Hungary
The Virtues of Prudence
July 21, 2009

By Pasquale Diana | London

We now think that rate cuts will start already in July: Previously, while stressing the NBH's desire to take rates lower from the current 9.5% level, we thought there would be no room for the bank to cut rates in 2009. Now, we think there is room for 150bp of rate cuts this year, and pencil in a terminal rate of 8%. We expect rates to fall to 6.5% by end-2010, so have left the end-point of the easing cycle in 2009-10 broadly unchanged. There are three key reasons why we expect earlier cuts than previously:

•           Better risk appetite: As we stressed many times, the NBH has de facto abdicated from its inflation-targeting role, focusing entirely on risk appetite. While its GDP and inflation forecast made rate cuts a no-brainer, it waited for normalization in market conditions before pulling the trigger. It now looks as though that normalization has taken place. CDS spreads have come down, the forint has strengthened versus the euro, and non-residents have stopped selling local bonds. Also, local bond auctions have showed higher bid-to-cover and increasing sizes. And finally, the Min Fin brought forward the issuance of the €1 billion 5-year Eurobond originally planned for 3Q09. The auction was oversubscribed, with orders of around €1.75 billion, according to domestic dealers. Funding at 395bp over swaps (6.8%) is more expensive than IMF funding (5.5%), but it is intended to show markets that Hungary does not have to be on life support indefinitely.

•           Tax changes were approved in parliament: On June 29, the 2010 tax changes were finally approved in parliament, reducing uncertainty around fiscal policy. Hungary has now corrected its structural deficit (cyclically adjusted primary balance) very fast, especially in comparison with regional peers such as the Czech Republic and Poland.  We acknowledge the fiscal adjustment, but would remain cautious. Hungary's mountain of debt (82% of GDP this year on our forecast) will force the government to maintain a continued primary surplus (1-2% of GDP), stabilize the exchange rate (290 versus the euro) and achieve a 3% real trend GDP growth rate to take the debt ratios to around 60% by 2018 - according to the AKK. Not impossible, but a rather tall order, within the backdrop of slowing trend growth.

•           Change in CB rhetoric. We have been stressing for a while that several members of the Council have been itching to cut rates. Nonetheless, the governor (Simor) and his deputies (Karvalits, Kiraly) were sounding a much more prudent note. However, we saw a marked change in tone in an interview by Karvalits (Bloomberg, July 9), who more or less openly advocated the need for monetary easing. The June 22 minutes, published today, stress that already a month ago the NBH felt that there was a "gradual" increase in the room for manoeuvre in monetary policy, and that the fact that other countries with similar measures of risk sentiment (likely Romania, South Africa, Turkey) to Hungary had cut rates also gives the NBH room to act. While the doves' motion to cut 50bp was defeated 6-3 in favor of no change, we think that the supporters of a rate cut will gain a majority already this month.

How Exactly Does Monetary Policy Feed Through the Economy?

As stressed in the past, the large stock of FX loans in Hungary (66% of total private sector loans) reduces the efficacy of domestic monetary policy, increasing the relevance of foreign interest rates. This obviously complicates domestic monetary policy. At the current juncture, despite the sharp fall in CHF three-month Libor, Hungarian borrowers have not benefited from lower rates - indeed, due to higher funding costs and increased risk, local banks have actually applied higher CHF rates. It is worth also noting that new credit has essentially ground to a halt, so rate cuts from here would mostly benefit those who borrowed in HUF at variable rates (we guess corporates primarily, for their working capital needs), rather than encouraging new borrowing, we think. The main channel via which monetary policy operates, the exchange rate, is a very risky one. We very much doubt that, despite the recent strengthening in HUF, the central bank is anywhere close to wanting to engineer a weaker currency, given households' FX exposure and the dangers of yet another overshoot above 300 versus the euro. The reduced efficacy of monetary policy and the lingering risks around HUF argue for a muted and prudent easing cycle (more on this below).

The Virtues of a Prudent Easing Cycle

We think that, mindful of what happened earlier this year, the NBH will steer clear of cutting rates intra-meeting or signaling particular values of HUF that it is comfortable with. The dangers of a sudden bout of risk-aversion and another leg of HUF weakness are real, so the bank will seek to erode the carry cushion only very slowly, we think. This is why we pencil in just two more cuts this year, following the 50bp July rate cut. Another reason to proceed carefully is inflation, in our view. The June print was benign, at 3.7%Y (Morgan Stanley: 4.0%, consensus: 4.1%), but due entirely to food. Core inflation actually edged up modestly, to 3.2%Y, remaining in the relatively stable range where it has been since the start of the year (3.0-3.5%). On our own measure of ‘clean' core, which excludes all food from core CPI, we see no slowdown of inflation momentum. Looking through all the noise, monthly changes in core CPI continue to be inconsistent with the 3% target. Regardless of how volatile food prices are, we believe that headline inflation will surge higher in the coming months on the back of tax changes, to end the year at around 7.5%. The bank's emphasis should therefore move on second-round effects, which, at least for the moment, the NBH appears to dismiss - relying on the output gap to tame all CPI pressures. We think that dismissing second-round effects out of hand would be a major policy mistake. After all, no one knows how large the output gap is (the starting point is uncertain, as is the potential growth assumption), and there is just no valid precedent to argue that inflation will remain muted due to slack. Given the bank's mixed inflation-fighting track record and the need to maintain credibility, this is another reason to proceed cautiously with rate cuts, in our view.

Important Disclosure Information at the end of this Forum

Russia
Oil Sensitivities Revisited
July 21, 2009

By Alina Slyusarchuk & Oliver Weeks | London

Given sharp recent moves in the oil price, we take a more detailed look at the sensitivity of macro variables in Russia to oil prices.  For the RUB we find that a 10% rise in oil prices would justify nominal RUB appreciation of 6.8%.  The real GDP impact is more limited - we find that a 10% rise in oil adds 1.6pp to real GDP growth in a year, but that after two years the growth impact turns negative, leaving long-run GDP unchanged.  We estimate that a US$10 rise in oil is worth 2.4% of GDP on export revenue, and 2.0% of GDP on budget revenue.  Our own central macro forecasts are based on an assumption of Urals flat at around US$70.  Morgan Stanley's commodity team is more bearish in the short term - seeing WTI dipping to US$55 in 3Q - and more bullish in the longer term - seeing the average at US$85 in 2010 and US$95 in 2011.  Inevitably there are caveats to our results, as detailed below, but if the commodity super-cycle is not over, we see strong implications for the RUB and fiscal policy, but do not see oil prices as a lasting source of growth. 

Current account and fiscal impacts large: The sensitivities of the current account and government budget to oil are relatively straightforward, and large.  Crude oil, petroleum products and gas were 65% of total exports in 2008 and are 56% in 1H09.  Assuming flat export volumes, we estimate that a US$10 rise in average oil prices over a year adds US$27 billion, or 2.4% of 2009 GDP, to export revenue.  Clearly where the current account balances depends strongly on domestic demand and imports.  We currently estimate this level to be around US$50, but expect this threshold to rise as imports recover after their spectacular collapse in 1H09. 

On the fiscal side, oil and gas revenues were 47% of federal budget revenues in 2008, and 32% in the first five months of 2009.  The marginal tax rate on crude oil exports remains around 90%, on refined products around 54%.  Using a bottom-up tax model, we estimate that a US$10 rise in oil around current levels raises consolidated government budget revenues by US$23 billion, or 2.0% of GDP.  The 2010 budget remains under intense discussion within the government but currently assumes a deficit around 6.5% of GDP with Urals around US$50.  A higher oil price will inevitably also see higher spending, but clearly the implications of oil moves for debt issuance and the balance of the oil funds are very large. 

Real GDP and oil only indirectly linked: The link between the oil price and real GDP is much less straightforward.  The direct link to real output is minimal, given that only changes in output volumes are measured.  Oil production responds only minimally to prices.  Not only has the marginal tax take on oil been high, but in the past three years the impact of this revenue has been smoothed by the rapid accumulation and disbursement of the government Oil Funds.  The extreme volatility of private sector capital flows seems to have played at least as important a role in output and RUB volatility.  But clearly there is a significant indirect link between oil and real GDP through balance sheets and consumer and investor confidence.  Husain et al (IMF 2008) find in a sample of ten oil-exporting countries (not Russia) that oil prices affect output only through their impact on fiscal policy.  For Russia, Ito (2008) finds that a 10% permanent increase in oil prices adds 2.5% to the GDP level over three years.  Rautava (2002) finds similarly that a 10% oil price rise is associated with a 2.2% rise in the long-run GDP level. 

We estimate GDP impact at 1.8pp after six quarters: For our own analysis, given short data series, recent instability and structural changes, and data that are not stationary or cointegrated, we use a simple vector autoregression model.  Besides the oil price, we include real investment as a share of GDP, the real interest rate and US GDP as a proxy for global demand.  Our data are quarterly and start in 1995.  As a trade-off between a short data span and accounting for more long-term effects, we use a lag of three quarters.  The estimated relationship is stable.  All inverse roots are within the unit circle.  Log likelihood of the model is 447.2, R2 = 0.99.   Signs of coefficients are in line with our expectations.  Higher investment and higher external demand imply higher growth rates, while higher real interest rates constrain growth.  Using impulse response functions, we find that a 10% rise in oil prices raises GDP after one year by 1.6%, with the peak impact at 1.8% after six quarters.  However, we also find that the growth impact turns negative thereafter, leaving output levels unchanged after 10 quarters.  This is more extreme than most published results, but we think that this underlines the plausible intuition that the long-term gain from an oil price change is limited, given ineffective use of past windfalls and crowding out of the non-commodity sector.  However, we would also note that since much of our sample predates the Oil Fund regime, we probably overestimate the short-run impact of oil prices, and to the extent that the NWF is spent on useful long-term projects, underestimate their long-run benefit. 

RUB-oil link limited by intervention: The link between oil and the exchange rate is further complicated by a history of active FX intervention by the CBR.  After the 2008-09 devaluation, the CBR is clearly moving towards a more flexible exchange rate policy, but we think that the government's tolerance for RUB volatility remains more limited, and that intervention will continue.  In a simple OLS model, we include Urals oil prices, inflation, the real interest rate differential, private sector capital flows and FX reserve changes (as a proxy for intervention) as explanatory variables.  We use a dummy for the 1998 crisis.  We thus specified the following equation for the period 1Q95 to 2Q09, where NER represents nominal RUB/USD exchange rate, Oil the Urals oil price in USD, Infl - inflation measured as CPI growth, Inter - CBR interventions, IRD - real interest rate differential, Cap - net private sector capital inflows, Dum98 - dummy variable for the 1998 financial crisis equals 1 for 3-4Q98 and 0 otherwise.

NER = -0.68* Oil + 1.12* Infl + 0.38* Inter - 0.004* IRD +0.45*Dum98 - 0.06*Cap

         (-8.60)      (19.51)        (2.74)          (-2.44)            (2.57)              (-1.72)

Adjusted R2 = 0.93, Standard error of the estimate = 0.19, Residual normality (p value) = 0.62, Standard deviation of the dependent variable = 0.70, T-statistics in parentheses. RUB/USD, Urals oil prices, CPI, capital flows and reserves changes are expressed in logs.

The estimated model captures 93% of the variation in the exchange rate.  Coefficients are significant at the 5% level, except capital flows which are significant at the 10% level due to their instability.  The signs are consistent with our expectations and economic theory.  A relative increase in interest rates, oil prices and capital inflows causes appreciation while higher inflation drives depreciation.  We find that a 10% increase in oil prices would cause a 6.8% nominal appreciation of RUB in the absence of intervention.  We plot the model estimate of where USDRUB might be in the absence of intervention.  It is worth noting that June 2009 saw minimal CBR intervention, but also we think a one-off capital inflow from China.  The model suggests that RUBUSD without intervention would be around 32.6 at US$60, 29.4 at US$70, and 36.9 at US$50.  Our own forecasts are weaker, partly because we think that there is a political preference for a weaker RUB, and that spending the oil funds will stimulate outflows.  In practice, we also think that oil would have to be weaker than 50 for the RUB to be allowed to breach the 41 basket floor.  However, as we move closer to a genuine free float, we believe that the importance of such calculations will grow rapidly.

Important Disclosure Information at the end of this Forum

Argentina
Fiscally Challenged
July 21, 2009

By Daniel Volberg | New York

After six consecutive years of surpluses, Argentina's fiscal accounts have dipped into the red, intensifying concerns about the sustainability of the country's fiscal accounts and, by extension, ability to honor debt service obligations.  The big change in the first five months of this year is that tax revenue growth has fallen sharply below the pace of expenditures.  The chorus of economists, after often voicing disparate concerns over the past few years, has moved towards a consensus that the authorities must engineer a fiscal adjustment in order to boost business confidence and steer the economy back towards a growth recovery.  In theory, the fiscal adjustment can come via either a boost to revenues or a reduction of spending growth.  We argue that, under current conditions, expenditure cuts are the right policy decision and that, in theory, there is room for the authorities to turn the fiscal dynamics around.  However, we are concerned that in the current political environment the authorities may not have the incentive to choose the prudent policy path in the near term.  In light of this dynamic, we are downgrading our forecasts for Argentina's fiscal balance to -0.6% of GDP (from 0.0%) for 2009 and -0.9% of GDP (from -0.4%) for 2010.

Deteriorating Fiscal Position

So far this year we have seen a meaningful fiscal deterioration in Argentina.  The overall fiscal balance has deteriorated to a slight deficit of Ar$94 million or 0% of GDP in the first five months of this year from a surplus of 2.9% of GDP in the same period of 2008. Much of the deterioration has come on the back of sharp declines in revenue growth while the pace of expenditures proved inelastic.  Total revenues grew, on average, only near 10%Y in the first five months of the year - a sharp slowdown from the near 33% annual growth last year. By contrast, the pace of expenditures in the first five months of the year was more than twice as high as the pace of revenues, averaging 22.5%Y - a slight decline from the near 31% average annual expenditure growth in 2008. 

The revenue-centered fiscal deterioration is driven by the negative economic cycle.  Much of the decline in revenue growth comes from just three categories: income taxes, VAT and export taxes.  Income taxes and VAT are driven by the pace of economic activity and, in the case of VAT, the pace of inflation.  With the economy in a deep slump - our estimates suggest that the economy may have contracted by 5.2%Y in the first five months of the year - and with inflation falling sharply to near 15%Y in May, from an average of near 23% last year - it is little surprise that income and VAT tax revenues have fallen sharply.  Meanwhile, export tax revenues suffered from the downturn in oil and soft commodity prices, as well as the lower production volume as Argentina's agricultural sector was hit by a severe drought.  This may be good news as commodity prices have rebounded from this year's lows and the pace of economic deterioration appears to have moderated.  Still, we are concerned that the full extent of fiscal deterioration is yet to come.

We are concerned that the worst of the fiscal deterioration may still be ahead. Given the seasonal nature of fiscal expenditures - the bulk of which comes in December each year - we are concerned that the loss of an overall fiscal surplus in the first half of the year may be signaling that Argentina could slip into a fiscal deficit of near -1.7% of GDP by year-end if the current gap between revenue and expenditure growth persists.  Of course, simply extrapolating current revenue and expenditure growth would be misleading - commodity prices have rebounded sharply since the lows seen earlier in the year and our survey data on economic activity suggest that Argentina's economy has bottomed out in April-May, leading us to expect some pick-up on the revenue front.  However, we expect a limited recovery in economic growth this year and next - our forecasts are for a 4.4% contraction this year (allowing a light sequential pick-up in growth in 2H09) and 1.0% growth in 2010 - as the global growth environment may prove challenging while the local business climate and willingness to invest or hire personnel remain weighed down by regulatory uncertainty and the recent heterodox policy actions.  Taking these factors into account, and absent a concerted effort by the authorities to adjust the fiscal accounts, our modeling work suggests that the overall balance could slip further to a deficit of roughly -0.6% of GDP this year and -0.9% of GDP in 2010.

Expenditure Cuts Needed

The negative near-term fiscal outlook clearly demands that the authorities engineer a fiscal adjustment.  One way to boost the fiscal coffers would be to raise taxes and thus raise the government's revenue stream.  But in the midst of an economic slump, raising taxes on income or consumption may prove counterproductive as the negative effect on growth may outweigh the higher tax rate and result in limited fiscal revenue gains.  Further, the authorities have lost the majority in both houses of Congress and are unlikely to manage to push through any tax increases.  As for export taxes, the conflict with the farmers has clearly shown that there is no room for any further tax increases on that front; in fact, the most likely next adjustment to export taxes could be a reduction as the agricultural community has gained prominence in the political arena.  With limited room to boost revenues, the authorities should instead rely on expenditure cuts to shore up the fiscal accounts.

Fortunately, there is significant room to cut expenditures while removing some long-standing distortions in the Argentine economy.  The main area where the authorities could concentrate their fiscal adjustment is in cutting the large and growing subsidies to the private sector, especially on the energy and transportation fronts.  Based on data through June, the authorities are likely to spend near 1.7% of GDP on energy and transportation subsidies in 2009.  And if we also include subsidies to the agricultural sector, the authorities are on track to spend 2.0% of GDP this year.  Eliminating these subsidies requires a reorientation of economic policy by eliminating price controls and other restrictions.  In both energy and public transportation, prices are distorted as the authorities have not allowed these sectors to raise prices - not even in line with overall inflation.

This, in turn, has led to a dearth of investment in each sector, the decline of each sector's capital stock and, in the case of energy, an increasingly tight constraint on the potential overall expansion of the Argentine economy.  As for agriculture, starting in late 2006 and early 2007 the authorities had begun interfering with soft commodity exports - for example periodically restricting exports of wheat and beef - and also attempting to control some domestic food prices.  These policies, the associated regulatory uncertainty and the attempt to raise export taxes on soft commodities last year had contributed to a significant escalation in political tension and may have also contributed to the falling outlook for agricultural export volumes this year and next.  Thus, a fiscal adjustment that eliminates subsidies to the energy, transportation and agricultural sectors by allowing the prices in those sectors to be determined by supply and demand, rather than by government decree, in addition to boosting the fiscal balance by near 2.0% of GDP directly, could also generate significant incentives for fresh investment and thus foster economic growth.

Forecast Change and Default Fears

But while there is room for expenditure cuts in Argentina's fiscal accounts, we are concerned that the authorities may not have the incentive to push through such a fiscal adjustment in the near term.  In the aftermath of the opposition's gains in the June 28 mid-term Congressional elections - the administration lost its majority in both houses of Congress - the opposition appears to be pushing for a reduction in the federal government's revenues.  In particular, the opposition appears to be behind initiatives that are gaining ground in Congress to force the authorities to automatically share out at least 30% of export tax and financial transaction tax revenues with the provinces.  By reducing the administration's revenue stream, the opposition may be attempting to force the authorities to cut spending by allowing for more flexible energy, transportation and agricultural prices.  But those price increases may prove unpopular with the general population and would thus force the authorities - who, according to local polls and the recent election results, are already declining in popularity - to pay the political cost while the opposition may then stand to reap the benefits in the aftermath of the 2011 general elections.  Therefore, while expenditure cuts through elimination of energy, transportation and agricultural subsidies may be the right policy choice for the medium-term economic health of the country, we suspect that in the near term the incentives may not be adequate for the authorities to take that route.

In light of the misaligned incentives for prudent fiscal action, we are downgrading our forecasts for Argentina's fiscal balance for 2009 and 2010.  We expect the natural cyclical forces to dominate both revenues and expenditures over the next 18 months.  In this environment, our modeling work suggests significant fiscal deterioration.  We are downgrading our forecasts for Argentina's fiscal balance to -0.6% of GDP (from 0.0% of GDP) for 2009 and -0.9% of GDP (from -0.4% of GDP) for 2010.

With a deteriorating fiscal position, investor concerns about Argentina's ability to honor its debt obligations may intensify.  While the markets are already pricing in a high probability of an Argentine default, we have consistently argued that the authorities can count on significant savings and pockets of liquidity that should allow them to honor Argentina's debt obligations even without market access.  In light of our downgrade of the fiscal outlook, are we forced to reconsider our long-standing call that Argentina should have ability to pay debt in the next 18 months?  While the risks are clearly on the rise, we still expect the authorities to be able to honor their debt obligations this year by relying on public sector deposits in the banking system.  As we look towards 2010, the public sector savings in the banks system are not sufficient to cover the debt service obligations - we see a gap of US$3 billion.  Still, as a last resort the authorities may be able to tap into the near US$46 billion in international reserves to help meet their obligations.  Therefore, we still expect Argentina to be able to pay its debt obligations even in the event that it remains excluded from credit markets.  However, given the increasing depletion of the savings, the potential for negative surprises on the fiscal front, the risk of coordination failure as a fragmented Congress may be pitted against a weakened Executive and the risk of further policy heterodoxy, we suspect that the risk in the near term may be skewed towards rising volatility.

Bottom Line

After six consecutive years of surpluses, Argentina's fiscal accounts are set to dip into the red, intensifying concerns about their sustainability and the country's ability to honor its debt service obligations.  While in this context expenditure cuts through elimination of energy, transportation and agricultural subsidies may be the right policy choice for the medium-term economic health of the country, we suspect that in the near term the incentives may not be adequate for the authorities to take that route. In light of this dynamic, we are downgrading our forecasts for Argentina's fiscal balance to -0.6% of GDP (from 0.0% of GDP) for 2009 and -0.9% of GDP (from -0.4% of GDP) for 2010.  And while we figure that even with the worsening fiscal outlook Argentina can still count on enough pockets of liquidity to honor its debt service obligations over the next 18 months, we suspect that the risk in the near term may be skewed towards rising volatility.

Important Disclosure Information at the end of this Forum

United States
Review and Preview
July 21, 2009

By Ted Wieseman | New York

After what had been a sustained and cumulatively enormous recovery off the highs in yields for the year hit in the days after the release of the May employment report on June 5, Treasuries reversed course to post big losses in their worst weekly plunge since the first week of June when that less-bad-than-expected jobs report was released.  A major recovery by stocks especially and credit to a somewhat lesser extent drove much of the weakness.  Also key in driving both the weakness in Treasuries and upside in equities was a growing investor appreciation of the potential for a much bigger gain in 3Q GDP than our most recent official forecast of +1.0% and roughly similar consensus expectations driven by auto assembly plans that point to an enormous contribution to 3Q growth from this sector.  So while upside surprises in earnings from a number of financial companies helped this sector be among the leaders in the stock market surge, more cyclical areas also saw major upside, with steel stocks, for example, clear potential beneficiaries of an auto assembly surge, posting major gains that outpaced the upside in banks.  The auto-centric nature of the potential 3Q jump in output creates the risk that investors could get overexcited about the possibility of a V-shaped recovery and be disappointed down the road when this boost fades and more sluggish results in the bulk of the economy result in what we still expect to be notably slower GDP upside from 4Q into 2010; but at least for now, if the data continue to point in the direction of a sharp rebound in 3Q industrial activity, optimism on the outlook will likely continue to build.  As investor focus increasingly turns towards the likely end to the recession in 3Q, the release of much of the remaining data for 2Q confirmed expectations for a continued contraction in the economy, though at a far slower rate than the 6% collapse seen in 4Q08 and 1Q09.  Weak underlying retail sales solidified expectations for a renewed contraction in consumption in 2Q, at least into June industrial production remained dismal, and while a jump in housing starts pointed to a slightly smaller drop in 2Q residential investment than we previously expected, fundamentally the recent recovery in starts while home inventories remain so bloated is hard to view as a positive development. 

On the week, benchmark Treasury coupon yields jumped 10-36bp.  With the front end remaining comparatively well anchored by firmly on hold Fed policy, the curve steepened quite a bit, though the intermediate sector was the worst performer on the curve as mortgages also took a big hit.  The 2-year yield rose 10bp to 1.00%, 3-year 17bp to 1.58%, 5-year 30bp to 2.51%, 7-year 33bp to 3.21%, 10-year 36bp to 3.65% and 30-year 33bp to 4.53%.  By managing to merely hold about unchanged for the week (other than big gains at the highly oil price-sensitive short end), TIPS massively outperformed, sending inflation breakevens much higher after they had fallen to their lowest levels since mid-May at the end of the prior week.  Spikes in headline CPI and PPI in June (though these will likely be largely reversed next month, given recent trends in gasoline prices) and some renewed upside in commodity prices after the big prior period of weakness were certainly helpful to the strong TIPS showing, but probably more important seemed to be investors' simply finding the current level of real yields attractive outright regardless of moves in inflation and commodities.  The 5-year TIPS yield dipped 1bp to 1.12%, 10-year rose 2bp to 1.80% and 20-year rose 4bp to 2.32%.  Mortgages also took a big renewed hit that largely tracked Treasuries, with current coupon yields rising to near 4.6% from the recent low of 4.3% reached at the end of the prior week.  That prior rally allowed the national average 30-year mortgage rate to fall to a seven-week low of 5.14% in the most recent survey week, but the renewed back-up in MBS yields should result in a move above 5.25%.  Weakness in mortgages, some pressures on Libor and Libor/fed funds spreads through the first part of the week, and general market directionality drove a major widening in swap spreads, with the benchmark 2-year spread jumping 8bp to 47bp and benchmark 10-year spread 6bp to 24bp.  There was very slight upside in 3-month Libor early in the week, but by Friday it was down to another record-low 0.50%, while the spot 3-month Libor/OIS spread was steady at 31bp, holding at the low since early 2008.  This marginal upside in Libor through the early part of the week was extrapolated forward to a much more notable extent, and this move was only partially reversed Thursday and Friday.  The forward Libor/OIS spread to September ended unchanged right near current spot levels at around 32bp, but the spread to December rose about 1bp to 42bp, March 2bp to 38bp, June 5bp to 39bp, and losses on eurodollar futures quickly ramped up beyond that to over 50bp sell-offs starting with the mid-2012 contracts. 

Risk markets had an excellent week, both directly pressuring Treasuries and also reflecting the underlying shift in sentiment about the near-term economic outlook that moved most markets notably.  The S&P 500 surged 7% to close just shy of the highs for the year hit in the first part of June.  Certainly generally better-than-expected financial earnings and resulting upside in bank stocks, with the BKX index up 8%, were a key driver of the rally, but cyclical sectors like basic materials, tech and energy provided even bigger boosts.  Investment grade credit had a very good week but hasn't kept pace with the recent rebound in stocks.  In late trading Friday, the IG CDX index was 14bp tighter on the week at 131bp, matching the close just before the employment report was released July 2 but comparatively further from the year's tightest close of 121bp seen in early June than stocks are from setting new highs for the year.  On the other hand, lower-quality credit has outpaced the equity rally and moved to the best levels since last fall. Through Thursday, the high yield CDX index was 61bp tighter on the week at 927bp and holding steady Friday after hitting its best close of the year of 922bp Wednesday.  The leveraged loan LCDX index was doing even better, showing a 96bp tightening to 856bp though midday Friday, which would be its tightest close since November. The actual implementation of S&P's warning of CMBS downgrades was apparently somewhat more severe than investors had been expecting and temporarily interrupted what had been a move by the CMBS market to the best levels since mid-May at Monday's close. The first subscription of TALF loans for legacy CMBS announced late Thursday wasn't a complete failure, but the meager US$669 million in loan requests also put a bit of dampener on this market Friday.  Even so, all the CMBX indices except the lowest-rated BB were able to wind up posting decent net gains for the week, with the AAA up 0.45 point to 74.39 and junior AAA a more impressive 1.31 points to 34.79.  Meanwhile, the recently renewed rally in the subprime ABX market picked up steam, with the AAA index (the lower-rated indices have effectively stopped moving at this point) up nearly 2 points to 27.77, just shy of the best levels since early March that were briefly reached in mid-May.  Just over a month ago this index seemed to be on a rapid trajectory to break below the record lows hit in April, but has since rallied 17% since the recent low hit June 22.  

The key emerging story for the economy as we move into the early part of 3Q is the potential for substantial upside to our prior +1.0% GDP forecast from auto production schedules that point to a major rebound after a huge prior decline.  In June, industrial production fell 0.4% with manufacturing output declining 0.6% for a 15.5% plunge over the past year, the worst annual decline since the winding down of war-time production in 1946.  Motor vehicles and parts output fell 2.6%, bringing the annualized decline over the first half of the year to nearly 50%, with assemblies plummeting to their lowest levels on record.  Indeed, the level of assemblies has fallen so far that even with the badly depressed pace of sales, inventories are falling substantially every month. Automakers have indicated that they intend to try to stabilize inventories at current low levels in 3Q, which would require an enormous recovery in assemblies. Indeed, taken at face value, auto assembly plans suggest that this now-small sector of the economy would add upwards of 6pp to 3Q GDP growth. While we don't expect this plan to be fully realized, the 2pp add we had previously been building into our 3Q GDP estimate is certainly looking much too low at this point. The degree of potential upside should become clearer before too long, since monthly assembly schedules suggest that most of the major surge in output for 3Q is planned in July. The auto sector typically sees a very large decline in output in July as there are normally widespread factory shutdowns in the first half of the month. To a substantial degree this does not seem to be happening this year, and if assemblies run at anywhere near a normal pace through the whole of the month, the boost from seasonal factors looking for this usual plunge in output could be immense in July IP that will be reported in mid-August. An early indication that this is playing out is the plunge in initial jobless claims the past two weeks, as auto workers who would normally be laid off in the first part of July haven't been filing in the first part of July because the typical seasonal shutdowns in assemblies aren't occurring to the usual extent. 

As we watch weekly auto production figures and the pattern of jobless claims to try to get a handle on how big a potential upside boost we could see in 3Q GDP, looking back to 2Q we marginally reduced our GDP forecast to -1.2% from 1.3%, as a weaker outlook for consumption was offset by a slightly less-bad path for residential investment. Retail sales gained 0.6% in June, but all of the upside was accounted for by an odd 2.3% jump in auto sales that contrasted with a decline in unit sales and a price-driven 5.0% surge in gas station sales.  Ex autos and gasoline, sales declined 0.2%, a fourth-straight drop for a 4.4% annualized fall since some brief upside early in the year following the disastrous holiday shopping season.  Areas of notable softness in June included general merchandise (-0.4%), drug stores (-0.3%), clothing stores (0.0%) and restaurants (-0.9%). The key retail control grouping rose a weaker-than-expected 0.4% after slight downward revisions to May (+0.4%) and April (-0.3%), confirming expectations for a renewed decline in consumption in 2Q after the small rebound in 1Q.  We cut our 2Q consumption forecast to -0.9% from -0.7%. Meanwhile, housing starts rose 3.6% in June on top of substantial upward revisions to prior months to reach 582,000 units annualized, a seven-month high.  Single-family starts surged 14.4%, the biggest monthly rise in five years, on top of a run of increases over the prior three months, to a 470,000 unit annual rate, a massive rebound from the record low of 357,000 hit in January and February.  Multi-family plunged 26% to 112,000, back not far from the record low of 91,000 hit in April. With the number of unsold homes for sale already extraordinarily high and set to ramp up further in coming months as foreclosures accelerate, this recent surge in single-family housing starts certainly seems ill-advised and likely to worsen still-massive imbalances in the housing market.  Still, at least in the near term the upside pointed to slightly less-bad residential investment in 2Q, as we made a slight adjustment to our expectation for residential construction spending over the next couple of months. Even with this change, we still see the residential construction component of GDP down 25% annualized in 2Q. Indeed, our overall -1.2% GDP estimate contains some unusually large swings among major drivers.  We see private domestic demand contributing -2.4pp and inventories being an additional negative of 1.6pp, with a major positive offset from an expected +1.8pp contribution from net exports and another +0.9pp from an expected rebound in government spending.

With almost no economic data of note out, focus in the coming week will be mostly on Fed Chairman Bernanke's semi-annual monetary policy testimony Tuesday and Wednesday. Judging from the minutes of the June FOMC meeting at which the economic outlook to be presented by the Chairman was compiled, his remarks are likely to be notably cautious about the economic outlook and provide little suggestion that there has been any change in the Fed's intention to keep rates at current near-zero levels for an "extended period". While FOMC members at the end of June expected the recession to soon end, the economy was still viewed as "quite weak and vulnerable to adverse shocks", and they believed that any return to growth in 2H would likely be "relatively slow". Downside risks to this hope for a return to at least some growth soon were seen as having diminished "somewhat" since April but as being "still significant". Inflation was not seen as a risk aside from some temporary energy-driven upside in headline price gauges, with core inflation expected to remain "subdued for some time" in light of "substantial resource slack". Of note in the FOMC forecasts to be presented in the monetary policy report Chairman Bernanke delivers to Congress was how pessimistic the view on the recovery next year is.  On average, the FOMC only expects the economy to expand by about 2.75% on a 4Q/4Q basis in 2010, which would be a pitiful recovery from the longest and deepest recession since the Great Depression. Our forecast for next year's growth is 3.25%, but we consider even this higher estimate to be a dour outlook, given how severe this recession was. Although the FOMC according to the minutes spent a fair amount of time studying staff presentations about future exit strategies and discussing this issue, the timing of such a shift seems still to be far enough off in the future that it probably won't be a primary focus on Fed Chairman Bernanke's remarks, though no doubt he will stress that the Fed will move promptly and aggressively to withdraw its massive liquidity injections when the appropriate time for such a shift eventually arrives.  Aside from the testimony, the main risk event on the calendar is probably Thursday's announcement of the next flood of record supply. While the last two supply weeks went quite smoothly, there has still been a recent tendency for the market to take a substantial hit on the supply announcements. We expect that the Treasury on Thursday will announce a US$6 billion reopening of the 20-year TIPS, US$40 billion 2-year, US$37 billion 5-year and US$27 billion 7-year for auction the following week in another run of four consecutive days of auction from Monday to Thursday.  All of these sizes would be unchanged, but the US$110 billion in total gross issuance would be another weekly record.  The economic data calendar is nearly empty in the coming week.  Other than the jobless claims report, which for initial claims will cover the survey period for the July employment report, the only particularly notable releases are leading indicators Monday and existing home sales Thursday:

* The index of leading economic indicators is likely to post another solid 0.8% advance in June, with most of the upside accounted for by the steep yield curve and building permits. Smaller positive contributions should come from stock prices, jobless claims and the manufacturing workweek. The money supply appears to be the only notable negative contributor.

* We forecast a small dip in June existing home sales to a 4.75 million unit annual rate.  The pending home sales index was little changed in May following some improvement in prior months. No doubt, this was at least partially related to the back-up in mortgage rates.  Thus, we look for little change in resales relative to the 4.77 million unit figure that was reported for May (and after taking into account an expected modest downward revision to prior months, reflecting a reporting glitch in California that was uncovered by a private sector housing economist).

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosure for Morgan Stanley Smith Barney LLC Customers The subject matter in this Morgan Stanley report may also be covered in a similar report from Citigroup Global Markets Inc. Ask your Financial Advisor or use Research Center to view any reports in addition to this report.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.