China
Policy Shifts Towards Boosting Private Demand
December 09, 2009

By Qing Wang | Hong Kong

The Central Economic Work Conference, the annual meeting among all key senior China officials that sets the policy agenda for the coming year, concluded on December 7. A comprehensive press statement was issued.

Key messages: The authorities consider that the foundation of China's economic recovery is still not solid, with unsteady global economic recovery and inadequate autonomous domestic demand. For 2010, the authorities plan to:

•           Maintain a broadly stable macro policy stance with a view to striking a balance between three objectives: stable and rapid growth, structural adjustment and managing inflationary expectations;

•           Focus on carrying out existing public investment projects while tightening approval of new projects;

•           Promote private consumption through enhanced income transfer to low-income households and maintaining various consumption-promotion incentive programs introduced this year;

•           Accelerate urbanization by easing the controls imposed by the current household registration system over rural-urban labor mobility;

•           Push ahead with energy conservation and retrenchment of over-production capacity;

•           Widen market access of private enterprise to sectors that are subject to state monopoly; and

•           Ensure steady export growth by maintaining relevant policy continuity and stability.

Our takeaways: As we read it, the policy priority in 2010 will shift toward boosting private domestic demand and away from stimulating the economy in the context of fighting a crisis through a massive public investment program as in 2009. While the key messages from this conference are in line with the statements made by senior policymakers over the past few weeks, the role of urbanization in promoting domestic private demand in particular has been underscored by the authorities this time. In this context, we find the authorities' decision to ease the controls over rural-urban labor mobility imposed by the existing household registration system most encouraging. This concrete policy initiative should help pent-up demand for urbanization - which has been artificially impeded by the household registration system - and thus help to boost private demand because: 1) easy migration by rural residents into the cities will encourage demand for permanent housing in urban areas; and 2) availability of social services granted to urban residents should reduce the precautionary savings of rural immigrants and thus boost their consumption. Although this deregulation is to be initially applied to small- and medium-sized cities, it does constitute a major step towards an eventual abolishment of the household registration system that has been in place for decades.

Impact on our calls: This latest development on the policy front is broadly in line with our expectations, and we maintain our economic and policy calls for 2010. Specifically, we expect China's economy to deliver stronger, more balanced growth with muted inflationary pressures in 2010, featuring 10% GDP growth and 2.5% CPI inflation. These baseline forecasts hinge on two key assumptions: 1) strong domestic demand in 2009 is largely sustained; and 2) the recovery in G3 economies remains tepid. The current policy stance is to turn neutral at the start of 2010 as the pace of new bank lending creation normalizes from about Rmb10 trillion in 2009 to Rmb7-8 trillion in 2010. The M2 growth target will likely be set at 17-18%. We project two 27bp rate hikes over 2H10, but do not rule out possibility of RRR hikes as early as the start of 2Q10. While we believe that an exit from the current regime of a de facto peg against the USD may occur in 2H10, any subsequent renminbi appreciation against the USD is likely to be modest and gradual (see China Economics: A Goldilocks Scenario in '10, November 22, 2009).

What's next: The various government agencies in charge of macroeconomic policy implementation - including NDRC, PBoC, MoF, Ministry of Commerce and CBRC - are expected to hold follow-up policy meetings in the coming weeks to echo the key messages from the Central Economic Work Conference and hammer out the policy details in their own areas of responsibility.

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United States
The Fed Will Exit in 2010
December 09, 2009

By Richard Berner & David Greenlaw | New York

Slow exit initially means steeper yield curve.  The Fed will begin the gradual exit from its ultra-accommodative monetary stance in 2010.  Three forward-looking factors will drive policy decisions: Inflation expectations are starting to rise, slack in the economy is narrowing, and the outlook for inflation will begin to change by mid-2010.  We think officials will implement the exit strategy in two stages: First, the Fed will start to drain reserves when Large-Scale Asset Purchases (LSAPs) end.  Second, it will begin raising the policy rate in 3Q, to 1.5% by year-end and 2% in 2011.  Normally, the start of a tightening cycle will flatten the Treasury yield curve.  Not this time, at least initially.  We agree with our colleague Jim Caron that forward yield curves are too flat because the market expects the Fed to tighten aggressively (see 2010 Global Interest Rate Outlook: the World Is Uneven, November 30, 2009).  While we expect more tightening by year-end than is in the price, we think the Fed's gradual exit, a rise in private credit demand and a significant shift to coupon issuance will boost Treasury yields by as much or even more than the policy rate by year-end.  With growth risks tilting from balanced to somewhat higher, the rising rate scenario may unfold sooner rather than later.

US Forecasts at a Glance

(Year-over-year % change)	2009E	2010E	2011E
Real GDP	-2.5	2.8	2.8
Inflation (CPI)	-0.3	2.6	2.5
Core Inflation (CPI)	1.7	1.4	1.9
Unit Labor Costs	-0.1	-0.0	1.1
After-Tax "Economic" Profits	-7.5	16.7	8.3
After-Tax "Book" Profits	-6.0	17.6	7.7

Source: Morgan Stanley Research     E= Morgan Stanley Research Estimates

Fed commentary reinforces the notion that any rate increases, at least through mid-year, are more likely to be at the back end of the yield curve than at the front.  Fed officials have yet to indicate any change in their extremely accommodative policy stance.  They have made their intentions abundantly clear in post-FOMC meeting statements, in the minutes of FOMC meetings, and in speeches.  At the November FOMC meeting they affirmed that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period".  With inflation likely to stay below the Fed's preferred level for some time, and the growth outlook improving but still uncertain, the costs of moving too soon are probably higher than those of being somewhat late, so Fed officials would rather err on the side of accommodation.  Thus, at the upcoming FOMC meeting on December 15-16, officials likely will acknowledge the improvement in the economy, but probably will make only minor changes to the language in the statement following the meeting.  More significant changes are likely in early 2010 when there will be additional signs of progress toward recovery in the labor market and inflation expectations have likely edged up a bit more.

Starting the exit still leaves the stance of monetary policy extremely accommodative.  While officials are ready in an operational sense to implement their exit strategy, implementation is several months off.  Indeed, far from exiting, quantitative easing will continue to add stimulus for the next few months.  Barring any change in the current timetable, the Fed will continue to purchase about US$250 billion more RMBS and agency securities in its LSAP programs through the end of March 2010.  The additional purchases will boost the Fed's overall balance sheet to US$2.5 trillion from US$2.25 trillion currently, and we assume that as a byproduct the Fed will also allow excess reserves to rise to about US$1.3 trillion from US$1.1 trillion.  In addition, the timetable for exit is conditional on the outlook.  As discussed below, the Fed is closely monitoring three criteria for exit, and we expect them to be met gradually.

However, ending the LSAPs does not mean that broadly defined monetary policy will suddenly become more restrictive.  The LSAPs were aimed at boosting economic activity by keeping longer-term private interest rates lower than they would otherwise be.  As Brian Sack, who runs the Fed's Open Market Desk, noted last week, the process works for Treasuries by narrowing the term premium, or the expected excess return that investors receive for their willingness to take duration risk.  For mortgage-backed securities, the LSAPs remove the negative convexity of MBS associated with prepayment risk from the market, keeping rates lower than they would otherwise be.  These portfolio balance effects operate through the levels of Treasuries, MBS and Agencies held on the Fed's balance sheet as a result of the LSAPs.  To be sure, the purchases themselves, or flows of those securities, might also have an impact on rates.  But the important point is that the impact on interest rates will persist after the purchases end, and will only fade slowly as the portfolio passively runs off.  While the Fed could sell securities from its portfolio to reverse those effects, officials have given strong indications that such actions would constitute an extremely aggressive move toward restraint that is unlikely to be needed. 

We assume that the Fed will implement the exit strategy in two stages.  First, using large-scale reverse repurchase operations, officials will begin to drain excess reserves (held primarily on deposit at the Fed) from the banking system at the end of 1Q.  The purpose is to bring the fed funds rate up to the level of the interest rate paid on excess reserves.  As the LSAP portfolios begin to run off, reducing the asset side of the Fed's balance sheet, the volume of reserves in the banking system would not change unless the Fed takes such action.  The gradual draining of reserves will also signal that policy will eventually be moving towards restraint.  The second stage of the exit strategy will involve raising the policy rate: Assuming that the criteria for exit are satisfied, we expect rate hikes will start in 3Q, with the policy rate going to 1.5% by year-end and to 2% in 2011. 

What are we and the Fed watching to trigger exit?  Three related criteria will set the timetable for exit: Changes in inflation expectations, and changes in the outlook for slack in the economy and for inflation itself.  In our view, all three are starting to change.  An ultra-accommodative monetary policy and its adjunct, a weaker dollar, have begun to boost inflation expectations; capital exit is helping to lift operating rates, and growth will soon move above trend.  So, while core inflation itself will decline for the next few months, these factors should promote a bottoming in inflation and a change in the inflation outlook.

Exit scorecard.  Inflation expectations are gradually rising; 5-year 5-year forward breakeven rates have moved up close to 2.5% in recent weeks, and 5-10 year median inflation expectations measured by the University of Michigan's consumer surveys have drifted up to 3%, or the high end of the recent range.  That gentle rise is far from alarming.  But it does reflect an incipient tension between the current stance of monetary policy and the improving economic and inflation outlook, and we believe that inflation expectations will continue to rise until the Fed signals a shift in policy.  Economic slack by any measure is still at record levels, with the ‘output gap' at more than 6% of GDP.  Industry operating rates have risen from their lows to 70.7%, but are still below previous record lows, and the unemployment rate at 10% is still at a 26-year high.  Meanwhile, we think core inflation is headed lower in the near term, thanks to the slack in labor and product markets, including housing.  From current levels of 1.7% (CPI) and 1.4% (personal consumption price index), we expect core inflation to decline to 1% by early in 2010.  But an improving economy will narrow all three measures of slack, and together with the ongoing rise in commodity and import prices, that change should alter the inflation outlook for the second half of 2010 and 2011. 

The case for sustainable growth.  Four factors should promote sustainable growth through 2011: 1) Monetary policy has fostered improving financial conditions and market healing; 2) fiscal thrust is poised to translate into fiscal impact; 3) strong growth abroad will lift US exports and earnings; and 4) economic and financial excesses are abating.  On the last point, housing and inventory imbalances are diminishing, companies have slashed capacity, and employment is now running below sustainable levels.

Healing in financial markets, credit crunch abating.  We think that the combination of aggressive policy stimulus, the dramatic improvement in the functioning of financial markets, higher prices for risky assets, and the recent slower pace of tightening bank lending standards will increase the chances for sustainable recovery.  To be sure, the Fed's Senior Loan Officer Survey indicates that banks were still tightening lending standards in October, but at a slower pace, and it's pace that matters for growth.  Tight lending standards are still depressing the level of lending and thus output, but their effect on growth is abating.  We find that a 10-point drop in the proportion of banks tightening standards allows a one percentage-point increase in bank lending growth (see Calibrating the Credit Crunch, November 20, 2009).

Lasting fiscal impact.  A second support for sustainable recovery comes from fiscal policy.  We have emphasized that there are significant lags between fiscal thrust and fiscal impact, so that the effects of fiscal stimulus will not soon peter out as some have argued.  Measured by the change in the cyclically adjusted federal deficit in relation to potential GDP, fiscal thrust should fall to about zero by the middle of 2010, and if the Bush tax cuts sunset as scheduled on December 31, thrust could turn into significant fiscal drag.  However, we suspect that there are lags of 3-9 months between thrust and impact, so that fiscal impact will remain positive well into 2011.  That is especially the case for infrastructure outlays, which at the state and local government level are only starting to show improvement in monthly data through October.  Signs of relief are also showing up in state and local government jobs; they have risen by 35,000 over the past two months after declining by 143,000 in the previous year.  In addition, there is upside risk to fiscal thrust itself, as Congress just enacted an extension to and expansion of the first-time homebuyer tax credit through April, plus increased jobless and Cobra benefits, and prospects have improved for a tax credit or other measures to boost employment.

Strong growth abroad.  A key narrative in our global recovery story is the notion that growth in the emerging market economies will continue to outstrip that in the developed world.  Strong EM growth is part of the reason why we believe US exports and earnings will grow vigorously.  That is far from conventional thinking, as we are conditioned to believe that the US economy will be the engine for global recovery.  Yet EM economies now account for 36% of world imports, up from 24% in the 2002-3 recovery.  Contributing to our forecast of 3.7% aggregate global growth in 2010, EM economies are growing at a 5-6% pace, three times the pace of DM economies. 

Exiting excess.  Progress on reducing four areas of excess also increases the odds for sustainable recovery (see Exit from Excess: Setting the Stage for Sustainable Growth, September 14, 2009).  First, housing imbalances are shrinking.  Single-family homeowner vacancy rates declined from their peaks of 2.9% to 2.7% in 3Q, and further declines likely occurred this quarter; the inventory of unsold new homes dropped to 6.7 months' supply.  We do worry that rising foreclosures could increase housing imbalances and the pressure on home prices, given the ‘shadow inventory' of yet-to-be foreclosed homes, reckoned by some to be 5-7 million.  But the bust in housing starts has slowed growth in the housing stock to less than 1%, and with demand improving, fundamental imbalances are dwindling (see Assessing Housing Risks, November 30, 2009). 

Second, inventory liquidation peaked in 2Q, and while companies continue to shed inventories that remain high in relation to sales, a slower pace of liquidation will add to growth through 2010.  The swing in inventories added 0.9 annualized percentage points to growth in 3Q, and we estimate that it will add almost two percentage points at an annual rate to 4Q growth.  That support won't end quickly, as production is still catching up with demand; in 3Q, GDP was still 1.1 percentage points below the level of final demand.  We expect the production-demand gap to close over the course of 2010, adding 0.6 percentage points to 2010 growth through a slower pace of inventory liquidation, and a shift to inventory accumulation should add about 0.4 percentage points to growth in 2011.

Third, companies are reducing excess capacity at record rates: Capacity in manufacturing, excluding high-tech and motor vehicles and parts industries, has shrunk by 1% over the past year - a pace far exceeding the post-tech bubble bust.  And capacity in another industrial subaggregate - including primary metals, electrical equipment and appliances, paper, textiles, leather, printing, rubber and plastics, and beverages and tobacco - has contracted by a whopping 2.7% over the past year.  As a result, operating rates are rising again, up 250bp from their spring lows, helping to arrest the decline in inflation and laying the groundwork for renewed capital spending gains. 

Jobless recovery less likely.  Finally, we've argued that past aggressive payroll cuts make a ‘jobless recovery' less likely.  Rising jobs and income are critical to promote a self-sustaining recovery.  Rising income is needed to support consumer spending and to reduce debt/income and debt service/income ratios.  It will also raise ‘cure' rates for delinquent mortgages and help consumers qualify for a loan. 

In our view, past job cuts have virtually eliminated what were minimal hiring excesses and are likely now creating some pent-up demand.  To gauge excess, we cumulate the errors made by a relatively standard relationship used to forecast labor hours worked and employment; positive cumulative differences suggest a labor overhang.  After moving to zero in 2Q, the cumulative errors are now sharply negative.  Moreover, early estimates indicate that non-farm payrolls were 824,000 lower in the year ended in March 2009 than currently estimated.  That implies, if those revisions were all in private payrolls, that the current private job tally is 650,000 lower than at the trough in the last recession in July of 2003.  As we see it, that implies some underlying pent-up demand for labor that should materialize in 1Q10. 

That move to positive payroll growth may now be underway.  Non-farm payrolls declined by just 11,000 in November, and with revisions, the 87,000 average decline in the past three months was the smallest since February 2008.  Three other signs of solid improvement in labor markets emerged in November: a 52,000 surge in temp hires, typically a leading indicator of labor demand; a 12-minute jump in the private workweek, also a classic early sign of improved demand; and a partial reversal of October's jump in the unemployment rate, which now stands at 10%.  A 0.6% surge in hours worked helped boost weekly payrolls (wage and salary income) by 0.7%, the biggest gain in two-and-a-half years.  It's important to note that this improvement in labor markets has to go much further to assure recovery, especially to bring the jobless rate down close to full employment.  But the recent rebound has been just as rapid as was the plunge when the recession began - an encouraging sign.

Don't get us wrong: There is still pain out there for consumers and lenders, and other headwinds to growth.  But tracing the chain from rising growth abroad to US output, employment and income demonstrates that there is more to this recovery than cars, housing and other spending. 

The case for higher real yields.  Four factors should boost real longer-term rates significantly over 2010: 1) the circumstances surrounding the Fed's exit strategy, which will trigger a repricing of the likely path of the policy rate; 2) sustainable growth that will begin to lift private credit demands; 3) massive Treasury borrowing and a shift to coupons; and 4) uncertainty over fiscal credibility and inflation, which will lift term premiums.  

Currently, fed funds and eurodollar futures are pricing in an 88bp move up in rates by end-2010, and a cumulative move by end-2011 of 205bp.  While that is significantly more than what markets expected a few weeks ago, it is less than what we expect through end-2010.  As a result, we think the market has more repricing of the yield curve to do.

Looming supply-demand imbalance and shift to longer maturities will push yields higher.  Rising private credit demands and higher Treasury coupon issuance will push real yields higher in 2010 and 2011.  Private credit demands will revive when businesses' external financing needs - at a record-low -2.5% of GDP in 2Q - turn positive and when household deleveraging gives way to new mortgage and other borrowing, if only at a moderate pace.  When companies switch from inventory liquidation to accumulation, and when capital spending revives, corporate spending will outstrip cash flow again. 

Although the US federal budget deficit may have peaked in F2009 (both in dollar terms and as a percentage of GDP), Treasury coupon issuance will continue to be pushed higher. This reflects an attempt to gradually boost the average maturity of the Treasury debt outstanding from its current level of about 4 years up to 6-7 years. Such a swing would take the average maturity from a historically low level at present to a level that is historically quite high. Thus, not only is gross coupon issuance poised for another sharp jump in F2010, but the average maturity of the issuance will have to move higher if the Treasury is to move toward a 6-7-year average maturity for the outstanding debt.

In short, we expect upcoming auctions to tilt steadily toward longer maturities, much as has occurred in the most recent announcements.  The shift from 20-year to 30-year TIPS also supported efforts to boost maturities.  The trend to longer maturities is likely to continue through mid-2010.  Beyond that point, we suspect that short-dated issuance (2s and 3s) may be reduced while longer-dated supply remains elevated.

Why does the Treasury want to lengthen the duration of its debt?  Treasury bill issuance soared in recent years and the average maturity fell, as is typical when there is a sharp and sudden spike in the borrowing need.  The Treasury now wants to rein in the bill supply and begin to normalize the maturity profile.  Why is it planning to go beyond historical norms?  Treasury officials appear to want to create a cushion of borrowing capability at the front end of the curve in case there is a sudden need for short-term funding.  Also, even though the Treasury's public position is that it is not an opportunistic borrower - i.e., it doesn't try to time the market - it appears advantageous to attempt to lock in low long-term borrowing costs at present.

One downside, two upside risks to growth outlook.  We see one potential downside risk and two upside risks to this outlook.  Rising mortgage foreclosures may threaten home prices, wealth and credit availability.  We are not sure if the ‘shadow inventory' of yet-to-be-foreclosed homes is as high as the most pessimistic estimates have it.  But even if the number of pending foreclosures is half that size, they will add to a looming supply overhang of unoccupied houses, and such additions may promote renewed declines in home prices as they come on the market in the spring.  On the other hand, there are two important upside risks: Quantitative easing may have improved financial conditions more than we think, as hinted in risky asset prices and issuance volumes, and Congress is already adding further fiscal stimulus, which may take effect as the economy is gathering significant strength.  For example, the recent extension and expansion of the first-time homebuyer tax credit will last through April 30, 2010, and other fiscal initiatives to boost employment are possible. 

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