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Hong Kong
The Tide Has Turned in Monetary Conditions August 05, 2008 By Denise Yam | Hong Kong HK$ M3 Contracted 3.8%Y in June HK$ broad money supply M3 contracted year on year for the first time in more than three years, by 3.8% in June. In our view, this should serve as a wake-up call that the liquidity party, which has buoyed The Liquidity-Driven Economy Revisited We have never reiterated enough the fact that Buoyed by Liquidity over the Last Few Years The Tide Seems to Have Turned, Nevertheless Unfortunately, recent monetary data suggest that the capital flows into HK$ assets over the past few years appear to be reversing. Given the large size of Hong Kong’s financial markets and fundraising activities relative to its monetary system, the standard money growth counters (money supply growth, deposit growth, etc.) tend to experience sharp fluctuations, making them less-than-ideal indicators of monetary conditions. Under the fixed exchange rate system, these traditional datapoints also say nothing about the monetary policy stance. The primary influence over monetary conditions under a fixed exchange rate system is capital inflows and outflows, and this is exactly what we should follow in the case of US$8.3 Billion Capital Outflow in June 2008 In Weakening HK$ and Rising Interest Rates? May 31, 2007, we detailed how we should keep track of changes in the banking system’s net foreign asset position as an indicator of capital flows into and out of HK$. This surged from an average level of US$22 billion before the May 2005 modifications to the currency board system, to a peak of US$86 billion in October 2007 when the stock market also peaked. Capital outflows since have brought this proxy for the stock of excess liquidity back to US$40.8 billion at the end of June, with a sizeable drop of US$8.3 billion in June alone. Sharp Rebound in HK$ Loan-to-Deposit Ratio A narrowing net foreign asset position in the banking system implies a rebound in the HK$ loan-to-deposit ratio (LDR), the low level of which had suppressed interest rates in the past few years. Indeed, the sharp rebound in LDR has narrowed the HIBOR-LIBOR spread significantly in recent months. And in the face of higher interbank interest rates, some banks (smaller banks that fund from the interbank market) in Conversion into Renminbi Deposits Only Accounts for Small Portion of Capital Outflows Some observers cite the steady purchases of renminbi by Hong Kong depositors as a significant contributor to China’s capital account surplus, as well as the outflow from HK$ in the recent months. However, we argue that this is not the case. The sharp surge in renminbi deposits in the Hong Kong banking system took place in the first four months of this year, bringing the total from HK$33.4 billion (end of Dec-07) to HK$76.6 billion (end of Apr-08), but since then the growth has stalled (HK$77.6 billion at end Jun-08). The total increase in 1H08 was HK$44.2 billion, equivalent to US$5.7 billion, which is very small compared to the portion of the increase in China’s FX reserves unexplained by the trade surplus (US$281 billion), and the total outflow from HK$ (decrease in banking system net foreign asset position) (US$34 billion). A Reasonable Buffer Before Monetary Conditions Become Tight, Nevertheless While capital flows have been unfavorable to the HK$ in the past few months, there is still a considerable pool of excess liquidity in A Reminder of Our View on the Exchange Rate Much debate has heated up concerning rising inflation in Bottom Line – the Tide Has Turned in Monetary Conditions Easy monetary conditions that have buoyed asset markets in the past few years appear to have made a decisive turn. We believe that the shortfall in credit and liquidity in the developed markets in the aftermath of the
China
Renewed Debate on the Renminbi Exchange Rate August 05, 2008 By Qing Wang | Hong Kong Renminbi Depreciation Warranted to Help Exporters? These developments and the prospect of further weak performance going forward have caused concern about a potentially sharp slowdown in exports and the negative employment implications. Against this background, calls have been made for policymakers to help exporters handle the difficulties. In particular, the cumulative renminbi appreciation of more than 20% against the US dollar since July 2005 has been blamed as a key factor in exacerbating the weakening export performance. In this context, the merit of further renminbi appreciation has been questioned, and some even pose the question of whether renminbi depreciation would be warranted to help exporters. Indeed, the pace of renminbi appreciation against both the US dollar and the currency basket has slowed noticeably since mid-June. No Market Basis for Sustained Depreciation While we cannot rule out completely the possibility of a near-term (e.g., in a matter of days or even weeks) renminbi deprecation as part of the authorities’ effort to create two-way volatility in the market, we believe that the risk of sustained renminbi depreciation is very low. Specifically, the renminbi exchange rate − as one of the most important macroeconomic variables − is still fundamentally undervalued and needs to appreciate towards its equilibrium level over the medium term, in our view. Without central bank intervention, market demand for FX must be greater than supply for renminbi depreciation to materialize. This is possible if: a) China’s current account balance turns from surplus to deficit, and the deficit is large enough to offset net capital inflows under the capital account; or b) China’s current account is still in surplus, but net capital outflows under the capital account are large enough to offset this surplus. However, neither scenario is likely in the foreseeable future, in our view. Here is why: First, given the sizable trade surplus at the current juncture, import growth would have to outpace export growth by a large margin for a sustained period to turn the trade balance from surplus to deficit. For instance, we estimate that, even if export growth were to drop to 10%Y and import growth were twice as fast (i.e., 20%Y), a sustained trade deficit would not emerge until after June 2010. Second, As long as there are net FX inflows (through either the current account surplus or the capital account surplus), the supply of FX will be greater than demand in the market, and the renminbi exchange rate will be under appreciation pressure unless the central bank intervenes. If the central bank were to intervene in the FX market aggressively, it could potentially bring about a renminbi depreciation despite large net FX inflows. To engineer a renminbi depreciation, the central bank could buy more FX than the market is willing to sell initially, thus bidding up the price of FX. However, we seriously doubt that the central bank would be able to conduct this type of ‘super-aggressive’ intervention on a sustainable basis. In practice, the typical policy response of central banks facing large FX inflows is to intervene with the objective of slowing the pace of domestic currency appreciation instead of completely reversing the appreciation trend, as this would entail much more accumulation of FX reserves than otherwise. We think that such a strategy would be especially inconceivable for the PBoC, which is already being challenged for too much FX reserve accumulation at the current juncture. To recap, we think that the renminbi exchange rate will be subject to strong appreciation pressure without central bank intervention; it is highly unlikely that the renminbi appreciation trend would be reversed even with central bank intervention. In a sense, hoping for renminbi depreciation to help exporters is wishful thinking, in our view. Slower Appreciation Likely While we do not believe that the Chinese authorities will defy the ‘law of gravity’ to engineer a sustained renminbi depreciation despite persistent FX inflows, we think it is likely that the central bank may fine-tune its intervention policy to effect a slower appreciation in the short run. For the foreseeable future, the renminbi exchange rate remains largely a policy instrument − that is tightly managed by the authorities − instead of a market-determined variable. To fulfill its role as a policy instrument, the renminbi exchange rate will likely be employed to help the economy cope with the cyclical headwinds stemming from weakening external demand. To this end, the appreciation pace of the renminbi exchange rate will likely slow meaningfully in the short run (i.e., 6-12 months), in our view. While it is debatable how effective slower appreciation of the renminbi exchange rate can be in mitigating the downside to export growth, the renminbi exchange rate is perhaps the most ‘convenient’ tool that policymakers can use. Do Not Confuse the Renminbi’s Two Policy Roles On the opposite side of the debate, some market observers argue that In our view, this argument for continued fast appreciation loses sight of the distinction between the two policy roles imparted to the renminbi exchange rate: coping with cyclical headwinds in the short run and facilitating structural adjustment over the longer run. If one focuses only on the latter, the conclusion is obvious: the exchange rate should appreciate as much and as fast as possible. However, this is rather dogmatic thinking, in our view. Policymakers are pragmatic and tend to strike a balance between addressing cyclical and structural issues. With an export-led cyclical slowdown well under way, cushioning the downside to the growth outlook has become a priority and would entail counter-cyclical policy responses, including use of the exchange rate instrument. With the renminbi exchange rate fundamentally undervalued, slower renminbi appreciation is an appropriate cyclical versus structural balance, in our view. Implications We expect a slower appreciation trend but more volatility in the exchange rate going forward. We expect the pace of renminbi appreciation to slow substantially in the next 6-12 months. We therefore endorse our global FX strategy team’s forecasts for the USD/CNY rate to reach 6.6 by end-2008 and 6.3 by end-2009 (see FX Pulse: Summer Dol(lar)drums, July 31, 2008). Notwithstanding a slower appreciation, we think that the authorities will try to create even more short-run two-way volatility than previously, with a view to continuing to imitate a managed-float exchange rate regime and keeping onshore market participants exposed to exchange rate uncertainty at least in the very short run. Moreover, energy price normalization will likely replace currency appreciation as the primary driver of
Spain
Macro: Construction Correction Driving Economy Down August 05, 2008 By Carlos Caceres | London Summary and Conclusions Spanish GDP Growth on a Clear Decelerating Path The Spanish economy has been growing above 2.5% on a year-on-year basis every quarter throughout its history inside the European Monetary Union (EMU). In fact, it has grown above that level since 2Q96 – following a period of fiscal tightening needed at the time to secure a place for The Economy Is Facing Tough Domestic Challenges … Internally, … Compounded by Mounting External Risks In any case, the correction in the construction sector is not the only challenge faced by the Spanish economy. In fact, the global headwinds that are affecting the euro area are part of the Spanish headache as well. We think that the strong euro, high energy prices, relatively high market-based short-term interest rate spreads (i.e., Euribor spreads), combined with the aforementioned domestic weaknesses, will likely have a negative and significant impact on the Spanish economy in the short-to-medium term. House Prices Clearly in House prices decelerated further in 2Q08. In fact, real house prices, which barely entered negative territory in 1Q08, decelerated further last quarter and are now falling by around 2.5% on a year-on-year basis. This compares with real house price growth above 15%Y during its peak in 2004. Nominal house prices are still growing at around 2.0%Y at the moment, but are likely to reach a standstill by year-end, and then the latter will likely fall throughout 2009. Currently, we think that real house prices are likely to record a rate close to -10%Y by the end of 2009, equivalent to a fall of around 6-7%Y in nominal terms. Yet, we think that risks to this call are skewed to the downside. In particular, house prices could fall further if there is a significant reversal in foreign (portfolio) investment flows, which have financed a significant proportion of the Spanish current account deficit. … and a C/A Rebalancing Could Bring Asset Prices Down The Spanish current account (C/A) deficit has been growing sharply in recent years, reaching 10% of GDP in 2007. Further, the widening of the current account in Property More Vulnerable than Most Asset Classes In the event that a significant correction in this current account imbalance were to materialise, we think that asset prices are likely to be the main ‘victim’, in particular house prices. Indeed, given that any adjustment cannot be done via a nominal depreciation within EMU, the real exchange rate would need to do the job, through a generalised price deflation within the country. However, it is a well-known fact that real wages tend to be relatively rigid in the short run. Hence, the most likely candidates to experience this price deflation are asset prices. Within asset classes, and in relative terms, we think that property prices might be more at risk compared with government bonds – linked to fiscal sustainability (Spain has sound fiscal policy rules, and relatively low public debt) – or even equity prices. The latter are linked to the intrinsic value of companies, and most of the quoted companies (for which paper is actually liquid) have performed so far better than the market expected, in particular thanks to their exposures outside Investment Still Set to Be the Weakest Link in the Economy Clearly, the correction in the construction sector will be reflected by a fall in construction investment. Indeed, this sub-component of GDP will likely experience a sharp slowdown this year, and an outright contraction is the most likely scenario for 2009, we believe. However, the other sub-components of investment in the national accounts would not be immune to the slowdown, notably capex. In fact, the corporate sector in Private Consumption Is Also Facing Significant Risks We still maintain our view that the wealth effects of falling house prices on consumption would be relatively low compared with, for instance, the Anglo-Saxon economies. Indeed, products such as mortgage equity withdrawals, home equity loans, piggy-back loans, etc., are relatively rare in Fiscal Policy: Too Little, Too Late
United States
Review and Preview August 05, 2008 By Ted Wiseman | New York Treasuries posted big gains over the past week as recession fears increasingly took hold on worse-than-expected GDP results – with a negative print now in 4Q apparently quite a shock to investors even though it didn’t take all that large of a downward revision to get there – a weak run of key early data for July in the employment, ISM, motor sales reports and a spike in initial jobless claims, even though this jump was clearly a result of a special factor. There also seemed to be sharply diverging views across different investor types about whether Merrill Lynch’s sale of US$31 billion in ABS CDOs at 22 cents on the dollar to a distressed asset investment fund was good news or bad news about the state of the financial sector and the severity of the unfolding credit crunch. Prior to this news when financial stocks were falling early in the week, the downside supported Treasuries significantly, driving a big rally Monday. But when bank and brokerage stocks sharply rebounded over the rest of the week after the Monday night Merrill announcement to end higher on the week, Treasuries were not pressured in any significant way by the upside – breaking what had been a very close recent inverse correlation. Interest rate market investors were also surprisingly pessimistic about the possibility that enhanced Fed liquidity measures could help to solve the severe term funding pressures in the interbank market. There was only a modest initial response in forward 3-month Libor/OIS and swap spreads to the Fed’s long-hoped-for decision to extend half the TAF loans to 3-months from 1-month starting in a couple weeks, and almost all of the improvement in Libor/OIS spreads and more than all of the small initial swap spread narrowing was subsequently reversed, while spot 3-month Libor and the spot 3-month Libor/OIS spread did not move at all. We think that there is a good chance that the TAF extension will have a meaningful positive impact, but clearly investors are taking a wait-and-see approach for now. On the week, benchmark coupon yields fell 13-22bp, led by the 5-year. The 2-year yield declined 20bp to 2.51%, the 5-year 22bp to 3.23%, the 10-year 16bp to 3.95% and the 30-year 13bp to 4.57%. A renewed flight-to-safety bid was evident at the very short end as well, with the 4-week bill’s bond equivalent yield down 20bp to 1.52%. Short-end TIPS continued to perform relatively poorly, but the longer end did well in the face of the significant gains in the nominal market as energy prices stabilized after their big prior fall, with September oil rising US$2 a barrel on the week to US$125. The 5-year TIPS yield fell 17bp to 1.07%, the 10-year 16bp to 1.62% and the 20-year 13bp to 2.12%. Swap spreads initially narrowed modestly in response to a decline in forward Libor/OIS spreads after the Fed’s TAF announcement Wednesday, but this was more than reversed on Thursday and Friday. The benchmark 5-year spread rose 4.25bp on the week to 94bp and the 10-year 2.75bp to 72.25bp. Current coupon mortgages lagged this swap spread widening slightly. In absolute terms, MBS still saw some improvement on the week, but spreads remain very wide and mortgage rates being offered to consumers are likely to remain elevated in the coming week. Freddie Mac’s weekly survey showed only a modest drop in the average 30-year mortgage rate in the latest week to 6.52% from 6.63% the prior week. These were the two highest readings since last summer, and up from sub-6% rates in the spring. A major focus in the MBS market remains the stance of Asian investors, who have been notably quiet. Our desk thinks that mortgages could outperform significantly if Asian buying resumes, but the continued absence of this key investor base is concerning. Agencies also lagged swaps a bit on the week, with 10-years ending the week at about Libor +5bp after closing the prior two weeks near Libor flat. Asian investors aren’t boycotting agencies, but the 30% distribution they received of the FHLB 5-year deal that priced Thursday was lower than normal. Risk markets were mostly little changed on the week, but a notable break occurred in the previously tight inverse correlation between Treasuries and financial stocks after Merrill Lynch’s announcement of its ABS CDOs sale. The S&P 500 ticked up only marginally for the week, but after a weak start (which significantly boosted Treasuries Monday), financials rallied. The BKX banks stock index gained 6%, and the S&P 500 investment banks sub-index 4%. According to our credit team, there simply isn’t enough public information available to make an informed analysis of whether the Merrill sale was a good or bad deal. Stock market investors certainly seemed to be adopting an optimistic tilt though, while interest rate investors were much more cautious. Credit also ended little changed. In midday trading Friday, the investment grade CDX was 2bp tighter on the week at 134bp. High yield did worse, with the index trading down a third of a point midday Friday after being 4bp wider on the week at 693bp as of Thursday’s close. The higher-rated subprime ABX indices reacted positively to the Merrill deal, with the AAA index rising nearly 2 points on the week to 44.25, a three-and-a-half-week high, and the AA almost a point to 11.04. The commercial mortgage CMBX market continued to be a relative laggard, with the AAA index widening 3bp to 163bp (after hitting a post-March wide of 170bp early in the week), the AJ 4bp to 496bp, and the AA 21bp to 712bp. A more dovish Fed outlook was priced into futures markets ahead of what’s likely to be an uneventful FOMC meeting on Tuesday. The market is still expecting the first rate hike to come in October, but sees a delay until December as increasingly likely. We continue to see the Fed on hold well into next year. The October fed funds contract gained 3bp to 2.085%, November 4.5bp to 2.16%, January 5.5bp to 2.25%,and February 7bp to 2.375%. Front-end eurodollars outperformed fed funds, but not by much as forward Libor/OIS spreads saw a disappointingly small improvement. Spot 3-month Libor didn’t move at all, ending the week unchanged at 2.79%, leaving the spot 3-month Libor/OIS spread little changed at 73bp. Almost no improvement is priced from this strained level out to September and December, and only a relatively modest narrowing to about +53bp out to March. Real GDP rose at a slightly lower-than-expected 1.9% annual rate in 2Q, as a huge drag from inventories (-1.9pp) was offset by an enormous positive contribution from net exports (+2.4pp). This was the largest quarterly add from trade since 1980, and the contribution of +1.5pp over the year through 2Q accounted for almost all of the 1.8% gain in GDP over this period. Final domestic demand was weak, rising at a 1.3% annual rate. Consumption (+1.5%) picked up a bit, but remained relatively sluggish even with a significant boost from tax rebate checks. Residential investment (-15.6%) was down sharply again, though less so than over the prior few quarters. The main negative surprise in the report was weakness in capital spending. Overall business investment rose a much lower-than-expected 2.3%, as a 14.4% jump in the structures component was largely offset by a surprising 3.4% decline in equipment and software. The annual revisions showed only slightly slower growth over the past three years. There were some significant adjustments to individual quarters, however. Of particular note, 4Q now shows a decline of 0.2% instead of 0.6% growth, while 1Q was adjusted down marginally to +0.9% from +1.0%. If not for the boost to 2Q from the tax rebate checks, without which GDP probably would have declined, the economy would likely now have been viewed as being in a clear recession. We are in the process of updating our estimates going forward. Relative to our last estimates of +1.0% in 3Q, -1.5% in 4Q and -0.5% in 1Q, the bigger-than-expected drag from inventories in 2Q and the recent pullback in energy prices should provide modest upside. On the other hand, the credit crunch continues to worsen, a bigger-than-expected boost from tax rebate checks in 2Q implies a bigger payback going forward, and the crucial support from net exports appears at increasing risk. Our colleagues in Early indications for 3Q in the initial round of key July data were weak. Job declines remained moderate, but other details of the employment report were weaker. The manufacturing ISM held up better than expected, but only because of a surge in the employment gauge that was hard to take seriously; key underlying details worsened. And motor vehicle sales were a disaster. Non-farm payrolls declined 51,000 in July, as continuing weakness in manufacturing (-35,000), construction (-22,000), retail (-17,000) and business services (-24,000) was partly offset by further good gains in government (+25,000) and healthcare (+34,000). Leisure and hospitality (+1,000) was also soft as the teenage unemployment rate hit a 16-year high of 20.3%. The overall unemployment rate rose another two-tenths to 5.7%, a high since March 2004 and up from the cycle low of 4.4% hit early last year. Other details of the report were also soft. The average workweek fell a tenth to 33.6 hours, matching the all-time low, which combined with the drop in payrolls resulted in a 0.4% fall in aggregate hours worked. Average hourly earnings rose 0.3%, keeping the annual rate steady at a sluggish +3.4%. Aggregate weekly payrolls, a proxy for total wage and salary income, fell 0.1%, pointing to weakness in underlying personal income within what will likely be a big overall drop resulting from much lower rebate check distributions in July than June. The composite manufacturing ISM index dipped just marginally in July to the breakeven level of 50.0 from 50.2, but only because of a bizarre eight-point spike in the employment gauge to 51.9, indicating growth in factory payrolls that the employment report made clear is not actually occurring. This was likely a temporary seasonal adjustment problem that will probably be reversed next month. Excluding this quirk, the report was weak. The orders index fell nearly five points to 45.0, a low since the 2001 recession, with the exports orders index seeing significant moderation to 54.0 from 58.5. To this point, the manufacturing sector has been supported by robust exports even as domestic demand has stagnated. But with Europe and Motor vehicle sales continued to collapse in July. Based on a nearly complete count, we estimate that sales plunged to just a 12.6 million unit annual rate from an already poor 13.6 million in June. We estimate that sales of domestically produced vehicles declined to 9.1 million from 9.9 million, a low since 1987, while imports held about steady at 3.5 million versus 3.6 million. Truck sales continued to plummet, but car sales are starting to show signs of weakness as well. And this is all on the domestic side, as imported car sales have remained quite strong. We estimate that sales of domestically produced cars sank to 4.5 million units annualized in July, a nearly 50-year low. The most notable event in coming week’s otherwise quiet economic calendar is clearly the FOMC meeting on Tuesday, but even here we’re not expecting much excitement. The fed funds rate is all but certain to be held steady at 2.00%, and we do not expect any significant changes in the statement. The recent pullback in energy prices will probably be mentioned, but we doubt that FOMC members will be making any meaningful changes in their inflation or growth outlooks as a result of this yet, given how volatile oil prices have been. There will probably be meaningful investor interest in the number of dissents in favor of higher rates, but we think that this focus would be largely misplaced, as the most vocally hawkish FOMC officials appear to be well outside the majority view led by Chairman Bernanke and Vice Chairman Kohn at this point. After the FOMC, focus will largely shift to the refunding auctions, US$17 billion in 10s Wednesday, up US$2 billion from last time, and US$10 billion in 30s Thursday, up US$1 billion. The most notable economic data will be the monthly chain store reports on Thursday, which seem likely to start showing some payback from the tax rebate boosted results in May and June. In May, US$48 billion in tax rebate checks were distributed and in June US$28 billion, but this fell to only US$14 billion in July, with the last large distribution on July 11. And gasoline prices moved to record-highs mid-month, only beginning to come significantly off the peaks towards month-end. Weakness in chain store sales on top of the dismal auto sales results would indicate significant potential weakness in July retail sales after the recent run of upside surprises. Other data releases due out include personal income and factory orders Monday, non-manufacturing ISM Tuesday and productivity Friday: * We look for a 0.3% decline in personal income in June and a 0.4% rise in spending. The quirk related to the distribution of tax stimulus rebate checks that contributed to a spike in income growth during May should partially reverse in June. Were it not for this special factor, personal income would be expected to rise 0.4% – quite close to the recent underlying trend. Meanwhile, retail control posted a sharp price-related jump in June, but sales of motor vehicles registered another decline. Also, outlays for services are expected to moderate following an outsized gain in May. So, overall spending is likely to show a more modest advance than in May, and we are likely to see small downward revisions. Finally, based on the PPI and CPI inputs, the headline PCE price index is expected to be up 0.75% with the core rising 0.20%. * Based on the durables data, we look for another solid 1.0% gain in June factory orders, although it’s important to keep in mind that some of the resent upside is attributable to price effects. Meanwhile, inventories are expected to rise 0.6%. * We forecast a 2.8% rise in 2Q productivity and a 1.0% increase in unit labor costs. The GDP data showed that output rose nearly 2%, while the labor market figures pointed to an outright decline in hours worked. So, it looks like productivity posted another solid gain in 2Q. And the year-on-year growth rate is actually expected to be a little bit above +3%. Meanwhile, unit labor costs appear to have moderated in 2Q, and we are likely to see downward revisions to prior quarters.
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