Politics May Stall the Easing Cycle
October 06, 2009
By Pasquale Diana | UK
Politics took centre stage in Romania this week, as the ruling government coalition between the centre right Democratic Liberals (PLD) and their junior partner Social Democrats (PSD) came to an end. The casus belli was the decision by Prime Minister Emile Boc to dismiss Interior Minister Nica (PSD) and send a replacement from his own party. The reason for the dismissal was Nica's accusation that the PLD was trying to unfairly influence the outcome of the November 22 presidential elections. In response, the PSD decided to withdraw from the government on Thursday. While it is in theory possible that the Liberals (PNL) replace the PLD as a junior coalition partner, they have thus far denied this possibility. Another possibility is for PM Boc to try and form a technocratic government, which seeks support in parliament on an ad hoc basis, and survives until some point in 2010. For now, the PM has nominated acting ministers to replace the PSD ministers who resigned this week. This gives him, under Romanian law, 45 days without having to receive a confidence vote in parliament. The situation is very fluid, but it seems to us as though early elections are the likeliest way out of the current impasse. Parliamentary elections could happen at the same time as the presidential elections. Note that in Romania the president nominates the prime minister, which in the event of a hung parliament can be of some significance in determining the direction of government.
Politics, the budget and the IMF: The two coalition partners have had an uneasy cohabitation since December 2008, when they first formed the government. With the 2010 budget negotiations underway, the latest spat between them could not have come at a worse time. With the presidential elections looming, neither party wants to concede too much ground. The IMF has thus far been understanding of the changing macro backdrop and appears willing to tolerate larger fiscal gaps: earlier this year, the IMF agreed to a deficit of 7.3% of GDP for 2009, up from the initial projection of 4.6%, in light of a much sharper GDP contraction for 2009 than assumed in the initial program (-4.1%). Note, however, that on a 12-month basis the deficit is already running at 7.9% of GDP, so slippage seems likely barring better fiscal results in 4Q09. While the IMF released the second tranche of its program last week (€1.9 billion) and funding until year-end should not be an issue, the authorities have committed themselves to lowering the budget gap to 3% by 2011, a very tall order indeed, in our view. Compliance with the IMF program has thus far been just good enough to keep assistance coming, but Romania is currently heavily reliant on IMF funding, and drastic budget cuts (requiring broad political agreement to be acceptable) are needed next year, in our view. The 2009 fiscal result will be discussed in the February review. At that time, the IMF may well ask the authorities to adopt more ambitious fiscal tightening.
Room for more cuts, but watch political instability and the RON: The National Bank of Romania cut rates by 50bp to 8% this week, as expected. This took the total cumulative easing since the peak to 225bp. The bank chose to leave the existing reserve requirement ratios (RR) on both FX and RON loans unchanged, at 30% and 15%, respectively. In the statement, the bank noted that disinflation has consolidated, and that the external gap has continued to narrow sharply on account of weak domestic demand. At the same time, however, the bank noted the first rise in monthly credit observed in the last six months. Some cautious signs of stabilization in credit dynamics may be the reason why the bank chose to leave the RR unchanged on both RON and FX loans.
More easing is likely, but risks have moved to the upside: The NBR will meet again on November 3, when a new Inflation Report is published. We think that another 50bp cut at that meeting is possible (to 7.50%), to be followed by some more easing early in 2010. We continue to see the trough in policy rates at 6% next year. This should take real rates to sub-3%, which is probably below neutral but entirely consistent with the domestic macro backdrop.
Painful correction in external imbalances: Romania was one of the hardest-hit economies across CEE. Strong increases in wages and easy access to credit were boosting domestic consumption and investment to double-digit levels between 2004 and 2008, pushing the C/A deficit to unsustainable levels. When credit came to a sudden stop in late 2008, trade collapsed and layoffs began, the correction was severe. This is mirrored in the rotation in growth contribution, with domestic demand now a large drag on overall GDP growth. The flip-side is an adjustment in imports and a sharp narrowing in the C/A deficit, from a peak of 14% of GDP last year to an estimated 5% by the end of this year. We see this year's growth at -7.8%, and expect a modest expansion next year (+1.7%). This is predicated on a stabilization of the q/q momentum in GDP in 3Q, followed by q/q increases. Risks are probably still to the downside, especially for 2010.
While the macro backdrop is clearly suggestive of lower rates, we believe that the NBR has to tread carefully, much like the NBH in Hungary. Although the leu has been managed effectively by the NBR due to intervention, the bank still likely wants to keep a decent carry cushion to protect the currency, given: i) FX exposure of households and corporates (60% of total credit, worth 23% of GDP, is in foreign currency, mostly EUR); and ii) significant FX-inflation pass-through. In a benign risk environment, our view is that there is some room for RON to catch up to its peers (towards 4.00 by year-end), while we are of course mindful of the risks associated with political risk and the IMF program. We note also that Moody's said that the rating would come under pressure if fiscal reforms were delayed. Currently, Moody's rates Romania Baa3, two notches below Hungary.
Bottom line: The latest political spat between the two ruling parties came at a particularly unfortunate time. Early elections look likely, and the 2010 budget may be watered down or postponed as a result. IMF compliance has thus far been just sufficient to keep the program on track, but the fiscal target for end-2009 looks to be at risk. The NBR seems inclined to continue its easing cycle for now. However, given the risks to RON coming from political noise, the risk is now that bank may decide to slow down or pause rate cuts, despite a macro backdrop that is strongly suggestive of lower rates.
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Review and Preview
October 06, 2009
By Ted Wieseman | New York
Big asset reallocations out of stocks and other risky markets and into safer interest rate markets as investors looked to lock in some gains at start of 4Q, a softer tone to the incoming economic data, a reversal of the more hawkish Fed path that was briefly priced in at the end of the prior week on Fed Governor Warsh's somewhat hawkishly interpreted article following more balanced remarks from Vice Chairman Kohn, and a big rally in mortgages that sent yields back down to the spring lows combined to drive another week of good Treasury market gains. Thursday's asset reallocations into Treasuries and out of stocks, and the resulting follow-through impact of mortgage convexity-related buying as the MBS market ripped higher and short covering as rates plunged, accounted for almost all of the week's net gains, though the data and Fed rethinking provided a positive. With the recovery expected to be bumpy and not V-shaped, we will probably continue to see periods of more mixed or weaker data interspersed with stronger numbers going forward. Thursday's big gains apparently overdid it somewhat for now, however, especially with a major run of supply the main focus in an otherwise fairly quiet calendar in the upcoming week, as yields backed up somewhat Friday after the market was unable to hold onto an initial extension of the rally on the downside surprise in the employment report. Disappointment in the jobs report was broadly based - a slightly bigger-than-expected drop in payrolls, a new generational high for the unemployment rate, a record low for the workweek, and negligible growth in average earnings. Other data through the week were more mixed, but this represented a continuation of a recent pattern after a run of prior regular upside surprises. The manufacturing ISM was down slightly after surging into positive territory last month. A lot of data bearing directly on 3Q GDP growth - the 2Q GDP revision (a surprising upward adjustment to -0.7% from -1.0%), consumption in the personal income report, construction spending, motor vehicle sales, government jobs in the employment, inventories and capital goods shipments in the factory orders report - just about netted out. We slightly raised our 3Q GDP forecast to +3.3% from +3.2%, though there were some more meaningful revisions to our forecasts for the GDP components, with upward revisions to our estimates for consumption and residential investment just about offset by more negative outlooks for business investment and government spending.
For the week, benchmark Treasury coupon yields fell another 8-17bp, with big outperformance by 5s and 7s as the MBS market put in a very good performance that sent current coupon yields back down to near the 4% levels that were seen for most of the spring. The 2-year yield fell 12bp to 0.87% - making it a bit rich compared to the 1% average fed funds rate that is now priced into futures over the next two years - 3-year 12bp to 1.35%, 5-year 17bp to 2.20%, 7-year 17bp to 2.82%, 10-year 11bp to 3.22% and 30-year 8bp to 4.01%. This left the 5-year at its richest level versus 2s and 10s since mid-July. Getting through quarter-end didn't end up providing much relief for the very short end squeeze, as some of the money coming out of stocks at the start of the current quarter went into cash. The four-week bill yield only rose 2bp on the week to just 0.03%. Weird repo market conditions at least faded once quarter-end was done, after overnight Treasury general collateral repo rates bizarrely traded significantly negative at times on September 30. TIPS lagged the nominal gains, but not by all that much as outright performance remained strong, with some help from some upside in oil prices after the big decline seen the prior week. Investors were also optimistic about stepped-up Asian demand at Monday's 10-year TIPS auction and were feeling more comfortable about the auction's prospects after a bit of weakness Friday pushed the issue's yield back a bit above 1.50% after having broken that level for the first time since April on Thursday. The 5-year TIPS yield fell 14bp to 0.81%, 10-year 5bp to 1.52% and 20-year 5bp to 2.01%. The initial impetus for Thursday's big rally came from money flowing out of stocks and other risk markets, but as yields plunged, mortgage duration-related buying added to the upside as mortgages had a very good week. Now current coupon 4% MBS surged nearly a point on the week to not far below par, outperforming the Treasury rally and sending yields down about 20bp to only slightly over 4%, lows since late May. MBS yields were consistently close to 4% from late March to late May, and average 30-year mortgage rates correspondingly at record lows near 4.75%, before a bout of weakness in late May and early June and then a period of stability at higher yields around 4.5%, with 30-year mortgage rates adjusting up in response to near 5.25%, from mid-June through much of August. If the strength seen in recent trading session can be sustained, mortgage rates should move back down to the 4.75% record lows, which should help temper the payback in home sales as we approach the expiration of the first-time homebuyers' tax credit.
There was a sizable dovish repricing of the Fed path in futures after Vice Chairman Kohn noticeably did not repeat language used the prior week by Governor Warsh suggesting that the Fed would likely need to tighten aggressively when tightening begins. Kohn did, however, reiterate Warsh's broader message that policy would likely be on hold for a good while longer but that the Fed would eventually need to begin tightening policy preemptively when slack started declining and not wait until it was eliminated. The Jan 2011 fed funds contract gained 12bp on the week to 1.34%, shifting from pricing in the likelihood of a 1.25% funds target at the end of next year instead of 1.50%, and the July 2010 contract gained 8bp to 0.645%, just barely favoring a 0.75% funds target in the middle of next year instead of 0.50%. The first hike to 0.50% is still seen as coming at the April FOMC meeting after a 6.5bp gain in the May 2010 contract to 0.465%. At the end of the prior week, a decent possibility that the first move could come as early as the March meeting was briefly priced in, but this risk was scaled back with a 3.5bp gain in the April 2010 contract to 0.35%. 3-month Libor rose very slightly on the week to 0.284% as the maturity date crossed over year-end after the latest run of record lows ended Monday at 0.283%, leaving the spot Libor/OIS spread little changed at 12bp, close to pre-crisis norms. Forward spreads continued to come down, however, as eurodollar futures gains outpaced the fed funds futures repricing. The forward Libor/fed funds spread in mid-December is only slightly higher than the current spot level, so no significant year-end funding pressures are currently being priced in, and the forward spread is now below 20bp through mid-2010 and then close to 20bp in 2H10 and into 2011. The Fed will be winding down 3-month TAF auctions in 4Q but will continue 1-month TAF auctions at least into January. If the recent normalization continues, this program should probably be eliminated soon.
As packed as the past week's economic calendar was, it was the simple calendar itself that drove most of the price action, as the move into 4Q on Thursday after the big rallies in equity, credit, and other risk markets and losses in Treasuries and other rates markets in the first three quarters of the year apparently led many investors to scale back risk and try to lock in some gains as we approach year-end. On the week, the S&P 500 lost 1.8% as a result of a 2.6% pullback Thursday. Financial returned to their high-beta ways seen during the recession to lead Thursday's losses, but for the week as a whole no sector particularly stood out on the downside. There was a defensive shift within equities, though, as consumer staples eked out a small gain on the week. Credit also saw modest losses, thanks to a Thursday pullback. The investment grade CDX index widened 7bp on the week to 107bp. Early on Friday, it looked like Thursday's sizeable losses in credit might be repeated, but the index was able to sharply reverse course in heavy volumes after trading as wide as 115bp. The high yield index also was able to reverse early losses Friday and post a big rally on the day to only end up about 5/8ths of a point lower on the week for the series 12 index (high yield rolled into series 13 mid-week). In the commercial real estate CMBX market, the AAA index was a strong performer, holding little changed at 79.46, but the sub-AAA indices have started to see a decent correction after an enormous rally from mid-September into the Tuesday highs (though to this point only about a third of the huge prior gains have been given back).
The early round of key September data was overall softer than expected. Non-farm payrolls fell 263.000 in September on continued major weakness in manufacturing, construction and retail, and some major downside in government, with state and local government employment very weak recently, that offset moderating job losses in business services and finance. The unemployment rate rose a tenth to 9.8% and would have risen much more if not for a sharp fall in the labor force participation rate to a 23-year low. Other details of the report were also soft. The average workweek fell a tenth, back to a record-low 33.0 hours, which combined with the drop in payrolls caused total hours worked to fall 0.5%. Average hourly earnings only rose 0.1%, which combined with the drop in hours resulted in a 0.5% decline in aggregate earnings. About the only sort of positive from the numbers was that with hours worked plunging 3% annualized in 3Q and growth poised for a decent gain, productivity likely posted another huge gain on top of the 6.6% surge in 2Q. Meanwhile, the composite manufacturing ISM index was little changed in September after surging into growth territory in August, dipping to 52.6 from 52.9, though the expansion was more broadly based, with 13 of 18 sectors reporting growth in September, up from 11 in August. The key orders (60.8 versus 64.9) and production (55.7 versus 61.9) gauges pulled back but remained well into growth territory while employment (46.2 versus 46.4) was close to unchanged, modestly below the 50 breakeven level. Notably, respondents said that inventories were "gaining balance" as the inventory index rose 8 points to 42.5, indicating a slower rate of liquidation. Finally, on the key initial September figures, motor vehicle sales fell to 9.2 million units annualized, a bit below the first half average after having surged up to 14.1 million in August during the peak of cash-for-clunkers sales. This will clearly contribute to a pullback in consumer spending in September after the big gain in August, but automakers indicated that sales were partly restrained by lack of inventories of popular models, which they had started to alleviate later in the month as production continued to ramp higher, pointing to a likely pick-up in sales in October. Surging motor vehicle output to continue restocking very low inventories is likely to continue to provide a sizable boost to GDP growth in coming months.
A bunch of data releases directly impacting our 3Q GDP forecasts were about offsetting, and we only marginally boosted our 3Q estimate to +3.3% from +3.2% after the surprising upward revision to 2Q to -0.7% from -1.0%. Within this little overall change, however, was a wider divergence between rebounding consumer spending and housing and weakness in business and government spending. On the positive side, a stronger-than-expected surge in August consumption - as services and ex auto retail sales were significantly better than expected to add to the spike in auto sales - caused us to boost our 3Q consumption forecast a half point to +3.0% even with a likely big pullback in September spending on the correction in auto sales (which will probably put 4Q consumption on pace for a more sluggish 1% or so gain). And a sharp recent rebound in homebuilding as the surge in sales off the early-year lows has nearly brought inventories back to more normal levels continued to be seen in the construction spending report, with combined single and multi-family residential construction spending up 42% annualized in the three months through August. Incorporating these better-than-expected results, we raised our 3Q residential investment forecast to +18% from +12%. On the negative side, as residential construction is recovering, private non-residential activity continues to deteriorate, and government spending to this point doesn't seem to be receiving much of a boost from the fiscal stimulus bill. Weaker-than-expected private non-residential construction figures through August pointed to a bigger further drop in 3Q business investment in structures that should offset some modest upside in equipment investment. We now see overall business investment falling slightly in 3Q instead of rising slightly. And weakness in state and local government construction spending combined with a horrible recent trajectory for state and local payrolls point to weakness in government spending in 3Q. We now see state and local government spending falling 1% in 3Q and overall government spending being up about 1%, down from our estimates coming into the week of +1% and +2%, respectively.
There's not much on the economic calendar in the coming week, so Treasury market focus will largely be on another huge run of supply, with US$78 billion of gross coupons scheduled to be sold in four straight days of auctions - consecutively from Monday to Thursday, a US$7 billion reopening of the 10-year TIPS, US$39 billion 3-year, US$20 billion reopening of the 10-year, and US$12 billion reopening of the 30-year. Market participants appeared cautious about the supply Friday, but over the past couple of months at least starting with the early August quarterly refunding, supply has not been a problem for the market as the auctions have mostly been met with quite robust demand. Some other early economic releases for September will be released - non-manufacturing ISM Monday and monthly sales results from most major retailers Thursday. The only other major data release is foreign trade Friday. We look for the trade deficit to widen by US$2 billion in August to US$34 billion, with both exports (+1.3%) and imports (+2.3%) likely to extend their recent rebounds. On the export side, industry data and factory shipments figures point to soft results for capital goods, but upside in prices should help to boost industrial materials. Also, autos are likely to see another big gain as North American assemblies ramp up. Higher commodity prices and rising auto output should also account for a good part of the expected import gain. Moreover, a pick-up in activity at the key West Coast ports indicates that the recent improvement in domestic demand is triggering stronger inbound shipments of a wide range of goods.
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