Time to Reverse the Accommodative Monetary Policy?
October 13, 2009
By Chetan Ahya | Singapore & Tanvee Gupta | Mumbai
IP Growth Is Recovering Fast
Loose monetary and aggressive fiscal policy have supported a recovery in domestic demand - household and government spending. A quick turnaround in global risk appetite since April 2009 has also played a key role in this domestic demand recovery. During the quarter ended September 2009, we estimate that capital inflows were about US$16 billion (annualized rate of US$64 billion), compared with an outflow of US$5.3 billion during the quarter ended March 2009. Increased capital inflows have not only meant higher liquidity in the banking system but, more importantly, they have also helped to repair the corporate balance sheet and reduced the NPL risks in the banking system. Apart from this recovery in domestic demand, over the next 3-4 months, we believe that the improvement in exports will also support an acceleration in IP growth.
WPI Inflation Likely to Accelerate Significantly
Headline inflation (WPI) has moved up from deflation to inflation mode. The headline Wholesale Price Index (WPI) accelerated to 0.5%Y (average) in September 2009 after remaining in deflationary mode since the first week of June 2009. A large part of the recent rise in inflation is due to higher food prices. Food inflation has accelerated to double-digit levels of 12.5%Y (average) in September 2009, compared to the trough of 6.5%Y (average) as of March 2009. Non-food WPI, which is more important from the perspective of monetary policy management, has continued to be in deflationary mode so far. Non-food WPI was down 4.3%Y (average) in September 2009 on account of the strong base effect of last year. However, we expect non-food inflation to move up to 4.5%Y by March 2010 as the base effect recedes. This, in turn, should push overall WPI to reach 6.5%Y by that time even as food inflation starts moderating from November post the festive season.
Excess Liquidity Balance Is Rising
Increased capital inflows and still weak manufacturing investment have resulted in rising excess liquidity within the banking system. Banks have parked US$33.5 billion in the net repo plus market stabilization scheme (MSS) bonds. In addition, they have invested surplus funds with liquid mutual funds. While bank credit is growing at 12.6%Y, deposits are growing at 19.8%Y as of the fortnight ended September 25, 2009. The incremental credit-deposit ratio at 47.3% is currently close to 2003 lows. We believe that year-on-year credit growth will start picking up only from December 2009 onwards after likely further deceleration over the next two months on the high base effect of last year.
Time to Reverse Accommodative Monetary Policy?
In our view, the recovery in growth and likely rise in WPI inflation imply that the RBI will need to start normalizing interest rates. India's short-term interest rates are at the lowest levels seen in many years. Our base case forecast is that the RBI will keep interest rates unchanged at the next monetary policy meeting on October 27. However, we do see more than an even chance of a hike in the cash reserve ratio (CRR). We do not expect the RBI to revive the plan to issue market stabilization scheme (MSS) bonds over the next three months. We believe that the RBI would not want to disturb the government's borrowing program by announcing MSS right now. A CRR hike is unlikely to influence banks' lending rates. We estimate that a 50bp hike in CRR would take away only US$4.8 billion from the excess liquidity. The RBI will aim to use a CRR hike to sterilize the rising capital inflows. Moreover, it would also serve as a clear signal from the central bank that time has come to start reversing the accommodative monetary policy. We believe that the RBI will start lifting policy rates only from January 2010. By then, the RBI would have had adequate comfort about the pace of recovery. Indeed, we expect a cumulative increase of 150bp in the repo rate in 2010. However, note that this potential rate hike is unlikely to derail recovery as we see this increase in policy rates as a move towards normalization rather than tightening that hurts growth.
Would a Rise in Inflation to Above 5% Not Cause the RBI to Tighten Aggressively?
We expect WPI inflation to rise to 6.5% by March 2010. In our view, while inflation will rise above the RBI's comfort zone of 5% in 1Q10, we do not expect the RBI to get too concerned about it. We believe that the RBI will continue to be gradual in pursuing rate hikes. The WPI basket is biased more towards basic inputs and intermediate products. Considering the fact that capacity utilization in large parts of the economy is still low, we believe that this rise in WPI (i.e., largely input prices) is unlikely to imply a one-to-one increase in finished goods prices. For instance, the rise in WPI above 6% in the second half of 2004 did not result in aggressive rate hikes. Hence, in our view, the coming rise in WPI when capacity utilization is low is unlikely to cause a quick rise in policy rates unless industrial production growth rises sharply from here. If growth were to surprise on the upside, this would imply higher capacity utilization, higher finished goods inflation and therefore the need to lift rates quickly.
What About Excess Liquidity Balance and Asset Price Rise Risk?
We believe that in the near term the risk of a potential rise in asset prices is likely to be a bigger challenge for the central bank, considering the rising excess liquidity balance. Moreover, rising global risk appetite and an increase in capital inflows are likely to add to the excess liquidity balance, as the RBI intervenes to prevent FX appreciation. In this context, we see a high probability of the RBI beginning to start increasing the cash reserve ratio again to sterilize the rise in excess liquidity. We see more than an even chance of a 50bp CRR hike on October 27, when the RBI announces its quarterly monetary policy decision.
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Review and Preview
October 13, 2009
By Ted Wieseman | New York
Treasuries posted big long end-led losses in the past week after two weeks of gains to low yields since May when the market violently reversed course late in the week following a somewhat softer, but certainly not terrible, 30-year auction that wrapped up the latest flood of supply. After having gotten progressively longer and more and more into flatteners for a while recently into the 30-year auction, the less-than-stellar results ended up driving a fair amount of lightening up of both outright and curve positions ahead of the long weekend. Fundamentally the week's backdrop certainly also supported a correction, but as long as the auctions, the week's main market focus, were coming in so strongly, this was being ignored. The economic data calendar was light but quite positive in what was released, helping to ease some of the concerns raised by the prior week's run of more negative numbers. A back-and-forth pattern in the tone of the incoming data like the past couple weeks could become the norm for a while if, as we expect, the economy has moved into a sustainable but modest and bumpy recovery. The non-manufacturing ISM index jumped above the 50 breakeven level, chain store sales were broadly significantly better than expected, the combination of some downside in wholesale inventories but a larger-than-expected narrowing in the trade gap led us to boost our 3Q GDP forecast a couple of tenths to +3.7%, jobless claims saw a big improvement, and weekly mortgage applications for new home purchases surged, indicating that the recent move back to near-record-low mortgage rates is offsetting the negative impact of the expiring first-time homebuyers' tax credit. On top of the better data, stocks strung together five straight rallies after what ended up being a very short-lived move at the beginning of 4Q to scale back risk and try to lock in some gains by shifting money out of stocks into safer areas looking towards year-end. Until early Thursday afternoon, however, very good results at the 10-year TIPS, 3-year and 10-year auctions and expectations for a similarly robust result at the 30-year sale had allowed the Treasury market to rally in the face of these seeming negatives. When the 30-year auction wasn't as strong as the prior three sales, however, a big reversal began Thursday afternoon that had a major follow-through in major Friday losses, as all of the issues sold during the week broke below their auction levels, and investors decided to lighten up positions for now.
On the week, benchmark Treasury coupon yields rose 9-21bp (though bill yields remained pinned near their lows), and the curve steepened. The 2-year yield rose 9bp to 0.96%, 5-year 14bp to 2.34, 7-year 15bp to 2.97%, 10-year 16bp to 3.38%, and 30-year 21bp to 4.22%. That Friday close for the long bond represented a 26bp back-up from levels seen just before the early Thursday afternoon auction tailed to be awarded at 4.01%. With such big nominal losses and support from the falling dollar that provided a good boost to commodity prices, TIPS substantially outperformed after having performed relatively pretty well recently even when nominals were rallying. The 5-year TIPS yield rose 2bp to 0.83%, 10-year 2bp to 1.53% and 20-year 7bp to 2.08%. The resulting 14bp increase in the benchmark 10-year inflation breakeven to 1.85% was a nearly one-month high. After having held at the lowest levels since May, only modestly above 4% for a week, current coupon MBS yields broke much higher in Friday's market rout, moving back up towards 4.25%. The run of lower yields allowed national average conventional 30-year mortgage rates to fall back in the latest week to very near the record lows close to 4.75% seen for much of the spring, which is apparently supporting continued upside in home sales despite the looming tax credit expiration. If Friday's market weakness isn't reversed, however, 30-year rates will probably shortly move back up to near 5%, potentially posing some challenge to this apparent home sales resilience. Friday's poor MBS performance also contributed to a widening in swap spreads that more than reversed a narrowing seen through Thursday, with the benchmark 5-year spread moving up to stand about 1bp wider for the week as a whole at 37bp after a 2bp increase Friday.
It was a generally positive week for risk markets, but with some equity and credit divergence late in the week as the former kept rallying all week while the latter stalled out after decent further upside Monday. The S&P 500 managed five straight rallies to gain 4.5% on the week and stand just fractionally below the year's best close on September 22. Although it is certainly causing some hand-wringing in the media and certainly some nervousness among investors, the dollar weakness at least for now is proving to be a stock market-positive, as the impact on commodity prices helped energy (+8%) and materials (+6%) lead the week's rally, along with typically high-beta financials (+6%). The more defensive healthcare (+2%), consumer staples (+2%) and utilities (+3%) sectors lagged as investors seem to have quickly ditched their brief move on October 1 and 2 to adopt a safer posture moving towards year-end. Credit markets rallied along with stocks only into Monday and then couldn't manage further gains, holding little changed for the rest of the week. For the week, this left the investment grade CDX index about 5bp tighter near 102bp, with all of the upside for the week posted Monday. This is still a way from the 92bp close reached September 22. The high yield index similarly tightened 40bp to 672bp Monday and then hardly moved (at least on a closing basis) the rest of the week. The commercial mortgage CMBX market performed worse than stocks or corporate credit. The AAA index eked out a quarter-point gain to 79.72 after only managing to hold on to a small part of a significant Monday gain after four days of small losses the rest of the week. Lower-rated CMBX indices were down substantially and have now reversed about two-thirds of the huge rallies seen in the second half of September. The junior AAA spiked from 47.15 on September to a high of 60.60 on September 29 but was down to 52.68 Friday after a more than 3-point plunge on the week. The AA index similarly went from 26.77 to 40.98 to 34.70 over this period, with nearly 3 points of the recent downside reversal coming in the past week.
It was a very light week for economic news, but what was released was notably positive after the run of disappointing numbers the prior week. A couple more key early releases for September were stronger, with the non-manufacturing ISM rising into positive territory and chain store sales posting broadly based better-than-expected results, after the previous disappointment in the downside in the employment, manufacturing ISM and auto sales reports. A couple of reports for August bearing directly on 3Q GDP growth were on net slightly positive. Wholesale inventories were down a lot more than we expected, though this resulted from a big surge in sales, which pointed to a smaller, but still quite large, add to 3Q growth from a slowed pace of inventory liquidation (but with offsetting positive implications for 4Q), but this was more than offset by a narrower-than-expected trade deficit. After resetting our 3Q GDP forecast to +3.5% in the monthly forecast update we published Monday, we slightly raised this estimate to +3.7% based on the wholesale and international trade reports. The weekly jobless claims report also showed big improvement, as initial jobless claims and the four-week average of initial claims both hit their lowest levels since January and continuing claims fell to their lowest level since March. So at this point it appears that the October employment report will probably show renewed improvement after the disappointing September results.
The composite non-manufacturing ISM index gained 2.5 points in September to 50.9, the first result above the 50 breakeven line in over a year. The business activity (55.1 versus 51.3) and orders (54.2 versus 49.9) gauges both moved well into growth territory, while the employment index (44.3 versus 43.5) was slightly less negative. Moderating costs helped to boost sentiment, with the prices paid gauge plunging 14 points to 48.3. Despite the overall improvement in activity, upside was narrowly based, with 5 of 18 industry sectors reporting growth in September (utilities, healthcare, retail, construction and wholesale) and still 13 reporting contraction. Meanwhile, the chain store sales results for September were much improved and significantly better than expected. Coming on top of the stronger August results, the key back-to-school shopping season appears to have been surprisingly robust. The plunge in September motor vehicle sales will still lead to a big drop in overall retail sales, but we now see ex auto sales gaining another 0.2% on top of the 1.1% surge in August.
The trade deficit narrowed to US$30.7 billion in August from US$31.9 billion in September as imports (-0.6%) fell slightly and exports (+0.2%) rose marginally, pausing after big rebounds over the prior couple of months. The recent surge in North American vehicle assemblies led to another month of big gains in auto imports and exports, but otherwise results were soft. On the import side, a plunge in petroleum product volumes to a 10-year low more than offset rising prices, and consumer goods were surprisingly weak after recent improvement in inbound volumes at the key West Coast ports. Exports were largely hampered by an aircraft-centered decline in capital goods. The real goods trade gap also narrowed about US$1 billion in August instead of the US$1 billion widening we expected. As a result, we now see net exports subtracting 0.2pp from 3Q GDP growth instead of 0.6pp, with exports on track for a 15% annualized rebound after a 15% plunge in the year through 2Q and imports tracking at +14% after an 18% plunge in the prior year. On the negative side, if only temporarily, wholesale inventories plunged a larger-than-expected 1.3% in August on top of a downwardly revised 1.6% drop in July, which led us to reduce our estimate for the add to 3Q GDP from inventories a couple tenths to +1.1 pp. Netting these together, we now see 3Q GDP growth running at +3.7% instead of +3.5%, with decent positive contributions from consumption and residential investment on top of the inventory boost.
Monday is a bond market, bank and government holiday (though the stock market will be open), but the economic calendar over the remaining four days of the upcoming week is busy. Retail sales on Wednesday is probably the most notable economic data release. The first round of regional manufacturing surveys for October will be out on Thursday from the Philly and New York Feds, so it's already time to start setting initial expectations for the next ISM report. The October survey week is late, so it will be another week before the jobless claims report has figures covering the reference period for the next employment report, but certainly there will also be a lot of focus on whether the improving trend in claims seen recently can be sustained as investors start to look ahead to the next jobs report. Other data releases due out include business inventories Wednesday, CPI Thursday and industrial production Friday:
* We forecast a 2.4% plunge in overall retail sales in September but a further 0.2% gain ex autos. A very sharp - but largely anticipated - fall-off in unit sales of motor vehicles in the aftermath of the cash-for-clunkers program points to a sizeable drop in headline retail sales for September. However, the chain store reports contained a number of upside surprises which suggest some follow-through gains in discretionary spending on the heels of a solid advance in August. In particular, we look for another sharp jump in the general merchandise category, which is expected to contribute to a 0.3% rise in the key retail control gauge that feeds directly into the consumption component of GDP. Finally, gasoline prices were little changed after accounting for normal seasonal variation, so we look for a flat reading in the service station category.
* We look for a 1.3% plunge in August business inventories. The figures that have already been reported for the manufacturing and wholesale sectors - together with an anticipated plunge in stockpiles of motor vehicles - point to another very sharp drop in overall business inventories. The I/S ratio is likely to move down to 1.33 - well above where it should be but down from the recent peak of 1.46 posted at the start of the year.
* We expect both the headline and core CPI readings to round down to +0.1% in September, as gasoline prices flattened out on the heels of a very sharp advance in August and quotes for food items continue to show little change. One of the keys in this month's report will be the motor vehicle category. Cash for clunkers contributed to a 1.7% decline in new car and truck prices in August - the sharpest drop in more than 35 years. However, we were actually looking for an even larger decline and suspect that there may be some spillover to this month's report. Moreover, new motor vehicles are expected to register only a partial rebound in September since the mid-month sampling methodology should delay a full reversal of the cash-for-clunkers effect for another month. Meanwhile, the used car category has been posting some hefty increases in recent months, but survey data suggest that the pace of increase is beginning to moderate somewhat this month. Otherwise, softness in the shelter category is expected to continue to act as a restraint on consumer price inflation. Finally, our September estimate implies that the core CPI should tick back up to +1.5% on a year-on-year basis.
* We look for a 0.1% rise in September industrial production. The employment report pointed to significant underlying weakness in manufacturing activity during September. In particular, we should see sharp production declines in the metals, machinery and furniture sectors. However, another surge in motor vehicle assemblies - a response to the extremely low inventory levels experienced in the wake of the cash-for-clunkers success - should provide considerable support. Moreover, we look for another weather-related jump in utility output this month. So headline IP is likely to eke out a fractional rise even though the key core category (manufacturing ex-motor vehicles) is expected to be down 0.4%.
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