had assumed that possible divisions within the board could keep it from hiking. However, recent pronouncements from the governor of the central bank, while not as hawkish, have failed to dismiss the notion of rising rates. Third, policy tensions probably change the dynamics. We had assumed that the central bank would be more willing to talk tough than to act on its words. However, rising policy tension between the central bank and the finance ministry probably complicates the picture. In normal times, hawkish central bank rhetoric does not necessarily lead to rate hikes. However, amid increasing hawkish language and worse-than-expected recent inflation data, keeping rates on hold now could be perceived by market participants as the result of undue external pressure – rightly or wrongly. In a sense, the central bank has found itself in a corner. How to Justify Monetary Tightening? The Copom will probably present its case as risk management. The base case scenario for inflation still appears benign. But the central bank will argue that the ‘balance of risks’ is a concern. The Copom may indicate that a rate hike is a way to buy insurance against the low-probability (but painful) scenario where inflation expectations increase too far, too fast. If a central bank waits until inflation prospects diverge too far from targets, the argument goes, then it has to tighten by more and for longer. In other words, the central bank will present a rate hike as pre-emptive action. And the Copom will probably also note that it looks at a broad range of variables beyond just inflation expectations alone. Should the Central Bank Hike Rates? The central bank should not hike interest rates if it trusted its own forecasts. The Copom’s main concern is that a mismatch between aggregate demand and supply could complicate the inflation outlook. However, the central bank’s own inflation model fails to foresee such pressures actually pushing inflation much above the target. The central bank’s latest published forecasts saw IPCA inflation at 4.6% in 2008 and 4.4% in 2009. The official inflation target is 4.5%, and the tolerance band ceiling is 6.5%. It is thus hard to justify rate hikes based on these numbers, if the central bank really trusts its own forecasts. Also on the dovish side, ongoing strong investment and productivity gains should expand the economy’s supply response over time. And globally driven food price inflation remains the main culprit behind upward surprises in headline inflation. Fiscal tightening would be a better response than monetary tightening. Even if the authorities conclude that policy tightening is necessary to cool down domestic demand, then policy rebalancing with tighter fiscal policy would be a superior structural response, in our opinion. The broader policy mix in Brazil is regrettably unbalanced, in our view. Fiscal policy is too loose, monetary policy is too tight. Brazil’s interest rates have historically been among the highest in the world. Is monetary tightening then the best course of action? Ideally, a policy rebalancing towards fiscal tightening should allow room for lower average interest rates over time. But don’t hold your breath. Given dim realistic prospects for fiscal tightening anytime soon, the central bank is left with monetary policy to steer the economy. And recent developments suggest that the Copom is indeed paving the way for a rate hike soon. Starting the Hikes We assume a 25bp hike this week. Observers are divided between 25bp and 50bp for the Copom meeting on April 16. The local yield curve is pricing in more than 40bp. Our forecast assumes an initial hike of 25bp, for three reasons. First, the so-called ‘Brainard Principle’ (William Brainard, “Uncertainty and the Effectiveness of Policy”, The American Economic Review, Vol 57, No.2, May 1967) argues for monetary policy gradualism in times of uncertainty. In other words, if you don’t know what you are doing, do it slowly. Second, the hike is intended to be pre-emptive, in order to preserve policy credibility (rather than reactive, in order to regain lost ground). We interpret this to mean that there is little reason for aggressive initial action. Third, if history is any guide, the Copom seems to prefer a gradual approach going into the cycle, judging by the initial 25bp hike in the last monetary tightening cycle in 2004. If the Copom instead hikes 50bp already now, then markets will wonder about two opposite, but both plausible, views: does this mean front-loading a brief cycle, or does it instead indicate aggressive hikes ahead? It might take a while before the true answer becomes clear, although the Copom minutes should help. The voting score might turn out to be deceivingly unanimous. Views within the Copom may vary about the best course of action on monetary policy. However, higher political tension with other parts of the administration may increase incentives for the board to present a unified front with unanimous voting, as the central bank may prefer to show internal cohesion in its policy decisions. It is interesting that the Copom explicitly considered a rate hike already in March, but still voted unanimously to stay on hold back then. How Long Will the Tightening Cycle Last? Uncertainty rises. Nobody really knows when and where the central bank will stop. What will the Copom look for in order to conclude that enough is enough? Maybe it is inflation expectations – but, then, how close to the target? Maybe it is growth deceleration – but, then, how much? One risk is that the whole affair becomes an open-ended process, with little visibility about its finish. The central bank’s communication strategy will become particularly important. The Copom’s reaction function is proving elusive. A difficulty here is that the central bank’s reaction function is changing. This means that history becomes less useful as a guide. For instance, the last time the central bank started hiking rates, in September 2004: • Actual past IPCA inflation was 7.2% (or 1.7 percentage points above the 2004 target). Today that would mean past inflation above 6.0%. • The market consensus expectation for inflation 12 months ahead was 6.2% (or 1.5 pp above the implicit target path). Today that would mean expectations hitting 6.0%. • The central bank’s own forecast for inflation 12 months ahead was 6.0% (or 1.3 pp above the implicit target). Today that would mean 5.8%. • The central bank’s own forecast for 2005 was 5.6% (or 1.1 pp above the target for 2005). Today that would mean 2009 inflation at 5.6%. In all comparisons, a hike this week means that the central bank is starting to act much earlier this time around than in the 2004 cycle. Maybe the central bank is intentionally trying to be more proactive. That is fine. But observers will be left with less relevant historical patterns to rely on. Rate cycle: shallow and quick, or deep and long? Analysts seem to fall into two broad camps. One camp says that the hiking cycle will be shallow and quick (say, a total of 100-150bp). Against that view, we would argue that once it starts, the central bank normally delivers a full monetary tightening cycle. Once you pop, you can’t stop. For the central bank, it is like taking antibiotics: take all the pills to make sure you really kill the bug. Also, one risk here is that the central bank initially thinks that the tightening cycle will be shallow and brief, but then ends up having to hike for longer as tougher global conditions complicate the picture down the road. Another camp calls for aggressive tightening, of as much as 300bp. Indeed, the yield curve is pricing in hikes in the 250-300bp range. In the last tightening cycle, the central bank hiked by 375bp over nine months, starting in September 2004. Against that more aggressive view, we would argue that inflation expectations are much better anchored now, and that the central bank is starting to hike much sooner than usual. Also, credit is a larger share of the economy now, and so monetary policy is more potent, as it gets more bang for its buck. We forecast a 200bp tightening cycle. Our forecast assumes an initial hike of 25bp this week, then three subsequent back-to-back hikes of 50bp, and a final 25bp hike in October, taking the policy rate to 13.25% by end-2008. Rates would then start to decline late next year, to 12.75% by end-2009. One concern is that policy tensions may re-emerge within the administration. Some latent tension may have always existed within parts of the administration. But a favorable global environment probably helped to keep them mute in recent years. As the central bank now tightens amid a global growth slowdown, political noise could become louder. In the end, when push comes to shove, we assume that the administration will continue to support orthodox policies and a market-friendly approach. But investors would grow concerned if, instead, more interventionist policies begin to flourish. Market Implications Investor response may vary. For fixed income investors, actual monetary tightening could entail some eventual flattening of the curve. But trying to call the peak in rates when the cycle is barely starting can prove risky business. Meanwhile, for equity investors, perceptions about monetary tightening fall in a range, but one thing seems clear: the equity space is not prepared for the aggressive monetary tightening that the yield curve has priced in. Equity is from Mars, fixed income is from Venus. The good news is that monetary tightening can be seen as a gutsy action that reinforces the central bank’s credibility. If brief and shallow, a pre-emptive monetary tightening cycle does not need to be a disaster for equity investors. But it will take time before the length and depth of the hiking cycle becomes clear enough. In the meantime, rising rates might undermine the local funds’ recent migration from fixed income into equities. Currency implications are harder to call. Higher rates would arguably support the currency through interest rate differentials. But implications for equity inflows seem less encouraging. For equity investors, Brazil has been a no-brainer in recent years – strong growth, falling interest rates and a favorable global backdrop. But as the global picture darkens, rates rise and domestic growth eventually slows, the case for equity flows into Brazil could become less obvious. In all, we continue to suspect that a tougher global environment will eventually call into question the strength of the real in the medium term. But we push our 2.0 year-end currency forecast to 2009, and instead now see the end-2008 exchange rate at 1.9. Our forecasts for other macroeconomic variables are little changed. The inflation outlook does not change much, as monetary tightening aims to anchor inflation expectations, rather than necessarily affect inflation itself. As for growth, rising interest rates could lead analysts to eventually mark down their real GDP forecasts, but our growth view is already below consensus. Bottom Line Our forecast now sees policy rates rising 200bp this year to peak at 13.25% by end-2008, starting with a 25bp rate hike this week. The central bank will present the hike as pre-emptive action, to assure that inflation prospects remain anchored around the target. But uncertainty is up: it will take time before the cycle’s full length and depth become clear.
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Abundance of FDI Continues
April 15, 2008
By Boris Segura | New York
There seems to be no stopping the COP. Despite measures enacted last year to slow or revert the currency’s appreciation, the COP continues to be one of the best-performing currencies in the world. It has rallied more than 12% year to date. The most recent rally has once again raised investor concerns over whether the currency can gain further ground or has moved too quickly. After all, Colombia runs the largest current account deficit among the region’s major economies − reaching US$5.9 billion or 3.4% of GDP last year. Add to that the fiscal deficit and one frequently hears investors bemoan the ‘twin deficit’ even as the currency continues to rally. Colombia’s peso has rallied for reasons common throughout Latin America − from the positive terms of trade shock as a result of commodity exports to widening interest rate differentials. However, there is one area where Colombia distinguishes itself from the rest of Latin America – its attractiveness to foreign direct investment (FDI). We estimate that Colombia had one of the largest FDI to GDP ratios in the region in 2007, and appears to be well on its way to repeating that in 2008. And despite the large current account deficit, FDI in Colombia more than covers it. Putting aside the microeconomic benefits of FDI, clearly it is a more stable and predictable type of capital inflow to finance gaps in the current account. Will this abundance be sustained? Or will it fizzle out at the first sign of trouble abroad? What if the US-Colombia FTA is rejected by the US Congress? We address those issues in this note. FDI in Colombia: Some Background Colombia’s attractiveness to foreign direct investment is recent. As a percentage of GDP, excluding the privatization-intensive years of 1996 and 1997, Colombia’s FDI did not surpass 3% until 2005. It wasn’t until 2006 and 2007 that FDI as a percentage of GDP has kept an upward trend, reaching a high of 5% in 2007. Some skeptics might even argue that the swings in FDI coming into Colombia are driven by external factors. In fact, until the end of 2005, FDI flows into Colombia and (future) economic conditions in the developed world were highly correlated. This fact should not be that surprising, as good times domestically are likely to encourage multinationals to take more risks abroad. However, since late 2005, there seems to be a structural break in the relationship as, even when the OECD’s leading indicator clearly headed down, FDI into Colombia first stabilized and later marched higher. In fact, Colombia has been catching up rapidly in the Latin American context. Along with Peru, Colombia shows the largest increase in FDI as a percentage of GDP between 2003 and 2007. There is little doubt that improvements in investment conditions under the Uribe Administration have helped to trigger the boom in FDI. In particular, dramatic improvements in domestic security, a semblance of macroeconomic stability and investor-friendly tax and regulatory regimes for new investors are the main drivers of this ‘structural break’ in FDI into Colombia. But the ‘catch-up’ that took place in 2006 and 2007 is showing no signs of slowing in 2008. Indeed, in the first two months of the year, the balanza cambiaria accounts show FDI inflows growing at more than double the pace for the same period last year. The US$1.75 billion in the first two months of this year has been mostly due to several lumpy investments in the retail and telecommunications sectors, but this still compares favorably to last year’s inflow during the same period of a little under US$800 million. Actually, FDI (as per balance of payments statistics) is likely to be higher than this figure, as the balanza cambiaria accounts capture transactions on a cash basis; these do not include, for example, capital goods imports associated with a particular investment project. Although we would warn against simply extrapolating from these figures, they do bode well for FDI prospects in Colombia this year. We estimate FDI for the year at a little over US$10 billion (5.2% of GDP), based on a list of high-profile investment projects that have been announced recently. One of the sectors where FDI has been pouring in is the oil sector. Since the introduction of new exploration and production contracts in 2003, which arguably present one of the most investor-friendly environments in the region, including a favorable tax regime, plenty of oil players have jumped at the opportunity of exploring and producing oil in Colombia. While ‘home run’ discoveries such as the fields of Cusiana and Cupiaga in the early 1990s have not been made recently, small- and middle-sized operations could still be profitable with small findings. Gas exploration in the Caribbean looks even more promising in terms of major findings. FDI into oil and mining (mostly gold and coal) represents almost half of total FDI into Colombia. We feel reasonably comfortable with the prospects of FDI into these sectors. After all, foreign investors are increasingly finding themselves not welcomed around the globe in resource-rich areas. Colombia represents a noticeable exception. Other sectors boast promising FDI prospects. For example, growth in tourist arrivals to Colombia is double the world average, and the country does not have enough hotel rooms to satisfy this pent-up demand. Therefore, there is a major drive to build hotels, not only in Bogota, but in major cities around the country. Recently implemented ‘free trade zone’ tax legislation is also an important magnet for FDI, even when it is not only aimed at export firms. This new tax regime is similar in shape and spirit to Ireland’s. It creates a ‘dual’ tax regime, where ‘new’ firms that fulfill certain criteria (basically, a minimum amount of investment over several years and a minimum number of new jobs) get a reduced income tax rate of 15%, plus exemption from VAT and import tariffs. In a nutshell, we are bullish about the FDI coming into Colombia. We are of the opinion that the ‘one-off’ recovery of FDI into Colombia does not appear to be over; this powerful driver is likely to continue to support the currency. Of course, as we saw during 2007, the currency has many other drivers, including global attitudes to risk − strong FDI flows did not stop the move from 1870 in June to 2200 in September, or the associated volatility in between. But it is likely to provide some support. Does the US-Colombia FTA Matter? The difficulties with the approval of Colombia FTA could prove a risk to FDI in the long term, but are unlikely to do much to stop the kind of FDI currently entering. Last week, the procedural change by the Democrats to suspend the fast-track voting time limits puts this FTA in a legislative limbo. Our initial assessment is that the Bush administration did not have the votes in the House of Representatives to pass Colombia’s FTA. Therefore, we think it is positive that this FTA is still alive rather than dead. Frantic negotiations between the administration and the Democratic leadership will likely ensue. Even if the FTA is rejected, it is highly likely that current trade preferences (APTDEA) are extended by Congress, minimizing the blow to exports in the short term. The same could be said for FDI. It is difficult to imagine that oil and mining exploration in Colombia will slow simply because there is no clarity on the FTA. And the tourism boom is still more a function of catching up after years in which hotel investment had dropped as violence had caused tourism to plummet. That isn’t to say that if the FTA is not passed that there are not risks. Clearly, in the medium term, the risk is that FDI moves to other neighboring countries that already have an FTA with the US (such as Peru and the countries of Central America), negatively affecting some investment flow momentum in Colombia going forward. But during 2008 and likely 2009, global growth, commodity prices and the catch-up that Colombia is still engaging in are all more likely to determine the pace of FDI, in our view. Bottom Line Strong foreign direct investment flows into Colombia have been a powerful driver of the strong rally of the COP this year. While the actual inflows can be quite lumpy, FDI in 2008 is likely to be higher than in 2007. And the ‘one-off’ recovery in FDI to Colombia does not appear to be over. Almost half of the inflow is going into natural resources, where not only are the regulatory environment and tax regime market-friendly, but other places in the world are also off-limits to foreigners. The rest of the FDI is fairly balanced across economic sectors and geographical regions. Even if the FTA with Colombia is rejected by the US Congress (which is not our base case scenario), we suspect that FDI would not collapse in the short run. However, in the medium term, the risk is that FDI moves to other neighboring countries that already have an FTA with the US.
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