Brazil
Meltdown Avoided, but Upside Capped
June 17, 2009

By Marcelo Carvalho | Brazil

Radical Revision

We have been far too pessimistic on the economic and currency outlook for Brazil.  Previously we thought that Brazil's recession would be sharp and prolonged, and that the currency would weaken - we expected real GDP growth at -4.5% in 2009 and 0.5% in 2010, while the currency would weaken to 2.5 by end-2009 and 2.6 by end-2010. It's now clear that the recession will be short and less pronounced, and that the BRL will be more resilient.  We now expect real GDP growth to be -1.0% in 2009 and 2.5% in 2010, with the currency finishing 2009 at 2.1 and 2010 at 1.9.

Diagnosing the Miss

We underestimated Brazil's resilience to negative shocks, and did not foresee quickly improving capital inflows and commodity prices.  Brazil's recent experience with and genuine progress on improved macroeconomic fundamentals has led firms, consumers and global investors to have confidence that Brazil could weather the global downturn.  As a result, firms did not cut employment as much as we expected, and thus income and consumer spending have been stronger than we thought.  For their part, global investors have returned quickly to Brazil, as progress on policy, balance sheets and the health of its financial system has also helped it to weather the storm.  So there was less spillover from the global financial crisis and the prospect of evaporating external capital inflows into home-grown problems. In fact, with global investors expressing confidence in Brazil's prospects, policymakers face a virtuous circle: The currency has strengthened, helping to keep inflation low, and allowing monetary policy to ease further to support demand.  Finally, the recent rebound in commodity prices and bottoming in Chinese demand for Brazil's exports has begun to foster recovery. 

External Factors Temper the Outlook

Brazil remains dependent on international conditions and global growth.  So, while our global team has revised up the global growth outlook, with 2010 closer to the 3% mark (and the IMF is reported to have increased its 2010 forecast to 2.4% from 1.9% before), we expect that the lingering impact on the financial crisis will keep global growth slower in the next few years than in the 2003-07 boom.  As a result, the global cyclical support for Brazil will likely be limited. And boosting Brazil's longer-term growth potential will continue to depend on advancing an unfinished agenda of structural reforms.

Details

Brazil's economy has been more resilient that we expected. The real GDP growth decline in 1Q09 was surprisingly mild, just -0.8%Q, after -3.6%Q in 4Q08, and much better than industrial production would suggest, judging by historical correlations. On the supply side, services did surprisingly well, with corresponding better-than-expected private sector consumption on the demand side. Private sector consumption quickly rebounded to +0.7%Q in 1Q09, from -1.8%Q in 4Q08. In all, although Brazil entered technical recession in 1Q, with two consecutive quarters of negative growth, the decline in 1Q was much milder than anticipated.

Labor markets, consumer confidence and credit availability have provided support for private sector consumption.  Labor markets have been more supportive than we thought. In previous crises, currency devaluation associated with market turmoil would typically push up inflation significantly. In turn, rising inflation would erode real wages. This did not happen this time, as pass-through to inflation was remarkably muted. And nominal wages cannot easily adjust down, as the constitution prohibits outright nominal wage cuts. In all, total real wage earnings have been resilient, despite a slowdown in total employment growth. In April, total real wage earnings were up 3.4%Y (above inflation), with real average wage earnings up 3.2%Y (per worker) and employment up 0.2%Y.

We thought unemployment would worsen sharply, but it did not. Seasonally adjusted, the unemployment rate increased from an average of 7.7% in 4Q08 to an average of 8.5% during January-April, while we thought it could be rising closer to double-digits by now. Judging by a separate formal jobs survey (CAGED), hiring froze in late 2008, but has improved since then. Seasonally adjusted, net formal job creation had averaged 175,000 jobs per month during the 12 months before the crisis hit last September. Net formal hiring then collapsed to a worst-on-record mark of -218,000 in December alone, but then improved to a net average of -17,000 per month during the three months through April this year (all seasonally adjusted).

Consumer confidence did not deteriorate much. Consumer confidence did take a downturn late last year - but this was relatively modest, still leaving consumer confidence high by historical standards. Looking at the components, consumer sentiment about current conditions declined relatively more, from a peak earlier in the year. But consumer expectations about future conditions did not suffer much, perhaps suggesting that consumers felt that the turmoil would prove to be temporary.

Credit conditions seem to have improved. Domestic credit conditions tightened late last year, but have recovered lately. Seasonally adjusted, new credit extension to individuals fell 5.1% in 4Q08 from the previous quarter. But instead of shrinking further, it is now up 7.6%Q on average during the three months through April. More broadly, Brazil's overall credit-to-GDP ratio still seems to be on a secular rising trend, reaching 41.7% of GDP as of April. Interest rates on new loans to individuals climbed to a peak of 58.3% in November, from 52.1% three months before - but have declined since then, to 48.8% as of April. It seems that we underestimated the health of the Brazilian banking system as a cushion against the global credit crunch.

Brazil's ability to run counter-cyclical policies in this crisis has differentiated its performance from previous episodes. The usual script in previous crisis was well known. Rising risk spreads would weaken the currency, forcing the central bank to hike rates in order to contain inflation. Given the public sector debt exposure to the currency and to short-term rates, the authorities would then tighten the fiscal belt in order to reinforce solvency. But fiscal tightening in turn would hurt growth, in a vicious cycle. That was then. Now, higher reserves, stronger policy credibility and a better debt structure have allowed Brazil to pursue counter-cyclical policies in the downturn. Fiscal discretionary expansion adds up to about 0.6% of GDP this year, and policy rates have fallen 450bp so far in the cycle.

Improving terms of trade, on the back of rising commodity prices, have been a positive surprise. Brazil's terms of trade worsened 13.1% around the turn of the year from three months earlier, but have now recovered 3.9% by April, on the heels of rising international prices for commodities, which represent about half of Brazil's total exports. There is a fairly robust empirical correlation between Brazil's real GDP growth and international commodity prices over time.

Foreign capital inflows have recovered surprisingly fast, much sooner than we had anticipated, helping local sentiment too. We had assumed that global turbulence and high risk-aversion would continue to damage international capital flows to emerging markets like Brazil. Instead, capital flows have recovered quickly. Equity and fixed income flows did take a sharp downturn with the global crisis late last year, but have rebounded smartly since then. Foreign fixed income outflows slowed to a monthly average pace of US$0.6 billion so far this year, with outright inflows in the most recent data, after a large monthly average outflow of US$3.0 billion in 4Q08. For their part, foreign equity inflows have rebounded to a positive average monthly pace of US$0.8 billion so far this year, after a sharp downturn to outright monthly outflows of US$2.9 billion on average in 4Q08. Foreign direct investment has also proven more resilient than we expected - the monthly average FDI so far this year stands at US$2.4 billion. That is down from an average of US$4.7 billion seen in 2H08, but is not far from the US$2.8 billion average pace seen during 1H08.

Chinese demand for Brazil's exports has also recovered. Despite global growth weakness, recovery in parts of the global economy such as China seems to have provided support for Brazil - including through commodity prices. The share of China in Brazil's total exports has risen dramatically. In April, China became Brazil's most important trade partner, displacing the US, which historically had been Brazil's top trade partner for decades. During January-April, Brazil's trade flows (exports plus imports) with China were up 13.9%Y, while Brazil's trade flows with the US were down 20.5%Y.

The New Outlook

Our new forecast sees positive growth going ahead. Brazil's improved fundamentals have cushioned the downturn, although the rebound next year remains sensitive to global conditions. Our old forecast had assumed negative sequential real GDP growth during 1H09, and a flat economy in 2H09. Our new forecast incorporates the better-than-expected 1Q data, and looks for resumed growth in coming quarters. Indeed, monthly data clearly suggest gains coming into 2Q, including recovering sentiment indicators.  We now see Brazil's real GDP growth at -1.0% in 2009 and 2.5% in 2010.

But external factors temper the outlook. Our global economics team foresees that lingering concerns will keep global growth slower in the next few years than in the 2003-07 boom. Our US economics team has recently revised up its forecast, but continues to look for a recovery that should be gradual, with the US economy growing by 2.2% in 2010, after -2.8% in 2009 (see Recession Ending but Recovery Will Still Be Gradual, Richard Berner, June 8, 2009). Our China economics team expects 8.0% real GDP growth in 2010, after 7.0% in 2009 (see Greater China Economics: Issues in Focus, Qing Wang and team, June 9, 2009).

On domestic factors, we assume supportive conditions into next year. Our new forecast assumes that domestic labor markets do not turn into a major headwind. It assumes that local sentiment continues to improve. We also assume that local credit conditions are supportive in 2010, barring a dramatic worsening in domestic credit quality. Fiscal policy will likely remain expansionary next year, while eventual interest rate hikes seem unlikely to alter much the 2010 growth environment, if they are gradual and later in the year.

As for the longer term, structural reforms still hold the key for sustained, faster growth in Brazil. To be sure, Brazil has come a long way. Its macroeconomic fundamentals have improved over the years, and Brazil rightly deserves to be investment grade, judging by a range of indicators that rating agencies usually look at. However, challenges remain, including a range of microeconomic reforms. Indeed, Brazil ranks poorly in the World Bank's annual Doing Business survey, which gauges indicators about local business environment around the world. Despite much progress, the reform agenda remains unfinished. A partial list includes social security reform, fiscal reform, tax reform and labor reform. That is, Brazil's improved fundamentals have helped to cushion the global cyclical downturn. But boosting Brazil's structural, long-term growth potential continues to hinge on further structural reforms (see "Brazil: Investment Grade, Why Worry?" EM Economist, May 9, 2008). 

On the currency, we now expect the real to be at 2.10 at end-2009 (2.50 before) and 1.90 at end-2010 (2.60 before). Terms of trade and growth differentials are some of the key drivers in our thinking - besides inflation and interest rate differentials, sovereign risk spreads and purchasing power parity considerations. In sum, a better domestic growth outlook and a more constructive terms-of-trade environment support a stronger currency view than we had before. Indeed, the currency has appreciated smartly in recent months - in part reflecting weakening in the US dollar itself.

The currency path ahead may well prove volatile. Markets now appear overly excited, which opens room for corrections. Looking forward, abundant global liquidity, rising commodity prices and terms of trade, besides robust capital inflows amid a supportive market sentiment, could well drive the currency even stronger in coming months, if markets remain frothy. However, we suspect that a market correction might happen before year-end, if global liquidity starts turning less abundant and markets begin to question the commodity price rally as they realize that a global growth recovery will be gradual. Still, as growth recovery gains more traction next year (in Brazil and globally), and capital flows to emerging markets strengthen, then the currency could appreciate again - although potential market uncertainty ahead of Brazil's October presidential elections might add some noise. The long-term ‘convergence' theme currently seems to be a key driver in investors' thinking about currencies like the real, but the actual currency path may well prove to be bumpy.

The central bank will likely continue to buy US dollars in the spot market, as long as the balance of payments produces surpluses. The policy intention is to absorb flows and accumulate foreign reserves, as opposed to establishing any target for the currency. The current account should remain in small deficit next year, but the central bank will continue to build reserves if capital flows remain strong, in our view. Foreign direct investment should trend higher as conditions improve, although portfolio flows can prove volatile.

As for inflation and monetary policy, we have adjusted our inflation estimates up, as the slack in the economy will not be as large as previously anticipated. We now foresee 4.2% CPI inflation in 2009, from 3.0% before, and 4.5% in 2010, from 4.0% before. This compares with an official inflation target center of 4.5%. As for monetary policy, recent signals from the central bank's monetary policy committee (COPOM) suggest that the monetary easing cycle is coming closer to an end, as the COPOM indicates that any additional rate cuts from the current 9.25% mark will have to be careful, or "parsimonious". We see rates falling to 9.0% at end-2009 (8.25% in our old forecast). We continue to suspect that the central bank may need to start hiking rates at some point next year - we foresee the policy interest rate finishing 2010 at 10.0%. 

There is now a lively monetary policy debate in Brazil - rates have come down to unprecedented lows, but can they stay there?  Rates have now fallen to single digits, for the first time in memory. The debate seems to boil down to structural versus cyclical considerations, with two main camps. In one camp, analysts would argue that, once real rates fall, they may well stay there. In this view, one reason why rates historically have been so high in Brazil is simply habit. Once rates come down, it is easier to keep them there. Let's call it the ‘multiple-equilibrium' camp. Observers in this camp would point to the previous experiences in Chile and Mexico to illustrate how rates can fall to a structurally lower range. By contrast, analysts in the ‘emergency cuts' camp would argue that ongoing rate cuts in part are an emergency response to fight a cyclical downturn. In this view, structurally lower rates would likely require structural reforms. We sympathize more with the second camp. In our opinion, rates should trend lower over time if more structural improvements are put in place, but cyclical considerations may still push rates up at some point next year.

Fiscal policy looks set to remain expansionary next year. Tax revenues should improve with the economy, but spending seems set to continue its multi-year expansion. After all, fiscal expansion has become fashionable globally, and Brazil's fiscal deficit and debt outlook seem to be in better shape than in many other parts of the world today. However, Brazil seems unlikely to embark on any massive fiscal stimulus plan. As for the debt dynamics, there is little reason to suspect any sovereign rating downgrade. But moving up another notch from the current investment grade status would likely require addressing remaining structural fiscal challenges, such as budget rigidities.

Risks to the Outlook

Risks appear biased to the downside. In a bear case scenario, global growth relapses, perhaps because some tail risk materializes. In one scenario, China's fiscal stimulus fades, while global demand falters. Commodity prices suffer, and Brazil's terms of trade deteriorate. Global risk appetite shrinks, and capital flows dwindle. The currency depreciates, perhaps towards 2.5. Interest rates rise to the 12-14% range. Growth slows to 1.0%. In one particular case, abundant global liquidity initially fuels a bubble that feels like a bull case scenario, only to burst into a bear case scenario later on.

In a bull case scenario, the global economy grows close to trend already next year, as US healing speeds up, and China expands faster. Commodity prices would benefit, which would boost Brazil's terms of trade. Risk appetite could rise quickly, and capital inflows would pick up. The currency would appreciate - say, to the strong end of the 1.5-2.0 range. Monetary easing would continue, pulling rates further down to the 6-8% range, while growth accelerates to 3.5%.

There are domestic risks too.  Labor markets, local sentiment and credit conditions will remain important factors to watch, besides policy action. Domestic risks are not entirely dissociated from external risks. For instance, if a global bear case scenario materializes, the risk of domestic policy slippage probably rises.

Bottom Line

We have been far too pessimistic on the economic and currency outlook for Brazil. We underestimated Brazil's resilience to shocks, and did not foresee quickly improving capital inflows and commodity prices. However, markets probably have run too far too fast, and external factors temper the outlook. Brazil remains dependent on international conditions, and we expect that global growth in the next few years will remain slower than in the 2003-07 boom. So, the global cyclical support for Brazil will be limited. And boosting Brazil's longer-term growth potential will continue to depend on advancing structural reforms. In all, we see real GDP growth at -1.0% in 2009 (-4.5% before) and 2.5% in 2010 (0.5% before), and look for the currency to be 2.1 at end-2009 (2.5 before) and 1.9 at end-2010 (2.6 before).

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Latin America
Speeding Up the Cycle, but Recovery Subdued
June 17, 2009

By Daniel Volberg & Luis Arcentales | New York

Whether a recovery in Latin America will happen this year is no longer in question; instead, investor focus is now on the nature of the rebound.  We are revising our outlook and now expect Latin America to experience a gradual recovery during 2H09 and into 2010.  We are lifting our annual growth forecasts to -3.2% (from -4.0%) for 2009 and to +2.3% (from +0.3%) for 2010.  Our new outlook stands in sharp contrast to our previous view that the severity of the downturn seen in Latin America at the turn of the year would have an impact on its duration, translating into no recovery at all in 2009 and during most of 2010 (see "Latin America: Lengthening the Downturn", EM Economist, March 20, 2009).  However, while sharp downturns tend to be followed by sharp rebounds, we suspect that markets may have run too far, too fast as this time around the recovery may take longer to gain strength.

Turning Optimistic...

Latin America has not been immune to one of the deepest global downturns on record - our global economics team expects the world economy to contract this year for the first time in six decades.  But we are now turning more constructive on the region's growth outlook for at least three reasons:

•           First, across Latin America, incoming data already point to a moderation in the pace of the downturn and, in some cases, a move towards recovery.  In Chile, for example, an unprecedented drawdown in inventories knocked a record five percentage points off GDP growth in 1Q, suggesting that the worst of the correction may be behind us.  In Mexico, incoming data suggest that the slump may have moderated as job losses slowed to a pace of near 500,000 annualized in March-May, less than half the 1.1 million rate in the three months through February.  And in Brazil there are clear signs of recovery as industrial production has rebounded in recent months - in the three months through April, industrial production has turned up 1.3%M, in sharp contrast to the 7% sequential contraction in the three months through December.  Confidence indicators and capital flows in Brazil have also rebounded.  In sum, incoming data - while far from uniform among the different economies in the region - suggest that for much of Latin America the worst of the downturn may be behind us.

•           Second, external conditions have turned up earlier and sharper than expected.  In our past work, we have highlighted that external conditions - terms of trade, risk premiums, world growth and world interest rates - may have played a key role in lifting the region's growth in the past few years of abundance (see "Latin America: Growing Disconnect, Growing Risk", EM Economist, March 7, 2008).  Therefore, the recent rise in commodity prices, if sustained, could be an important source of support for the region's growth outlook.  This rise in commodity prices was unexpected - we were looking for the severe downturn in global growth to push down commodity demand and keep prices subdued throughout the year.  Instead, since early March commodity prices have rebounded sharply: oil is up 75%, copper is up near 50% and soybeans are up near 40%.  And given the high share of commodities in Latin America's exports - commodities range from about a fifth of all exports in Mexico to near half in Brazil to roughly two-thirds or more in the rest of the region - the sharp increase in prices has likely lifted the region's terms of trade.  This, in turn, has raised our expectations for a more pronounced growth recovery since, historically, rising terms of trade have been accompanied by strong growth performance and currency appreciation in the region.

•           Last, but not least, the speed of the macro adjustment in the region has come much faster than in past cycles, opening up the prospect of a shorter downturn.  If past history is a guide, labor markets soften during downturns with a 3-5-month lag across most of Latin America's economies.  Take, for example, Brazil, Mexico or Chile: in the two or three previous downturns - marked by sustained monthly declines in activity - labor markets turned down with a lag of one to two quarters.  This lag served to lengthen the downturn as softening labor markets would hit domestic demand, forcing firms to adjust production further and creating a negative feedback loop back to activity.  Thus, if the past is any guide, the labor market correction should have gained momentum around mid-year this year and into the third quarter.  Actual data, however, show that the impact has been significantly faster.  In this downturn, the labor market correction in the major economies largely coincided with the downturn in activity. 

Labor markets softened in tandem with activity in this cycle, in part due to the higher visibility of the negative external shock, in our view.  In Mexico, business confidence deteriorated much more rapidly than in the past.  Meanwhile, our modeling work suggests that much of the labor market softening consistent with the severity of the current downturn has already taken place.  Similarly, in Chile the adjustment in confidence has been more rapid.  And labor markets followed closely behind, softening much faster than in the past - rather than the usual three to five months, the lag to a downturn in activity has been limited to just one month.  Finally, in Brazil formal employment plunged in 4Q08, just as economic activity took the biggest hit.  In line with the rest of the region, business confidence in Brazil fell sharply in the December quarter.  The connection between a faster deterioration in business confidence and faster labor market adjustment may not be a coincidence: we suspect that the higher visibility and severity of the external shock - as the global financial system went into a tailspin, credit dried up and capital fled the region - had made it easier for firms in Latin America to anticipate a severe downturn and therefore advance the necessary adjustments.  But if the downturn is set to prove to be shorter, a key question is whether the rebound could also be sharper?

...but Challenges Remain

While we are turning more constructive on the region's growth outlook, especially for next year, we suspect that risks are skewed to the downside.  Going forward, we see two main challenges to growth in the region:

First, the sharp improvement in external conditions may be unsustainable. The dramatic run-up in commodities stands in sharp contrast to a challenging global growth outlook.  Our US economics team forecasts that the US consumer is in the midst of a multi-year adjustment to save more and consume less.  In fact, the personal saving rate has already risen from near 0% of disposable income average in the past four years to 5.7% in April.  And our US economists expect it to remain near 5% this year and next, before rising even further the foreseeable future (see US Economic and Interest Rate Forecast: Recovery Closer, but Risks Persist, Richard Berner and David Greenlaw, May 11, 2009).  Given our calculation that at market exchange rates the US consumer accounts for near 40% of global private consumption, this prolonged adjustment may be a headwind for global demand and thus the rebound in global activity may prove to be subdued, raising risks to the sustainability of elevated commodity prices.

After all, much of the rise in commodity prices appears to be driven by liquidity, not fundamentals.  Net speculative long positions in commodities have risen dramatically in recent weeks.  One possibility is that commodity markets are pricing in a sharper global economic recovery.  But the outlook for global growth remains fraught.  Another possibility is that the rise in commodities is driven by a surge in liquidity in the developed world, especially the US.  After all, the Federal Reserve has overseen a liquidity injection of unprecedented proportions over the course of the last six months - the monetary base has nearly doubled in the US, from near 6% of GDP on average in the past decade-and-a-half, to near 12% in 1Q09.  But if it is liquidity that is driving the rise in speculative demand for commodities, then we are concerned that recent gains may prove fragile.  Risks include evidence of a weaker-than-expected growth recovery, policymakers beginning to withdraw liquidity sooner than expected or simply a change in market sentiment.

Second, domestic countercyclical policies may not gain much traction.  Some have argued that the region should be more resilient in the face of a global shock this time around.  After all, this is the first downturn where the authorities across Latin America were able to deploy countercyclical policies - most notably by loosening monetary policy.  Central banks across the region - from Chile, to Brazil, to Colombia and Peru, to Mexico - cut policy rates by hundreds of basis points in just a few months.  Yet we are concerned that the effectiveness of these measures in cushioning the downturn may have been limited.

We find that for much of Latin America credit availability was more affected by the sharp deterioration in external conditions than the rapid declines in policy rates aimed at offsetting that shock.  A notable exception is Chile, where domestic issuance soared and helped to provide an alternative source of financing for local businesses in 1Q09 (once the monetary authorities cut interest rates aggressively).  By contrast, in Brazil and, less so, in Mexico, capital markets largely dried up at the turn of the year, when they were needed most.  In the near term, as credit markets continues to heal globally, we expect capital markets in the region to come back to life.  In fact, in Brazil issuance sequentially improved in March and April, coinciding with the improvement in global markets.  However, any reversal in global credit markets may leave local companies in Brazil and Mexico exposed, in our view.

The New Forecast

In line with our more optimistic view, but also mindful of the challenging economic landscape, we are revising our forecasts.  Our biggest change comes in Brazil, where we are moving our growth and currency forecasts for 2009 and 2010.  On the growth front we are moving to -1.0% (from -4.5% before) in 2009 and 2.5% (from 0.5% before) in 2010.  As for the currency forecasts, we now expect 2.1 (from 2.5 before) at end-2009 and 1.9 (from 2.6 previously) at end-2010.  In Mexico, we are moving our growth forecasts to -7.0% (from -5.0% before) for 2009 and to 2.4% (from 0.2% before) for 2010, largely reflecting the surprisingly sharp downturn in 1Q and the impact of the flu outbreak.  We are leaving the currency forecast unchanged.  We are also upgrading our 2010 outlook for growth and currencies across the region.

Bottom Line

We are revising our outlook and now expect Latin America to experience a gradual recovery during 2H09 and into 2010 as the duration of the downturn appears to have been shortened by a faster labor market adjustment and rising terms of trade.  As a result, we are lifting our annual growth forecasts to -3.2% (from -4.0%) for 2009 and to +2.3% (from +0.3%) for 2010.  But while we are turning more constructive on the region's growth outlook, our optimism is tempered as markets appear to have run ahead of themselves amid a still challenging global environment.  Therefore, looking ahead, we expect that economic recovery in Latin America will remain below trend.

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United States
Review and Preview
June 17, 2009

By Ted Wieseman | New York

While the past week's performance by Treasuries could hardly be considered robust, coming as it did after the enormous sell-off of the prior week, yields did at least come down somewhat from the nearly across-the-board highs for the year (with only the very short end remaining extremely rich) hit after the employment report rout that initially extended into Monday.  This has certainly not been the norm this year during weeks of heavy issuance such as the past one, in which US$65 billion in 3s, 10s and 30s were sold.  The mild silver lining at least to the recent surge in yields appears to be that they have reached levels that are seen to be quite attractive to many investors, as all three of this latest run of auctions saw unusually strong demand from final investors, who took down more than half of the week's new supply at the auctions, substantially reducing the pressure on still badly balance sheet constrained primary dealers to backstop the sales and allowing the market to absorb the new issuance far more smoothly than has been typical this year, when runs of supply have generally resulted in significant increases in yields.  In addition to the strong demand by final investors at the auctions, the seeming switch among investors towards seeing the market as excessively cheap was also notable in the 10-year's immediate rallying after briefly breaking the 4% yield level a couple times, the second rebound coming in the face of stronger-than-expected economic data Thursday morning.  And buying by real money investors at the longer end has been persistent recently (on top of the strong bidding at the 30-year auction) as the highest-yielding long zeros traded through 5% most of the week before rallying back through that level Friday.  Along with the general change in investor attitude towards the relative attractiveness of current yields after the huge recent back-up, the market's mild recovery was aided at the front end by a reversal of much of the Fed repricing in the futures market after the employment report, while the belly of the curve benefited from some ultimate net stabilization for the week (but only after a continued run of substantial intra-week volatility) in the mortgage-backed securities market, though at yields still not far from 5%, about 100bp higher than a few weeks ago.  This, at least, temporarily eased pressure on mortgages and also allowed a decent narrowing in swap spreads, further aiding the broadly more positive tone in interest rate markets.  It was a light week for economic news.  What little data were released were actually better than expected, but as noted, this was trumped by valuation, as Treasuries rallied in the face of upside surprises in the retail sales and jobless claims reports.  The better-than-expected underlying retail sales results and a better trajectory for net exports provided by the trade report, with a partial offset from industry data pointing to a much bigger drop in motor vehicle inventories than we had previously assumed, led us to raise our 2Q GDP forecast to -1.5% from -2.0%.  And while we won't get claims figures covering the survey week for the June employment report until this Thursday, the recent improving trend in initial claims, though they remain at a very high level and continuing claims are still terrible week after week, suggests that we could see some further moderation in job losses in the next employment report. 

On the week, benchmark Treasury yields fell 2-12bp, with the stabilization in the mortgage market helping the 7-year lead a solid performance by the intermediate part of the curve, the front end receiving a bit of a boost from a notable Fed repricing, and the long end helped by the strong 30-year reopening.  The 2-year yield fell 4bp to 1.27%, 5-year 7bp to 2.78%, 7-year 12bp to 3.43%, 10-year 6bp to 3.78% and 30-year 2bp to 4.63%.  Although it was in a good bit from Monday's high of 1.41%, this move in the front end was still relatively small compared to the much bigger reversal of the repricing of the Fed seen after the employment report.  The November fed funds contract sold off 19bp to 0.485% June 5, fully pricing in a rate hike by the November FOMC meeting.  By the end of the latest week, this plunge had largely been reversed as the contract rallied back to 0.335%, shifting the timing of the expected first hike back out to the December meeting (which we still think is considerably too early).  Even with oil and a number of other commodity prices (notably industrial metals, with the LME composite index up 6%) moving to new highs, TIPS struggled on a relative basis, with the 5-year TIPS yield down 5bp to 1.07%, the 10-year steady at 1.86% and the 20-year yield falling 4bp to 2.42%.  While Treasury supply has been ramped up massively across all nominal maturities, TIPS sizes have so far held steady, aiding their relative performance.  But with 10-year and 20-year TIPS auctions rapidly approaching in July, investors were still starting to get nervous about the possible supply pressures on nominals appearing in a more pronounced way soon in much less liquid TIPS. 

While substantial volatility continued for much of the week, on net the mortgage market settled down significantly after having been in a severe correction for several weeks.  Current coupon MBS yields moved to new highs above 5% since before the Fed initially announced its MBS purchase plan in late November on Wednesday, but by Friday had moved back down to near 4.8% from about 4.9% at the end of the prior week, in line with the rally in the belly of the Treasury curve, after substantially outperforming a solid Treasury rally Friday to reverse prior underperformance.  Average 30-year mortgage rates broke above 5.5% in the week through Wednesday after holding steady at record lows near 4.75% for two months through late May and appeared headed north of 5.75% when MBS yields were at their highs mid-week, but if the late week rebound can be sustained, rates should be able to at least stabilize at around 5.5% for now.  The late week stability in the mortgage market substantially eased previously intense pressure on swap rates, with spreads coming back in substantially as mortgage-related paying stopped, and this combination of improvement in mortgages and swaps helped the intermediate part of the Treasury curve's outperformance.  On the week, the benchmark 10-year spread fell 10-28bp and the 2-year 7-42bp.  On top of the easing in mortgage-related paying, the underlying interbank market improvement resumed and further added support for narrowing swap spreads.  After seeing a bit of brief upside on the post-employment report Fed repricing, 3-month Libor was back down to another new record low of 0.62% Friday, leaving the spot 3-month Libor/OIS spread near 41bp, still around the lows since February 2008.  This also flowed through into a narrowing in forward spreads back towards their prior lows, with the forward Libor/OIS spread to September falling about 9bp on the week to near 47bp, December 6bp to 61bp and March 3bp to 47bp. 

Risk markets were generally little changed on the week, which left equity and credit markets at or near their highs for the year.  The prior week's complete turmoil in interest rate markets, especially mortgages, though the Treasury market rout was certainly extreme as well, didn't make any dent at all of note in risky markets, which were up solidly.  But it appeared that with some delay the recent rates market turmoil restrained further gains in stocks and bonds in the latest week to some extent.  The S&P 500 didn't move a whole lot through the week and ended up not much changed, though a further 0.7% rise did leave it a new high for the year.  Credit was narrowly mixed and also not far from the year's best levels.  The investment grade CDX index was a couple of basis points wider on the week at 123bp in late trading Friday after hitting its recent best close of 121bp at the end of the prior week.  The high yield index was 7bp tighter on the week at 938bp through Thursday's close and with a moderate further rally as of Friday afternoon looked to be on pace to move through the year's prior tight of 926bp hit June 2.  The leveraged loan LCDX index was similarly on pace to just barely set a new high, with the index 7bp tighter as of midday Friday at 902bp after having seen its best recent close of 905bp also on June 2.  The IG and HY CDX and LCDX spreads have all been roughly cut in half over the past three months.  In contrast to these other markets that have held near their best levels, the commercial mortgage CMBX market has been badly struggling recently, but at least the AAA index stabilized in the latest week, rising marginally to 69.86, down from the recent peak of 81.29 hit May 20.  That high came after the Fed announced the expansion of TALF funding to include AAA rated legacy CMBS, but since then investor optimism about how successful TALF would be in restarting the broken CMBS market has dimmed quite a bit.  The lower-rated CMBX indices have been trading more technically recently, with more downside in the latest week further partially unwinding what was a huge short squeeze-driven rally in the first part of May.  The subprime ABX market also extended its recently renewed weakening trend in the latest week, with the AAA index down 1.22 points on the week to 24.93 and steadily approaching again the all-time low just above 23 hit in early April after what had been a decent recovery that lasted into the second half of May. 

It was a light week for economic news, but the data that were released continued the recent pattern, pointing to a notable moderation in the severity of the recession.  The trade and retail sales reports, with a partial offset from industry figures on plunging truck inventories, led us to boost our 2Q GDP forecast to -1.5% from -2.0%, and the jobless claims reports possibly suggested that the rate of decline in payrolls could moderate further in June.  There are notable near-term risks to this recent improving trend - the surge in energy prices that seems to have been driven much more by speculative flows than improving demand is a significant threat to consumers' spending power, the surge in mortgage rates could cause a renewed down leg in the housing market after some recent signs of stabilization, and plans for widespread summer auto plant shutdowns could have broadly negative impacts across a significant section of the manufacturing sector - but for now, at least, the trend of steadily less bad economic data has remained intact. 

The trade deficit widened to US$29.2 billion in April from an upwardly revised US$28.5 billion in March, with exports (-2.3%) and imports (-1.4%) extending their collapses that began last summer.  Exports have now plunged at a 33% annual rate over the past nine months and imports 43%.  The pattern of real exports and imports coming into 2Q that included the incorporation of annual revisions with this month's report pointed to both being down severely again, but with the net being more positive for overall growth.  We see real imports and exports both plunging about another 19.5% in 2Q, which would result in net exports adding about half a point to 2Q GDP growth, up from our prior estimate of a flat trade contribution.  Meanwhile, retail sales rose 0.5% in May overall and excluding autos, and weakness in April (ex autos -0.2% versus -0.5%) and March (ex autos -1.1% versus -1.2%) was revised to show smaller declines.  Almost all of the gain in underlying sales in May was accounted for by a price-driven surge at gas stations (+3.6%), with sales excluding autos and gas ticking up 0.1%.  Still, this was marginally better than expected as a result of gains in clothing (+0.4%) and drug stores (+0.7%), which were much stronger than implied by the monthly chain store sales results.  However, other key discretionary categories remained weak, including general merchandise (-0.2%), electronics and appliances (-0.5%), furniture (-0.4%), sports, books and music (-0.8%), and non-store, mostly internet, sales (-0.4%).  The key retail control component rose 0.4% in May, a bit better than we expected, and April (-0.2% versus -0.5%) was revised higher.  As a result, we boosted our forecast for 2Q consumption to -0.5% from -1.0%.  We also incorporated into our GDP estimates some industry figures pointing to a very large further decline in truck inventories in May, that led us to cut our estimate of the contribution from motor vehicles to 2Q GDP growth to a drag of about half a point from a roughly neutral factor, partly offsetting the expected better results from net exports and consumption but still resulting in a half-point boost to our GDP estimate. 

The calendar is fairly active in the upcoming week.  Initial jobless claims Thursday will cover the survey period for the employment report, and the initial round of regional manufacturing surveys (Empire State Monday and Philly Fed Thursday) are out, so early expectations for the June employment and ISM reports will be established.  We'll see to what extent the calmer attitude towards supply created by the strong demand at the past week's auction can be sustained as we look ahead to another flood of supply with Thursday's announcement of the 2-year, 5-year and 7-year notes that will be auctioned the following week.  We expect the sizes to be held steady, which would mean another massive US$101 billion in total issuance during the week of June 22.  A worried eye will also certainly remain on the mortgage market, which has recently been alternating between violent sell-offs and subsequent periods of calm and partial recovery.  Given this recent trend, no one is going to take a lot of comfort from the MBS market's improvement Thursday and Friday after the prior run of major weakness that peaked Wednesday.  Indeed, our interest rate strategy team still looks for mortgage/Treasury spreads to continue widening, as even after the recent bout of severe MBS weakness, they view the current MBS/Treasury spread as too tight to properly compensate investors for the greater risk of holding mortgages (see US Interest Rate Strategy: The New Normal for the Yield Curve, June 12, 2009).  Other data releases due out include PPI, housing starts, and IP Tuesday, CPI Wednesday and leading indicators Thursday:

* We forecast a 0.9% surge in the overall producer price index in May but a flat reading excluding food and energy.  A sharp jump in wholesales quotes for gasoline should lead to some significant elevation in the headline PPI this month.  However, we look for a pullback in food prices following a surprisingly sharp jump in April.  Most important, the core should remain well contained, thanks to further softness in apparel, motor vehicles and metals.

* We look for housing starts to rebound to a 485,000 unit annual rate in May.  The key single-family category appears to have flattened out - albeit at an extremely depressed level - over the course of recent months.  Meanwhile, the volatile multi-family component seems to be due for at least a modest rebound after plunging to a record low in April.  Thus, we look for overall starts to post about a 6% jump in this month's report.

* We forecast a 1.7% plunge in May industrial production.  The May employment report pointed to another very sharp drop in hours worked within the factory sector.  So, we look for a steep decline in industrial production, with sectors such as machinery, metals, high-tech and electrical equipment registering big negatives.  Also, the motor vehicle category is expected to post a decline following three straight monthly advances.  Finally, unusually mild weather across much of the country points to a dip in utility output.

* We expect the consumer price index to be up 0.2% in May overall and excluding food and energy.  Retail gasoline prices soared about 10% in May - a much larger advance than typically occurs around this time of the year.  Indeed, even after factoring in the seasonal adjustment, we still look for the gasoline component of the CPI to rise 3.5%.  However, prices for household fuels should edge lower in May, and quotes for most food items appear to have remained very well contained.  Meanwhile, the core is expected to be up +0.15% - about the same as seen in recent months if one excludes a recent tax-driven surge in the tobacco component.  On a year-on-year basis, the core is expected to be +1.85% in May.

* Based on currently available components, the index of leading economic indicators is likely to post a second straight sharp gain in May, rising 1.2%.  Positive contributions are expected from a number of components, including supplier deliveries, the yield curve, money supply, stock prices and consumer confidence.

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United States
The Two Sides of the Inflation Debate
June 17, 2009

By Richard Berner | New York

Two camps are joined in a heated inflation debate: One is convinced that higher inflation is coming, while the other fears a long flirtation with deflation.  Our view is that opposing forces will keep inflation tame for now: Aggressive global monetary stimulus is reflationary, but persistent slack in the global economy will push ‘core' inflation lower over the next year.  On a year-on-year basis, we expect core inflation as measured by the CPI to move down toward 1-1.25% by autumn.  Sequencing matters for inflation as well as for the policy response: the near-term risk of lower underlying inflation gives the Fed latitude to maintain accommodation for now.  But monetary policy's reflationary thrust is now at work, so unlike those who believe that low inflation and easy money will persist into 2011, we think tighter monetary policy will be needed in 2010 to prevent inflation from rising in 2011-12. 

Inflationary forces.  A cornerstone of our view is that inflation is ultimately a monetary phenomenon.  Persistently creating too much money chasing too few goods will, over time, push up inflation as Milton Friedman taught us long ago, and as our colleague Joachim Fels legitimately reminds us today.  But changes in the structure of the financial system and in the channels of intermediation through both the banking system and the capital markets have made it difficult to calibrate monetary policy using the monetary aggregates.  While the Fed's aggressive quantitative easing has made the monetary aggregates relevant again, it is especially tricky to track them (for a full discussion, see David Greenlaw's Revenge of the Ms, November 18, 2008).  The narrow monetary aggregate, M1, is up 15.6% from a year ago, but the aggregate has fluctuated wildly in recent weeks as risk aversion has faded.  Moreover, monetary easing has lifted the monetary base (bank reserves plus currency) relatively more, so the ‘money multiplier' has edged lower after plunging late in 2008.  So, tracking the effects of monetary easing on inflation potential through the monetary aggregates is tricky.

In our view, moreover, monetary policy now works primarily and more subtly by influencing inflation expectations.  These expectations are no easier to measure than the Ms, primarily through surveys and market-based measures such as inflation breakevens - the difference between nominal Treasury yields and those on TIPs - as well as the dollar and commodity prices.  The combination of those factors can help to assess the extent to which policy is easy or tight.  While a weaker dollar and rising commodity prices will primarily change relative prices, like those of imports and energy goods and services, they can nonetheless influence both inflation expectations and inflation itself.

Secularly, we think that policy has anchored inflation expectations compared with the 1960s and 1970s, so stagflation is unlikely.  The University of Michigan's canvass of consumer sentiment has tracked inflation expectations for 31 years.  In sharp contrast with the late 1970s, the levels of surveyed medium-term (5-10 years) inflation expectations have rarely risen by more than half a point above their recent 3% trend, and while the variability of inflation expectations has risen lately, it declined steadily through 1999 to levels one-tenth of the stagflationary Seventies. 

Cyclically, unprecedented monetary ease - both in terms of rates and quantities - is acting to boost inflation expectations, but so far the impact has been slight.  Five-year five-year breakevens have drifted up towards 3%, a high since last summer.  While TIPs yields are still distorted by liquidity premiums and the Fed's US$300 billion Treasury Asset Purchase Program, the direction of movement likely is suggestive of investors' inflation expectations.  The Michigan survey indicated that 5-10-year and 1-year inflation expectations both edged up to 3.1% in June. 

Beyond market- and survey-based indicators, we think that a weaker dollar and rising commodity prices are tangible evidence of the Fed's reflationary thrust.  Since the Fed stepped up its quantitative easing at the March 18 FOMC meeting, the dollar has declined on a broad, trade-weighted basis by 8.7%, crude oil quotes have jumped by 47%, and broad commodity price indices have risen by 18-26%.  To be sure, as our FX strategy team has argued, the dollar's recent decline reflects reduced risk-aversion, and rising commodity prices also are a sign of investors' increased appetite for risk amid hopes for global recovery.  But they are all part of the policy transmission process.  Fortunately, none of these yet suggests the danger that monetary policy is too accommodative, courtesy of lags between changes in those forces and their influence on inflation, together with their diminishing importance for US inflation in a globalized world and their smaller impact in recession, when it is more difficult to pass through such costs into inflation (for background, see The Dollar and Inflation, May 5, 2006; Inflation Model Uncertainty, June 3, 2005; and The Inflation Message in Commodity Prices, March 14, 2005).

Disinflationary forces.  Unprecedented slack in the US and global economies is still acting as a brake on inflation, and we think it will for now stymie pricing power for companies around the world.  Intuition and the fact that inflation typically falls well after recessions end support that view.  Yet casual empiricism suggests that neither the ‘output gap' - the difference between potential and actual GDP - nor capacity utilization are highly correlated with inflation; simple correlations between the output gap or operating rates and either headline or core CPI (or the PPI) are -0.33 or less.  Moreover, these correlations appear to be unstable over time.

However, careful empirical work shows that, adjusted for inflation expectations and supply shocks, the output gap (or other measures of slack such as operating rates) is a highly useful guide to future inflation (see Jeremy Rudd and Karl Whelan, "Modeling Inflation Dynamics: A Critical Review of Recent Research", Journal of Money, Credit and Banking, vol. 39 (February 2007), pp. 155-70).  That's in spite of the fact that the so-called Phillips curve seems to have become flatter (i.e., a given change in slack has a smaller influence on inflation, raising the so-called ‘sacrifice ratio') over time; but the flatter curve may in fact reflect the success of monetary policy.  Whether the influence of slack on inflation is smaller than in the past, there's no mistaking the fact that slack in the US economy has rarely been larger.  The output gap stands at 6.3% (largest since 1983) and operating rates have plunged to record lows of 69%; both are likely headed further into record territory.  In addition, slack affects inflation dynamics: The level of the output gap appears to affect changes in inflation, as it affects the extent to which firms can push through changes in energy and other costs, and changes in the output gap appear to affect inflation, as firms sense that recession or recovery accompanies falling or rising pricing power.  Likewise, slack in labor markets has begun to promote a deceleration in wages.  Measured by the Employment Cost Index, wages and salaries of private industry workers decelerated to 2% in 1Q - a record low.  Coupled with better-than expected productivity gains, the resulting performance of unit labor costs may also be disinflationary.

Stagflation unlikely.  Some analysts believe that stagflation - high inflation and subdued growth - is the likely outcome of this financial crisis.  This could occur if policy allowed inflation expectations to move higher, if the trend in productivity were to move lower, and if policymakers misjudged that trend.  But policy has anchored longer-term inflation expectations, and actual productivity has held up much better than in past cycles, hinting that the trend is running close to the 2.25% average of the last 14 years.  Our assumption that potential growth will be as high as 2.5%, if anything, could be a bit low.  And Fed officials seem well aware of the downside risks to trend and potential growth, so the mistakes of the 1970s seem unlikely to be repeated.  As a result, we think that stagflation is an unlikely outcome.

Policy credibility and policy communication.  Market participants frequently cite two reasons to worry about Fed credibility: First, and most important, they fret that officials won't have the mettle to tighten or will be constrained by politics from tightening appropriately.  Second, some believe that the Fed will make a policy mistake and overstay its welcome.  We think that those risks are overblown, but agree that uncertainty about them is affecting markets.  In order to defuse these risks, the Fed could clarify some key policy issues at its June 23/24 meeting.

First, does it believe that the back-up in mortgage rates has tightened financial conditions enough to require additional action, if only as insurance against downside risks?  Or does it simply reflect the rise in risk-free yields that accompanies reduced risk-aversion, the vanishing of the downside tail risks for the economy and inflation, and hopes for an improving economy?

Second, and related, what are the risks around the Fed's April 28-29 forecast for a slowly improving economy and troughing inflation?  Even if financial conditions are tighter, officials can't argue for additional action if the outlook risks are now tilted to the upside.  On the contrary, under those circumstances, rising rates would help the Fed by making financial conditions slightly less accommodative in advance of any discussion of a tighter monetary policy.

Third, and most important, can the Fed be clearer about the way it thinks about adjusting the size of the balance sheet in response to changes in the outlook - that is, its reaction function - especially given today's unusually uncertain lags between monetary policy actions and their effect on growth and inflation?

In our view, monetary policy is very accommodative, and with the notable exception of the back-up in mortgage rates and Treasury yields, financial conditions broadly continue to improve.  It seems unlikely that the Fed will expand its large-scale asset purchase programs, given an improving economic outlook. 

Nonetheless, as is evident in our Global Risk Demand Index (GRDI), inflation concerns and uncertainty about the policy response to them will likely continue to be a key focus in bond, FX and risky asset markets.  As Sophia Drossos in FX strategy notes, "Since the middle of April, the GRDI sub-components appear to be signaling increased inflation concerns, and we believe that this is dampening investor risk appetite."  Market participants likely will have to contend with higher headline inflation readings, more Treasury supply, upward revisions to economic forecasts and gradual improvement in the tone of economic data without being able to rely on the Fed for support during this period.  While last week's price action suggests that yields had risen high enough to attract investors in the face of large Treasury auctions, the longer-term pressure on yields will still lie to the upside, in our view.

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