Mexico
The Hikes Restarted
June 24, 2008

By Gray Newman & Luis Arcentales | New York

Despite the announcement by the Calderon administration of price freezes on more than 150 items on Wednesday June 18, two days later Mexico’s central bank surprised analysts with a rate hike.   Although interest rate markets have begun to price in a series of hikes, only a small minority of local and foreign-based economists were calling for a rate hike on June 20.  We revised our interest rate forecast to reflect two 25bp hikes between now and year-end to bring interest rates to 8% (see “Mexico: Time to Hike”, This Week in Latin America, June 16, 2008).  We had previously held the view that Banco de Mexico would keep interest rates on hold at 7.5% during 2008. 

Still, the move higher is remarkable.   Less than three months ago, most market participants were anticipating significant rate cuts in Mexico.  We argued then that it was difficult to imagine that Banco de Mexico could ease its tone, much less interest rates, ahead of the May-June period when inflation would appear to be on the rise (see “Mexico: No Hurry to Ease”, EM Economist, February 8, 2008).  Further, Mexico’s central bank found itself facing much less pressure to ease than the Fed. While the Fed was battling a downturn in the US, it was also facing the specter of a much more challenging environment for the financial system. In contrast, Mexico’s banking system was well capitalized and was facing no subprime turmoil.    

Rationale for Hiking

We highlight three factors that caused us to conclude that the balance of risk on the inflation front in Mexico has deteriorated to the point that a failure of Banco de Mexico to raise interest rates could put at risk the centrality of its 3% inflation target.   In fact, while the June 20 statement pointed out that medium-term expectations remain “well anchored” and that contamination from the commodities shock has been “limited”, it also acknowledged that the inflation “balance of risks had worsened”.  

First, we believe that the Banco de Mexico’s decision to revise upward its inflation path for 2008 (and 2009) and the subsequent May inflation reading (which showed it at the upper range of the new forecast path) have contributed to a worsening in the balance of risks for inflation.  Recall that in late April, Banco de Mexico moved its inflation path for 2Q and 3Q08 from a 4-4.5% range to a 4.5-5% range once it was clear that inflation would breach the path’s upper limit.  May’s inflation reading in turn showed headline inflation at 4.95% and core at 4.86% – both running against the upper range of the new path.  Indeed, the June 20 statement went as far as acknowledging that the inflation path “for the rest of the year and the beginning of 2009 could be somewhat higher than expected in the most recent Inflation Report” from late April.

We believe that Mexico’s central bank is right to note that inflation is likely to show an improvement after peaking at mid-year. In addition, Mexico is hardly alone in dealing with rising food prices, which largely reflect an external shock, rather than a response to domestic demand pressures. Further, nowhere is the US slowdown likely to be felt more acutely than in Mexico.  After all, while Mexico is likely to show resilience in the face of the US slowdown, it is not immune.   Indeed, Mexico’s economy is showing signs of slowing.  After accelerating from October to February at a 4.5% monthly pace, we estimate that monthly GDP slowed to only an average of 0.7% in March and April.

It is not difficult to imagine that the combination of moving the inflation path significantly away from the central bank’s target of 3% and the subsequent May reading (which suggested that the central bank’s late April forecast was at risk of being overtaken) could contribute to a worsening of the balance of inflation risks in Mexico. 

Are the central bank’s actions and the recent May inflation report enough to justify a hike in interest rates?  Perhaps not.   But they come amid other worrisome signs on the global and domestic inflation front.

Second, there are signs suggesting that a prolonged period of inflation farther from the central bank’s 3% inflation target is taking its toll of price formation.  While the number of items in Mexico’s consumer price index basket that are posting price increases above the target have been on the rise since late 2006, most of the uptick appears to be from localized processed food. 

However, there are a growing number of items outside processed food that also appear to be moving farther from the target. It is difficult to make too strong of a call with the data available; in fact, after removing from the May policy statement the line about “limited contamination” into other prices from the commodity shock, Banxico reintroduced it in the June 20 communiqué.  And while there has been some uptick in service inflation, some of the housing uptick also appears to be related to higher metal costs embedded in building materials.  And it is difficult to know if the uptick in services represents a new trend or simply volatility within a range seen in recent years.

The same can be said of the wage data. While the 4.7% increase in May contractual wages appears to be bad news, particularly because the uptick comes in a context of rising inflation and ahead of important negotiations in July such as Pemex’s, in the past two years monthly spikes in wages have coincided with months when only a relatively small number of workers negotiate wages such as May, June and December.  In addition, May’s pressures did not seem to be generalized, as wages in services remaining well behaved at 4.3% – in line with the January-April average – while those in industry were pushed higher by outsized moves in mining (5.9%).  And the same can be said for medium-term inflation expectations, which have risen from 3.39% at the start of the year to 3.46% during in May, but remain below levels seen in 2H07 (3.53%).  At the very least, these factors suggest that Mexico does not appear to be on a clear path to lower inflation. It is not hard to imagine that the combination of factors suggest that price formation is at greater risk today than a few months ago.

Third and finally, the recent disorder in Mexico’s interest rate markets suggests that if Banco de Mexico had decided to maintain policy interest rates unchanged on June 20, such a decision could have been misread as a sign of the central bank’s complacency with even higher inflation.  While Mexico has had no monopoly on disorderly interest rate conditions during the past week, the abrupt upward move nearing 70bp in 10-year rates during the past two weeks has been pronounced.  Part of the sell-off at the long end of the curve as well as the lack of liquidity likely reflects the disorder seen in US and global markets. But we are concerned that home-grown factors have also played a role. The decision of Banco de Mexico in late April to change its inflation path higher without raising policy rates has left some residual uncertainty among market participants.  But we believe that the series of declarations from the most senior level of the Calderón administration suggesting that it is time to reduce interest rates has created additional uncertainty. Had the central bank kept interest rates on hold in June – even after the voluntary agreement to freeze prices of 150 food stuffs – we are concerned that the curve would have continued to steepen as a new round of questions arise regarding the monetary authorities’ decision-making process.

Caveats

It might seem odd to many that we expect Banco de Mexico to hike interest rates once more even as we expect Mexico’s economy to continue to slow further.   And there is little that Mexico’s central bank can do to stop a cascade of higher food prices by hiking policy rates by 25 or 50bp.  But we believe that both criticisms miss the critical point of Banco de Mexico’s actions.  The June hike by Banco de Mexico was aimed at controlling inflation expectations and price formation at a time when both are facing extraordinary risks.  The goal is to respond to reduce the risk that a series of external shocks goes beyond an adjustment in relative prices and begins to contaminate broader pricing decisions.

If Banco de Mexico hikes again as we expect and the economy also continues to slow during 2008, we believe that Banco de Mexico will be able to take back the interest rate hikes in 2009 or even later this year.   Accordingly, we are keeping our 2009 interest rate forecast at 6.75%.  It is important to note that, in our view, while June’s communiqué did not rule out another rate hike, it also failed to confirm that another move was imminent or likely.  

Some may criticize the central bank for hiking when faced with a slowing economy and then possibly removing the hikes as soon as six months later.  Some may argue that this is evidence of a policy mistake.  We disagree.   Hiking interest rates in Mexico today is akin to buying fire insurance: the subsequent absence of a fire is hardly valid criticism of the decision to purchase insurance in the first place.

We are also using this opportunity to adjust upward our inflation forecasts for 2008 to 4.3% from 3.8% and for 2009 to 3.5% from 3.3% previously.  Our inflation models have been slowly creeping higher since we last published a forecast review last year.

Bottom Line

The specter of global imported inflation has prompted Banco de Mexico to abandon its stance over the past eight months of holding policy rates steady.   With inflation in Mexico still relatively benign, it might seem odd that the central bank decided to hike interest rates.  After all, Mexico’s inflation rate is likely to fall short of US headline inflation in the coming months.  In addition, Mexico’s economy is likely to slow further in the coming months.  And senior policymakers are calling on Banco de Mexico to cut its policy interest rate and negotiate price freezes. We certainly agree that Mexico needs lower interest rates. Ironically, perhaps the most powerful support that Banco de Mexico can give to produce lower interest rates is by acting now in hiking its policy rate and in the process reaffirming its commitment to price stability.

Argentina
Argentina: Policy Dilemma Redux
June 24, 2008

By Daniel Volberg & Gray Newman | New York

All eyes in Argentina have been on the tensions between the government and the farmers. The latest developments in the conflict − including the farmers’ decision to lift the fourth round of the strike, as a new export tax bill is being debated in Congress − are positive, in our view. However, despite the positive developments in June, the end of the conflict between the farmers and the government is not assured. And even if the farmers’ dispute is resolved, we fear that it is not the main challenge facing Argentina today. In our view, this continues to be rising inflation and the risks it poses for the Argentine economy.

A Wage-Price Spiral?

High inflation remains our top concern in Argentina this year. According to our survey data, annual inflation in the March-May period has been near 23%, in contrast to the official releases that suggest it was near 9%. In fact, the risk is that inflation may be even higher. Even as many provincial statistical agencies have stopped publishing inflation statistics, two provinces that continue to do so – Neuquén and La Pampa – report significantly higher inflation in April-May, with 28% in La Pampa in April and 35% in Neuquén in May.  And if inflation expectations are any guide, there is significant inflationary pressure in the pipeline – one-year-ahead inflation expectations made an abrupt jump higher in April-May, to nearly 35% from nearly 23% in the previous eight months. We are concerned that wages and inflation may follow suit. Indeed, we are concerned that what we had been considering a risk scenario – a wage-price spiral – may become the central case.

Indeed, wages have begun to validate rising inflation expectations, raising the risk that inflation will follow suit. In the past month, several large unions have negotiated collective bargaining agreements, granting salary increases in excess of 30% for metal workers and meat industry workers (32%), hotel, restaurant and food service worker’s union (31%) and auto mechanics (35%). These agreements represent a sharp break with the wages negotiated in the first four months of the year, when salary increases were limited to the 20-25% range. In turn, these increases are likely to put pressure on other union leaders to renegotiate their wage agreements for extra salary hikes later in the year and could produce a second round of wage negotiations.

We are concerned that, in a repeat of last year, the labor cost-push shock will result in inflation accelerating by year-end. Recall that last year wages rose 21% and inflation accelerated from nearly 10% to nearly 19%, according to our estimates. This is consistent with full pass-through of labor costs to inflation, after subtracting the near 3% productivity growth. And this year, we expect productivity growth to be highly unlikely to beat last year’s 3%, suggesting that when we subtract it from the 32% wage hikes of the past month, inflation should accelerate to around 29% by year-end.

Cracks in the (Weak Peso) Model

Higher inflation leaves Argentina particularly vulnerable. In our view, the current economic model hinges on a weak currency to provide import protection to local industry, a boost to local consumption and an incentive to invest (see “Argentina: Policy Dilemma”, EM Economist, November 30, 2007). While initially a weak peso provided cover for many local industries, enabling job creation and real wage growth, we suspect that this policy is nearing its limit, as rising inflation has pushed the real exchange rate to appreciate after five years of real depreciation. In fact, using our inflation estimates, we calculate that in the first five months of the year, the real effective exchange rate has appreciated by 8%.  This is in stark contrast to the 2% annual real depreciation that the Argentine economy enjoyed in the previous five years. We are concerned that the cushion afforded by the weak real exchange rate is fast evaporating. 

We build three scenarios for real exchange rate appreciation to gauge the speed with which the weak-peso cushion may disappear. While it is difficult to determine an equilibrium level for the real exchange rate, we take the average of the 1980s and 1990s as the lower bound, the average for the 1990s as the upper bound and the midpoint of the range as the central target to guide us in the analysis. Our three scenarios for real exchange rate appreciation to the center of the ‘equilibrium’ range are based on three probable inflation scenarios and the assumption of nominal exchange rate stability. Our three inflation scenarios are based on inflation stabilizing at current levels, inflation accelerating in line with the labor cost-push shock of the recent wage increases and inflation accelerating in line with one-year-ahead expectations.

In our first scenario of inflation stabilization, the weak-peso cushion is gradually removed in the next 18 months. We assume that inflation continues to stabilize at 23% (consistent with what we estimate for March-May). Under this scenario, we expect the real exchange rate to have appreciated by 35% between the end of 2007 and the end of 2009. With 23% inflation, the real exchange rate reaches ‘equilibrium’ by the end of 2009. This scenario is consistent with some slowing in real GDP − we estimate 5.3% this year and 4.7% in 2009, even while recognizing that the risks to our GDP forecasts are on the upside for this year and somewhat on the downside for 2009.

In our second scenario, where inflation stabilizes at nearly 30% by year-end, Argentina’s current weak-peso cushion is removed by mid-2009. This scenario assumes that inflation accelerates in line with the recent wage hikes. According to our estimates, the real exchange rate appreciates beyond the midpoint of our long-run equilibrium range by the middle of next year and reaches the upper limit by year-end. In fact, the real exchange rate under these assumptions appreciates by just over 46% in the period from December 2007 to December 2009. To put this into perspective, in the run-up to the last major crisis, the real exchange rate appreciated by 38% between December 1998 and October 2001, a three-year period.  While there are many differences between the economic situation in Argentina today and the run-up to 2001 – the macroeconomic balance sheet today is much stronger, with fiscal and current account surpluses and a large stock of international reserves, a large positive terms of trade shock and a manageable debt profile – the magnitude and speed of the shock are reasons for concern. Despite strong balance sheets, such dramatic real appreciation may be a significant headwind for the current economic model and could generate a sharp pullback in economic activity by the middle of next year.

In our third scenario, where inflation stabilizes at 40% by the middle of next year, the weak-peso cushion is removed in the first months of 2009. A 40% inflation rate by mid-2009 is broadly consistent with current year-ahead inflation expectations that have climbed to around 35% in April-June after eight months near 23%. In this scenario, the real exchange rate appreciation in the December 2007 to December 2009 period is a huge 65%. In this scenario, we expect the real exchange rate to breach the midpoint of the equilibrium range by early 1Q09 and to breach the upper bound by the middle of the year. We suspect that such rapid appreciation may result in severe economic dislocations starting late this year and early next year.

The End-Game

We suspect that a real exchange rate appreciation will have three significant macroeconomic implications, regardless of the speed at which the appreciation takes place. First, we suspect that the appreciation would result in a significant deterioration in the incentive to invest. Investment has been the fastest-growing segment of GDP over the past five years – machinery and equipment investment has expanded at a near 20% growth rate for the past three years and has allowed supply to somewhat keep up with the robust demand. Second, we suspect that real exchange rate appreciation would result in a deterioration of the trade balance as relatively cheaper imports become more attractive, substituting out locally produced goods. Third, we suspect that real exchange rate appreciation would be a significant headwind for private consumption. We suspect that as cheaper imports begin to substitute locally produced goods, employment would be cut in sectors that have been protected by the weak-peso policy. According to our estimates, while these sectors employed only a third of the workforce last year, they were responsible for nearly half of all new (formal sector) jobs that were created in 2003-07. Given limited credit, we suspect that rising unemployment may generate significant consumer retrenchment.

Bottom Line

While the conflict with the farmers may continue to generate headlines, we suspect that rising inflation is a far bigger problem. With risks of another round of wage negotiations on the rise, we suspect that risks to inflation remain on the upside. We are concerned that inflation expectations are driving inflation higher, as the authorities continue with a set of policies that seem insufficient for the scale of the inflation challenge. With inflation eroding the cushion of a weak real exchange rate, we are concerned that the risks of a hard landing in the next 18 months are on the rise.

Brazil
Brazil: The Coming Growth Slowdown
June 24, 2008

By Marcelo Carvalho | Brazil

It is no surprise that real GDP growth was strong in 1Q, with the economy advancing about 6% at around the turn of the year. However, we do not expect this strength to last long. In fact, growth has probably peaked already. The central bank is hiking interest rates, there is surely more monetary tightening in the pipeline, and risks for rates look biased to the upside. Also, the global growth and inflation outlook does not look bright.

Brazil’s economy is set to lose steam, with lags. Growth in 2008 should be weaker than it started. Average real GDP readings for 2008, as a whole, should remain robust. But growth into 2009 looks set to frustrate hopes for sustained strength. We reaffirm our bellow-consensus call for a real GDP growth slowdown to 3% next year.

Deceleration to moderate growth should be seen as a victory for Brazil, but it will likely frustrate hopes for a faster expansion. Likewise, the growth slowdown may call into question current estimates of Brazil’s growth ‘potential’.

Monetary Policy Is in Full Tightening Mode

There is no predetermined ceiling for how high rates can go. The June Copom minutes removed all previous references to April’s initial 50bp hike as a “relevant part” of the full cycle, as suspected. There is no longer any indication about the magnitude of the full hiking cycle. Policy will be data-dependent, evolving according to circumstances. That is, the Copom will do whatever it takes to keep inflation under control. There is no pre-commitment about the pace of tightening for coming meetings. Markets will likely remain divided between a 50bp and a 75bp hike, ahead of the next Copom meeting on July 23.

Upcoming quarterly inflation report looks set to sound cautious. Keep in mind that the latest minutes provide an assessment as of the time of the Copom meeting on June 4. That is, recent (high) inflation data will be incorporated in the central bank’s published analysis only at the quarterly inflation report, to come out on June 25. Given recent bad inflation surprises and the likely worsening in inflation expectations over coming weeks, we suspect that the inflation report will prove more hawkish than the latest minutes. 

But hasn't the central bank essentially given up on hitting the central target in 2008, and is increasingly focused on (benign) 2009 inflation? True: the central bank is increasingly focusing on next year’s inflation outlook, given usual time lags. But this is very different from saying that the central bank does not care about 2008. The trick is that 2009 is not fully independent of 2008. The higher IPCA goes in 2008, the higher the potential inertia for 2009.

So, the Copom is not off the hook. The good news is that consensus inflation expectations for 2009 are not too far above the 4.5% target (at least at the moment). The bad news is that expectations for 2009 have been rising steadily. The recent trend is clearly up. We suspect that the key concern for the central bank is that initially localized pressures in 2008 could end up contaminating the broader inflation picture into 2009, amid currently strong domestic demand.

Risks for rates seem biased to the upside. In all, recent inflation data, trends in expectations and policy signs consolidate the notion that the Copom could have to hike for longer than it originally envisaged. Our forecast continues to assume a full hiking cycle of 300bp, to 14.25%, by end-2008. But risks around our call remain biased to the upside.  Depending on how inflation expectations evolve, our econometric work suggests that the hiking cycle could prove to be in the range of 400-500bp (see “Brazil: Taylor-Made Monetary Policy”, This Week in Latin America, June 2, 2008).

And the global outlook facing Brazil does not seem bright. In fact, risks of global stagflation appear to have risen. Our global economics team has revised down its global growth forecast in recent weeks. Global real GDP growth in 2009 is expected to weaken below 2008. And risks for the 2009 growth outlook appear biased to the downside. Our global team has also marked up its global inflation forecast, as inflation surges to multi-year highs in several countries across the globe. Our global team expects inflation to be higher and more persistent in the next several years than what is priced into bond markets and what consensus forecasts suggest (see Cross-Asset Strategies: The New Inflation Regime, June 13, 2008).

Monetary Policy Works

There are several factors currently supporting Brazil’s growth performance. Brazil has displayed plenty of domestic demand momentum. Labor markets are supportive, as unemployment falls to record-low marks while workers enjoy real wage gains. Above all, domestic credit has expanded at a fast clip.

However, do not underestimate monetary policy’s ability to steer the economy. The 2004 experience is illustrative. The central bank started hiking rates in September 2004, and continued to hike during the next nine months, for a full tightening cycle of 375bp. As Copom tightened, a number of observers back then voiced skepticism about the efficacy of monetary policy. The economy was strong, and fast credit expansion would keep the economy roaring − the argument went.

Back in the 2004 tightening cycle, it took the market consensus more than six months to start revising growth forecasts down. The market consensus view for 2005 average interest rates was revised up repeatedly as the central bank hiked rates. But the consensus forecast for 2005 real GDP growth was little changed for several months. More than two quarters after Copom started hiking rates in 2004, the consensus finally started cutting its forecast for 2005 growth. In the event, growth did slow appreciably, from 5.7% in 2004 to 3.2% in 2005. The consensus view for growth was eventually reduced by about one percentage point from initial forecasts.

What is wrong with the consensus? We suspect that a similar story is unfolding right now. The consensus view for interest rates next year has been rising steadily, from an initial consensus forecast of 9% for the policy rate for end-2009 towards the 13% mark in recent surveys. Yet, the consensus view for real GDP growth next year remains stuck at 4.0%. Something has to give. We think that growth next year will frustrate current consensus expectations.

To be sure, each cycle is different. There are several differences between now and 2004. On the one hand, the central bank now arguably enjoys more credibility than years ago. This could help to anchor inflation expectations and limit the number of hikes needed. On the other hand, the global inflation and growth environment looks significantly worse now than back in 2004.

Still skeptical of a coming slowdown? Here is more evidence. Historical data suggest a compelling relationship between moves in the overnight policy interest rate and the response in real GDP growth, industrial production, retail sales and industrial capacity utilization, with time lags that can vary across indicators. In fact, market interest rates in the yield curve typically begin to bite even before the policy rate is actually increased.

What if growth continues unabated and monetary tightening proves ineffective this time around? Be careful what you wish for. The end-game is a domestic demand slowdown, as the central bank worries about overheating. If rate hikes do not work to cool down demand sufficiently, then the authorities would need to increase the dosage and/or resort to other tightening tools. In turn, this could increase the risks of overkill and hard landing down the road. 

Growth Has Peaked

The economy was strong in 1Q. Real GDP growth in 1Q was strong as expected, at 5.8%Y. This is shy of the 6.2% peak seen in 4Q07, but otherwise it is the strongest pace since mid-2003. Sequential growth decelerated as expected, to a still-decent 0.7%Q pace in 1Q. Domestic demand continues to outpace overall GDP growth. Investment continues to grow the fastest, at 15.2%. Private sector consumption sustains a solid 6.6% pace, on supportive labor markets and expanding credit. Surprisingly, government consumption accelerated to 5.8%, the fastest clip since mid-2002. Net exports remain an increasing drag on overall growth. Exports in volume terms actually declined (-2.1%), falling into negative terrain for the first time since 2H06.  Imports continue to climb fast, up 18.9%.

Looking ahead, the economy is set to slow under ongoing monetary tightening, with a lag. The central bank estimates that the impact of interest rates starts to be felt on real GDP with a lag of about one quarter. Our own work confirms the finding. Headline average growth in 2008 will still remain strong, almost surely above the 4% mark. But the average masks deceleration through the year. 2Q will probably remain relatively robust, although there are tentative signs that consumer confidence may have peaked around March. Evidence of a slowdown should become more visible by 2H08. In our forecast, growth will decelerate from a 5-6% pace in 1H08 to a 3-4% range in 2H.

Credit set to lose steam. Extension of domestic credit to the private sector rose 29% in 2007, and actually accelerated to 32% in April 2008. However, there are anecdotal signs that banks are starting to backpedal on their appetite to extend credit. Demand for credit remains strong. But financial institutions now appear more cautious, proactively preparing for potential credit quality deterioration in 2H08. Our bank analyst, Jorge Kuri, expects credit growth to slow to 18-20% by end-2008, and then to around 16% in 2009. Rising market interest rates have already started to increase rates for consumer loans, and there is surely more to come.

The problem is 2009. Given lags, the total cumulative impact of ongoing monetary tightening will only be fully felt in 2009. Given the growth acceleration throughout last year, 2008 started on a strong note. The statistical carryover from 2007 into 2008 was 2.5%. But the picture changes for 2009. In our computations, as the economy slows throughout 2008, the statistical carryover into next year will decline to about 1.5%.

Besides, interest rates look set to remain elevated through most of 2009. In our forecast, average policy interest rates would increase from some 12% in 2008 to above 14% in 2009. In all, our forecast continues to see average real GDP growth of 3% in 2009, below the consensus view of 4%. We assume a 300bp rate hiking cycle. If instead rates rise in the 400-500bp range, growth might dip into the 2-3% range.

Investment may prove to be an important casualty in the coming growth slowdown. If history is any guide, investment seems to be the real GDP component most sensitive to swings in policy rates. As monetary policy tightens, we suspect that investment growth will eventually decelerate, from the current mid-teens to low single-digits.

Moderate growth next year should be seen as a victory for Brazil. To keep things in perspective, 3% real GDP growth in 2009 should be interpreted as a sign of success for Brazil, given a darkening global outlook and Brazil’s own lackluster average growth performance in recent decades − not to mention outright recessions during previous downturns. 

Still, a growth slowdown next year could frustrate hopes for higher figures. A sub-par growth performance in 2009 would likely disappoint those that are used to seeing Brazil as a 5%+ growth economy. In a sense, observers got spoiled. Brazil enjoyed incredibly supportive global conditions over the last several years. As the world decelerates, Brazil will need to shift back into a lower gear too, in our view.

Estimates for potential growth in Brazil may well be revised down, as a consequence. Most estimates would appear to put Brazil’s real GDP growth potential currently in the 4-4.5% range. We would not be surprised to see a downgrade in such estimates to the 3-4% range by the end of next year.

Bottom Line

Brazil started 2008 with strong growth, but we believe that it is set to end the year on a weaker note, as the impact from monetary tightening is felt. As happened before, we believe that the consensus view is tardy in cutting its growth forecast, despite rising interest rates. But it will move lower eventually, if history is any guide. We reaffirm our below-consensus forecast for real GDP at 3% in 2009, given monetary tightening amid a global growth slowdown. We think that such an outcome would be a victory for Brazil. But it would frustrate hopes for faster expansion, and could call into question current estimates of Brazil’s ‘potential’ growth.

United States
Review and Preview
June 24, 2008

By Ted Wieseman | New York

Treasuries posted good gains across the curve over the past week, but the front end only managed to reverse a bit more than a quarter of the prior week’s enormous sell-off.  It was a quiet week with a light economic calendar.  Another rough week for financial stocks, with the BKX banks stock index plunging to another six-year low, provided support, especially during a solid rally Friday.  Ahead of Wednesday’s FOMC announcement, investors also rethought somewhat the massive, and in our view greatly overdone, repricing of the Fed seen the prior week that had left futures coming into the week priced for the likelihood of an August rate hike and even a not insignificant risk of a hike at the upcoming meeting.  In addition to the renewed worries about the health of the financial sector, this rethinking, which just about fully priced out any risk of a hike at the upcoming meeting and priced out the likelihood of an August move – though still left it priced as a significant risk, a sentiment we think probably won’t be validated by Wednesday’s FOMC statement – followed articles in both the Wall Street Journal and Financial Times on Tuesday that reported that Fed officials did not consider such an early policy reversal likely.  The week’s main negative came from more stronger-than-expected data in Europe.  After the upside surprise in the UK PPI to start the prior week destroyed the front end of the gilt market as the Bank of England path was hugely repriced and had major spillover into Treasuries that kicked off the week’s collapse, an upside surprise in UK retail sales Thursday again pounded short-end gilts (though not nearly to the degree of the prior week’s PPI reaction) and again spilled over significantly into Treasuries during the week’s only broadly negative trading session.  Economic data and monetary policy surprises in Europe are starting to become a recurrent risk for the Treasury market, raising investors’ cautiousness about holding long positions overnight.  Economic data released over the past week were mostly soft, but they had little market impact.  Housing starts fell to a 17-year low in May, and industrial production was weak.  On the inflation front, it was a familiar story from the PPI – big energy and, to a lesser extent, food-driven upside in the headline measure but a much better behaved core reading.  Weakness in jobless claims and the early regional manufacturing surveys pointed to soft results from the upcoming employment and ISM reports.  Our preliminary forecast is for a 60,000 drop in June non-farm payrolls and a 1.6 point fall in the ISM to a five-year low of 48.0. 

On the week, benchmark Treasury yields fell 10-19bp, with the majority of the gains coming in a good rally Friday as bank stocks broke to new lows, helping to drive the overall stock market to big losses, and credit spreads widened substantially.  The 2-year yield fell 19bp to 2.85%, the 5-year 18bp to 3.55%, the 10-year 12bp to 4.13%, and the 30-year 10bp to 4.70%.  A rush into cash is starting to squeeze the very short end again as we approach quarter-end, with the 4-week bill’s bond equivalent yield down 39bp to 1.48%.  Energy prices were volatile through the week, but ended up little changed, as optimism that China’s gasoline price hike would reduce demand was apparently offset by rising geopolitical concerns.  July oil dipped US$0.24 a barrel to US$134.62 and July gasoline US$0.02 a gallon to US$3.44.  Agricultural commodity prices were also just a bit softer on the week.  TIPS still underperformed substantially in the face of the significant rally in nominals, except the long end, which did very well.  The 5-year yield fell 13bp to 1.02%, the 10-year 8bp to 1.66%, and the 20-year 11bp to 2.21%.  This resulted in the benchmark 5-year inflation breakeven falling 5bp to 2.54% and the 10-year 4bp to 2.47% – a combination that reduced the benchmark 5-year/5-year forward another 4bp on top of the prior week’s 10bp decline to 2.41%.  This spread has come down 20bp in the past three weeks, so at least this gauge of long-term inflation expectations has moderated quite a bit since the Fed ramped up its anti-inflation rhetoric in an effort to keep such expectations in check. 

With not much in the way of economic data or Fed news during the week, rising worries about the financial sector provided key support to the Treasury market’s rebound.  Of particular note was another terrible week for financial stocks.  The BKX banks stock index fell another 6% to another six-year low (and nearly traded to its worst level since 1998 on an intraday basis), having now plunged 17% so far this month.  This sell-off helped to push the S&P 500 down 3.1% on the week to its lowest close in almost three months.  Credit also traded significantly lower, with most of the weakness on Friday, with the investment grade CDX index 11bp wider on the week at 125bp in late trading Friday, which would be the worst close since mid-April.  The high yield index was 14bp wider at 620bp through Thursday close, but the index was also hit hard Friday and on pace for its worst close in a couple months.  Other risk markets did relatively better.  The commercial mortgage CMBX market had a rough Friday also, but ended the week with the highest rates indices only slightly worse, with the AAA index 3bp wider at 115bp and the AJ 5bp wider at 351bp (the lower-rated indices did somewhat worse).  The leveraged loan LCDX index was 6bp wider on the week at 362bp as of midday Friday.  This index has been little changed and not shown much day-to-day volatility over the past month.  After getting crushed over the prior few weeks, the subprime ABX market did relatively much better in the latest week.  The AAA index dipped 0.33 point to 48.92, but all the lower-rated indices gained.  Still, given the big prior sell-off, investors are still worried that there could be big further subprime write-downs when firms with June quarter-ends report next month, and these worries received some confirmation on Thursday when Citigroup’s CFO said that the firm would report ‘substantial’ subprime write-downs for 2Q. 

Fed rate hiking expectations were significantly scaled back, with the market now not seeing an August rate hike as likely, though still a significant risk.  The July fed funds contract gained 3bp to 2.025%, largely pricing out any risk of a rate hike Wednesday, August 8.5bp to 2.09% and October 18.5bp to 2.30%, shifting the timing of the first expected hike to the September from the August FOMC meeting, November 18.5bp to 2.46%, and January 21.5bp to 2.64%, pricing a close call on whether the funds target will end the year at 2.75% or 2.50%.  A funds rate target of 2.75% is now seen after the January meeting instead of 3% after a 24.5bp gain in the February contract to 2.81%.  Eurodollar futures gains were led by the Mar 09, Jun 09 and Sep 09 contracts, which rallied 29bp to 3.615%, 30bp to 3.805% and 29bp to 4.025%, respectively.  The greens (Sep 10 to Jun 11) also did quite well, rallying 26.5-28.5bp, in line with the 5-year Treasury’s strong performance on the curve. 

It was a light week for economic data.  The only major monthly releases were PPI, housing starts and industrial production, all released Tuesday to little market reaction.  The producer price index surged 1.4% in May for a 7.2%Y rise, boosted by a gasoline-driven spike in energy prices (+4.9%) and a significant rise in food (+0.8%).  The core was better behaved, gaining 0.2% for a 3.0% annual increase, restrained by pullbacks in the volatile motor vehicle components, with cars and light trucks each down 1%.  Drug prices also flattened out after big upside earlier in the year.  Results at earlier stages continued to show major pipeline cost pressures.  The core intermediate index (+2.0%) posted its biggest increase since 1980 on upside in chemicals and metals.  The core crude surged another 5.0% for a 33% spike over the past year.  Housing starts fell 3.3% in May to 975,000 units annualized, a 17-year low.  The volatile multi-family starts moved lower after a sharp rise in April boosted overall starts, falling 8.0% to 301,000.  Single-family starts fell 1.0% to 674,000, a 13th-straight decline.  Single-family starts have now fallen 63% from the January 2006 peak, but we expect about another 25% decline through the early part of next year to bring bloated inventories of unsold new homes back to more normal levels.  Industrial production declined 0.2% in May as the key manufacturing gauge was flat, and a weather-related drop in utility output (-1.8%) was a drag.  Motor vehicle and parts production (+1.0%) posted a surprisingly small rebound after plunging 11.5% over the prior two months.  We had expected a much sharper gain after the American Axle strike ended, but the Fed data will likely show a very big rise next month.  Excluding motor vehicles, factory output dipped 0.1%, in line with the soft hours data from the employment report.  The overall capacity utilization rate fell 0.2pp to 79.4%, low since December 2004, down from a peak of 81.4% hit last July, and more than a percentage point below the long-term average, pointing to falling pricing power in the industrial sector.

Initial indications suggested that the key early round of June data will be weak.  Although jobless claims showed a bit of improvement in the latest week, based on their high level and underlying deterioration seen over the past month, we look for a 60,000 decline in June non-farm payrolls, which would extend the run of negatives to six months for overall jobs and seven months for private sector payrolls.  The two early regional manufacturing surveys were quite soft, pointing to a pullback in the ISM after last month’s gain.  On an ISM comparable weighted average basis, the Empire State manufacturing survey fell to 48.0 in June from 49.9 in May, a five-year low, and the Philly Fed survey to 45.3 from 47.2, the second-lowest reading since the 2001 recession.  Based on these results, our preliminary ISM forecast is for a decline to 48.0 from 49.6, which would be a five-year low.  We’ll update our forecast in the coming week based on the results of the remaining regional Fed surveys from Richmond on Tuesday, Kansas City Thursday and Dallas on June 30.  Finally, early indications suggested that auto sales, which already collapsed in April and May, might have fallen substantially further in June.

Focus in the coming week will be on the FOMC meeting Tuesday and Wednesday.  Any actual change in rates seems very unlikely (and the market is now priced that way after seeing a risk of a hike a week ago), but the statement released Wednesday will be closely scrutinized to see to what extent it validates the market’s expectations for a series of rate hikes starting no later than the September FOMC meeting.  We think that the statement may be tweaked somewhat to raise concerns about inflation and possibly indicate lesser fears about downside risks to economic growth.  We’re not expecting any major shifts in the language, however, and we do not expect the statement to validate the pricing still of a significant risk of a rate hike at the following FOMC meeting on August 5.  The market will have to take down a lot of supply in the day’s surrounding the FOMC meeting, with a US$30 billion 2-year auction Tuesday and US$20 billion 5-year Thursday.  Although we’re coming into this heavy supply with a much better tone after the past week’s bounce, this much greater issuance could still prove tough to swallow.  The market has taken a significant hit each of the past three months during the week of 2-year and 5-year issuance.  The data calendar is fairly busy in the coming week, but with releases of mostly secondary importance ahead of the key round of initial June data the following week.  Data due out include consumer confidence Tuesday, durable goods and new home sales Wednesday, revised GDP and existing home sales Thursday, and personal income and spending Friday:

* We look for the Conference Board’s measure of consumer confidence to fall to 55 in June.  Surging gasoline prices and continuing deterioration in the labor market should send confidence down another couple points to a 16-year low.

* We forecast a 0.7% decline in May durable goods orders.  The April orders data were surprisingly strong, and the ISM orders gauge showed a nice uptick in May.  Still, we lean toward a modest pullback in bookings. The key core category – non-defense capital goods excluding aircraft – is also expected to slip 0.7%.  Finally, company reports point to little change in the often volatile aircraft category this month.

* We expect new home sales to be about unchanged in May at 525,000 units annualized, consistent with the recent performance of the homebuilders’ survey.  From a broader standpoint, the latest round of price cutting appears likely to trigger a bottoming in sales, and thus we look for activity to drift sideways over the next few months.

* We look for a modest further upward move in 1Q GDP growth to +1.2% from the prior reading of +0.9%.  The main contributors are expected to be higher consumption and inventories.  Meanwhile, upward revisions to both exports and imports should prove to be just about entirely offsetting.

* We expect May existing home sales to rise to 4.95 million units annualized.  The sharp jump in the pending home sales index points to some upside in May resales.  Our estimate implies about a 1% uptick this month.

* We look for a 0.3% increase in May personal income and 0.4% gain in spending.  The labor market data point to a modest rise in income this month.  Meanwhile, consumption is expected to post a slightly larger advance.  The retail sales data showed a surprisingly sharp gain in retail control – even though the price-related spike in gas station sales was somewhat below expectations.  That report also pointed to upward revisions to consumption in March and April.  Finally, we expect the core PCE price index to rise by 0.16%, which would keep the year-on-year pace steady at +2.1%.