The Case for the Doves
April 07, 2010
By Luis Arcentales l New York|
When Mexico releases the March inflation figures this week, the expected high reading is likely to once again fuel speculation that Banco de Mexico will hike interest rates at some point this year. After all, if the consensus view for a monthly increase of 0.70% materializes, then average annual inflation for 1Q would rise to 4.75%, matching the upper limit of Banco de Mexico's quarterly forecast path. And even though the central bank maintained rates unchanged at 4.50% in its March 19 meeting, the policy statement contained some hawkish undertones as the authorities stressed that they were "carefully" watching medium and long-term expectations, in addition to signs of potential second-round effects on inflation from higher taxes and administered prices.
Despite the 1Q spike in inflation, we find the talk about forthcoming interest rate hikes premature and we continue to expect Banco de Mexico to remain on hold over the course of this year (see "Mexico: Hike Another Day" and "Mexico: Rate Hikes? Not This Year" in This Week in Latin America, December 8, 2009 and February 8, 2010, respectively). Persistently high inflation, which could eventually lead to an upward move in medium and long-term expectations, represents a risk to our call that overnight rates will stay unchanged at 4.50% in 2010. However, there are several key factors that should provide Banco de Mexico with sufficient room to accommodate the ongoing inflation shock without hiking rates. First, the recent real strengthening in the exchange rate has translated into a meaningful tightening of monetary conditions. Second, after last year's wrenching recession, there is plenty of slack in the economy. Third, even though labor markets are on the mend, the rate of unemployment remains very high. And, last, one of the key transmission channels of monetary policy, namely credit, has yet to show tangible signs of recovery. Put together, these factors make a strong case for the doves, in our view.
Stronger Peso = Tighter Monetary Conditions
The recent strengthening in the Mexican peso has reduced the need for the central bank to increase interest rates, in our view. Last week the peso - which has been rallying almost uninterruptedly since early February - approached the 12.3 mark to the dollar, the strongest nominal level since October 2008 when the financial crisis and local companies' derivatives woes pushed the currency sharply weaker. On a real effective basis, more importantly, by the end of March the peso was trading at the strongest levels since September 2008.
The real appreciation of the peso, in turn, has led to a significant tightening in monetary conditions, even as the central bank has maintained its policy rate objective unchanged at 4.50% since last July, according to our proprietary Monetary Conditions Index. Indeed, our work suggests that since last December, the stronger peso has translated into a tightening in monetary conditions equivalent to interest rate hikes of as much as 350bp. In other words, had the peso remained stable on a real effective basis at the level of December 2009, at current levels our Monetary Conditions Index implies that Banco de Mexico would have had to increase interest rates from 4.50% to as much as 8.0%. With the peso doing the tightening lot of the job for Banco de Mexico, the central bank is unlikely to be in any hurry to hike.
An Abundance of Slack
Another key factor likely to keep Banco de Mexico on hold is the ample slack currently present in the economy, which should play an important role in limiting the risk to broader inflation from higher taxes and administered prices. This is despite the recent string of upgrades to consensus 2010 GDP growth expectations to around 4.0%, which in our view still has further room to go (see "Mexico: Stronger Still", This Week in Latin America, March 8, 2010). Indeed, the March 19 policy statement highlighted that "various indicators of capacity utilization, private investment as well as some determinants of consumption suggest that activity levels will remain below potential this year". In this statement, the central bank also acknowledged the upward revisions to 2010 growth estimates of late and pointed out that, as the output gap closed, its contribution to limiting inflationary pressures "was diminishing". Rather than a warning of dwindling slack in the economy, by using that seemingly hawkish line we suspect that Banco de Mexico wanted to emphasize the recent improvement in the country's growth outlook. Indeed, even with our above-consensus growth forecast of 5.2% in 2010, our estimates suggest that the output gap is likely to close in late 2011. And this result seems consistent with the central bank's own work, which estimated a negative output gap in both 2010 and 2011 under a scenario of average GDP growth of 3.2-4.2%. When the next quarterly Inflation Report is released on April 28, we expect that the central bank will boost its 2010 GDP growth forecast to as high as 5%, in line with recent comments by the central bank's governor. Even so, the central bank's projections are likely to show that the output gap won't close until some point in 2011 instead of 2012 as previously expected.
In the debate about the magnitude of the slack in the economy, the nature of the ongoing recovery is also important. So far Mexico's strong economic rebound largely reflects the ongoing V-shaped recovery in industrial activity and manufactured exports. For example, by February of this year exports from the automobile sector reached historically high levels while shipments from other industrial areas were just 12% below the all-time highs from mid-2008. By contrast, activity in domestic-focused sectors - which are more closely linked to consumption - had barely stabilized by the turn of the year. We still expect that the strong externally driven upturn will translate into a broader recovery over the course of 2010; however, on its current path it does not seem that Mexico's improved growth outlook will translate into worrisome demand-side inflationary pressures anytime soon.
Slack also is evident in labor markets, which represent another important variable in our call for no rate hikes this year. Despite rising inflation, wage pressures have remained contained so far in 2010. In the first two months, contractual wage adjustments averaged 4.48%, a pace similar to the 4.39% average of last year. Moreover, expectations for wage hikes ahead - which average 4.56% for the March-April period - do not point to a material shift in trend. Last, surveys in the fast-recovering manufacturing sector do not point to mounting wage pressures either: in the first two months of the year, only 3.7% of Banxico's industrial survey participants reported greater competition to hire production personnel, about a quarter of the 16.2% that reported less competition. Indeed, when we net the results, the levels of labor market slack in early 2010 - though well off the mid-2009 bottom - still appeared to be ample.
The rate of unemployment, moreover, remains near historically high levels even after some modest improvement since its peak in 3Q. Even though by January-February the seasonally adjusted jobless rate was back to levels last observed in 2Q09, the move has been accompanied by a decline in labor participation which has likely exaggerated the improvement (swings in labor participation also seemed to have exaggerated the move on the way up last year). The narrower but more timely formal employment indicators seem to tell a similar story. Last year's deep economic slump led to a loss of just over 600,000 formal positions or over 4% of total formal jobs in the year ending July 2009. The economy resumed creating jobs in August and by February 2010 it had recovered a little over half the jobs lost during the recession. If this pace were sustained over the course of the year, the economy would add close to 580,000 new formal jobs, not nearly enough to absorb the almost 700,000 average new entrants to the labor force every year. Against a backdrop of high unemployment, the central bank is more likely to err on the side of caution by keeping interest rates unchanged.
Credit Wanted
One final factor likely to keep Banco de Mexico on hold until 2011 is the lack of credit growth. In 4Q09, total credit to the non-financial private sector plunged -5.4% in real terms from a year earlier. The contraction was more severe in consumer loans, which collapsed by 12.9%, led by a 21.8% plunge in credit from commercial banks (+1.6% from non-bank institutions). As a share of GDP, consumer loans went from 4.8% in 4Q08 to 4.2% a year earlier.
Though NPLs peaked around mid-2009 and the outlook for the economy has improved significantly since, on aggregate banks seem to remain quite cautious as suggested by early 2010 data: in the first two months of the year, bank loans to consumers were 19.4% lower than in the same period in 2009 adjusted for inflation, while total bank credit to the non-financial private sector was down 7.7%. And seasonally adjusted figures confirm that credit growth has yet to turn around: total real bank credit contracted in January-February at a pace of almost 9% annualized with consumer loans down at a similar clip, according to our calculations. Without tangible signs of a turnaround in credit growth, the central bank is unlikely to hike rates as one key transmission mechanism of monetary policy seems to be still missing.
The greatest risk to our call probably lies outside of Mexico. If the Federal Reserve hikes the fed funds target to 1.50% by the end of the year as our US economists Dick Berner and David Greenlaw currently expect, then that is likely to increase pressure on Banco de Mexico to act. While we don't subscribe to the view that Banco de Mexico has to move one-to-one with the Fed - and, in fact, we find plenty of reasons that should allow Banco de Mexico to stay on hold in 2010 - we believe that monetary policy in Mexico cannot be conducted entirely outside the context of Fed policy actions.
Bottom Line
Despite facing a complex inflation outlook in 2010, Banco de Mexico is likely to keep its policy stance unchanged, given ample slack in the economy, high unemployment and lack of credit growth. Importantly, the stronger exchange rate has already led to a tightening in monetary conditions, thus doing some of the tightening job for the central bank. Indeed, we suspect that rather than this year's inflation shock, the main risk to our call comes from possible actions by the Federal Reserve.
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Renminbi Exit from USD Peg: Whether, Why, When, How
April 07, 2010
By Qing Wang l Hong Kong|
Whether to Exit: A Recap of Our Consistent Views on the Renminbi since 2008
The Chinese authorities launched the reform of the renminbi exchange rate regime on July 21, 2005, by de-pegging the renminbi from the US dollar and adopting ‘a managed float exchange rate regime with reference to a currency basket'. However, in practice, the USD/CNY trajectory resembled that under a typical crawling peg regime during July 2005-July 2008. Since July 21, 2005, the renminbi has already appreciated against the US dollar by over 20% from the pre-reform USD/CNY level of 8.27.
However, the USD/CNY rate has been kept very stable at around 6.83 since July 2008, the three-year anniversary of China's exchange rate reform. In fact, the renminbi returned to a de facto hard peg to the US dollar - a new regime that we were among the first to identify back in November 2008 - after three years' practice of a crawling peg (see China Economics: A New Renminbi Regime? November 24, 2008).
Since mid-2009, with the global economic recovery underway and the US dollar under renewed downward pressures, market observers have started to cast doubt over the sustainability of the new regime and wonder what exit strategies exist for the renminbi. Back then, we believed that "the current renminbi exchange rate arrangement will remain unchanged through 2009 and most probably through the next 12 months" (see China Economics: An Exit Strategy for the Renminbi? June 9, 2009).
In particular, when speculation about an imminent renminbi policy move intensified toward end-2009, we cautioned against getting too exited about an imminent policy move on this front by suggesting that "to gauge the potential policy shift on renminbi, one should think more like a policymaker than a fund manager" and reiterated our call that "the current renminbi exchange rate arrangement will remain unchanged through mid-2010" (see China Economics: A Dialogue on the Renminbi, November 11, 2009).
Just as the international financial press and many China observers started to be rather discouraged by the strong defense recently made by Chinese Premier Wen and other senior officials that the renminbi is not under-valued and considered that the renminbi peg is here to stay for a long time, we have instead turned increasingly constructive about the prospect for an renminbi exit from the USD peg, because we have a different interpretation of Chinese authorities' message. We expect that "An exit of renminbi from the US$ peg will take place, most probably in the summer of this year, potentially involving a modest one-off revaluation of 2-3%, followed by gradual appreciation for the rest of the year; cumulative appreciation of the renminbi against the USD could reach 4-5% in 2010" (see China Economics: Takeaways from Premier Wen's Press Conference, March 14, 2010).
Why to Exit
Despite a 20-month-old de facto renminbi hard peg against the USD dollar, Chinese authorities have in fact never changed their official commitment to a managed float exchange rate regime. According to a recent statement by PBoC Governor Zhou, the current arrangement should be considered as part of anti-crisis policy package, which, we interpret, should be temporary by default.
Moreover, there are four key concrete considerations in favor of an exit from the peg and subsequent renminbi appreciation. First, it helps contain ‘imported' inflationary pressures stemming from rapid increase of key international commodity prices. China's non-food CPI inflation is heavily influenced by PPI inflation, which in turn, is closely correlated with international commodities (see China Economics: Inflation Outlook in 2010: A Supply-side Perspective, November 1, 2009).
Second, while Chinese authorities have made a strong case for the status quo, China's major trading partners consider the renminbi undervalued and its hard peg against USD as a symbol of a ‘mercantilist bias' in China's foreign trade policy. An open and free international trade system has proven to be of strategic importance to China's long-run economic development and much more important than a few percentage points gain in market share due to improved competitiveness as a result of an undervalued currency. If this system is deemed threatened by China's current exchange rate practice, it makes a lot of sense for China to demonstrate flexibility and pragmatism on this issue with the objective of safeguarding the global trade system, in our view.
Third, a stronger renminbi helps effect real appreciation of the renminbi and thus renationalize relative prices between tradable and non-tradable sectors. This helps rebalance the economy away from over-reliance on external demand as a driver of growth towards more domestic-demand, non-tradable-sector-driven growth.
Last but not least, renminbi appreciation in the near term should help China eventually move towards a more flexible exchange rate arrangement, which is a prerequisite for independent monetary policy.
When to Exit
We maintain our long-standing call that the most likely ‘window of opportunity' for renminbi exit from USD peg is early 3Q or the summer, although we cannot completely rule out an early move hinging on the timing of key political events (e.g., US-China Strategic Dialogue in late May).
There are two necessary conditions for an exit from the peg, in our view. First, the strong recovery in export growth should be considered sustainable. Second, inflationary pressures should become significantly strong. The former condition is of particular importance, as it helps soften resistance from within the government to renminbi appreciation. We expect that both necessary conditions would have been met by the summer. For instance, we forecast exports to maintain double-digit growth through 1H10 and CPI inflation to reach a peak at 4.0-4.5% in June-July.
Moreover, in his latest decision on April 3 to delay the issuance of the currency manipulation report, US Treasury Secretary Tim Geithner stated that "There are a series of very important high-level meetings over the next three months that will be critical to bringing about policies that will help create a stronger, more sustainable, and more balanced global economy. Those meetings include a G-20 Finance Ministers and Central Bank Governors meeting in Washington later this month, the Strategic and Economic Dialogue (S&ED) with China in May, and the G-20 Finance Ministers and Leaders meetings in June. I believe these meetings are the best avenue for advancing US interests at this time."
By highlighting the "next three months", Secretary Geithner is giving China another three months (April-June) to form a consensus and make a decision on the renminbi exchange rate, and this effectively sets July as a deadline for such a move, in our view. This is consistent with our long-standing call on the timing of a policy move on this front. Moreover, China's exit from the renminbi peg against the USD during the summer would allow: a) the Obama administration to claim credit of ‘their skillful diplomacy' in the run up to the mid-term election in November; and b) the Chinese authorities to demonstrate its ‘global responsibility' in the run-up to the G20 Summit that is to take place in Seoul in November.
Incidentally, it is worth noting that both the depeg of the renminbi from USD in 2005 and the repeg of the renminbi to the USD in 2008 took place around July 21 of the year. While this may well be pure coincidence, a move in July allows the Chinese authorities to take comprehensive stock of the developments in 1H10 in general and external balance of payments in particular, in our view. Comprehensive data for the latter tend to be available only on a semi-annual basis.
Another potential reason why July is chosen as the month of such an important policy move is perhaps related to the timing of IMF's annual review of Chinese economy, or the Article IV Consultation, in our view. IMF Article IV consultation with China tends to take place in late July and early August each year. IMF is the only international organization that has the mandate to monitor and assess the appropriateness of a member country's exchange rate arrangement, and its opinion therefore carries substantial more legitimacy and authority than any other view expressed by either another sovereign state (e.g., the US) or multilateral groups (e.g., the G7, G20).
How to Exit
There are three potential scenarios when the exit takes place: i) resume gradual appreciation without an initial adjustment; ii) a modest initial adjustment of 2-3% to be followed by gradual appreciation such that cumulative appreciation would be 4-5% for the year; and iii) a large initial revaluation (i.e., over 5%) to be followed by gradual appreciation.
Scenario ii) is most likely, in our view. Specifically, first, the political benefit from scenario i) will unlikely be significant enough to appease major trading partners and demonstrate the Chinese authorities' seriousness, especially given that so much political capital has been expended on this issue. Second, in absence of major inflation (i.e., over 5%Y) or a very large trade surplus, we believe it is very unlikely for the Chinese authorities - who are known for their hallmark gradualist approach - to make such a bold move. We therefore would rank the probability of the three scenarios from the highest to lowest as: scenario ii> scenario i> scenario iii.
The initial adjustment could be in the form of a high-profile announcement of a one-off revaluation of the central parity by 2-3%, i.e., exactly like the policy move on July 22, 2005. Alternatively, a de facto one-off revaluation could be engineered such that the USD/CNY spot rate is allowed to decline by 2-3% in a matter of weeks upon exit from the peg.
While the exit may involve some minor modification of existing mechanism (e.g., widening the trading band), its initial impact will likely be largely symbolic. It is important to understand how the existing (or pre-crisis, pre-new peg) trading band works technically. At the beginning of each trading day, the USD/CNY central parity of the current trading day is determined based on the weighted average of the price quotes provided by the market markers. The central parity rate is announced 15 minutes before trading begins each morning. The trading band is one for the intra-day moves only in that the USD/CNY rate is constrained within now ±0.5% of the renminbi-US dollar central parity of that trading data. However, the central parity rate may, in theory, vary by any magnitude from the closing rate of the previous trading day. In another words, the inter-day changes are not constrained by the band (see China Economics: Band Widening ≠ Faster Renminbi Appreciation, May 21, 2007).
Although the central parity of renminbi-US dollar exchange is, in principle, determined based on the weighted average of the quotes from market makers, it is still heavily managed by the PBoC, which has considerable discretion over determining the weights when the weighted average is calculated. Thus, the pace of renminbi appreciation ultimately hinges on how comfortable the Chinese authorities are with allowing faster appreciation of the central parity rate instead of the intra-day volatility around the central parity rate.
If the Chinese authorities were to announce a widening of the existing trading band upon the exit from the peg, it would relax a non-existent constraint on the pace of renminbi appreciation against the US dollar. While the trading band widening per se may not necessarily lead to faster renminbi appreciation, it would signal Chinese authorities' renewed commitment to a more flexible exchange rate regime.
USD/CNY Forecasts
We envisage that the exit will take place in early 3Q, such that the USD/CNY rate will likely reach 6.64% by end-3Q10 and 6.54 by end-4Q10, implying about 2.83%Y and 4.50%Y appreciation against the USD in 3Q10 and 4Q10, respectively. We forecast that the USD/CNY rate could reach 6.17, implying another about 6% appreciation the USD through 2011.
With these USD/CNY forecasts through 2010, we estimate - based on the exchange rate forecasts made by Morgan Stanley's Global FX Strategy team - that the trade-weighted nominal effective exchange rate (NEER) for the renminbi would appreciate by about 7-8% by the end of 2010 to a level still below the highs reached in 1Q09 and by another roughly 1% in by end-2011 (see FX Pulse: How's the Year Going? April 1, 2010). The faster NEER appreciation in 2010 than 2011 is warranted by the need to catch up, in our view.
FX Market Implications
If our forecasts were to turn out to be right, the offshore NDFs would be wrong. As of end-March, the offshore renminbi NDF market has priced in only modest appreciation of the renminbi against USD, with the 6-month and 12-month outright NDFs at 6.74 (or 1.19% appreciation relative to the spot) and 6.66 (or 2.42% appreciation relative to the spot), respectively.
Why is the pricing on offshore NDF market ‘wrong'? Who is long USD/CNY on the NDF market when short USD/CNY seems a rather safe one-way bet at the current juncture? Our understanding is that the long USD/CNY trades on the offshore NDF market are mainly put on by two types of onshore players: a) those corporate accounts who want to lock in cheap CNY funding cost; and b) onshore/offshore USD/CNY forward market arbitragers.
Regarding onshore companies' effort to lock in cheap CNY funding, since the interest rate spreads between onshore renminbi loans and US loans are nearly 300bp, many Chinese enterprises prefer to borrow ST FX loan at much lower rates and then sell the US dollar borrowed on the onshore spot market and at the same time buy US dollar forwards from the NDF market to hedge FX exposure. As a result, they lock in very cheap financing cost.
For instance, at end-March, the interest rate of the 1-yr renminbi loan is at 5.31% and that of the 1-yr USD loan at 2.41%. If company A borrows USD100mn from banks and sells it immediately on the spot market at USD/CNY of 6.8260, it can obtain Rmb682.6mn proceeds. To hedge its long USD exposure, company A buys (through Chinese banks) 12-month USD forwards on the offshore NDF market at 6.6605. This transaction helps company A to lock in its renminbi funding cost at -0.07% (= (6.6605 *1.0241-6.826)/ 6.826*100). Not a bad deal! This is the key reason why FX loan growth in China has surged since 3Q09.
As of end-February 2009, there was nearly USD400bn outstanding amount of FX loan. Even if there were only a fraction of this amount to be hedged through the offshore NDF markets, the demand for long USD/CNY trade from onshore players would be so strong as to easily dominate the offshore speculators who are on the short side of this trade.
Regarding onshore/offshore USD/CNY forward market arbitragers, we observe that some onshore companies tend to have strong interest in conducting onshore/offshore forward arbitrage if the difference between the two reaches 1,000 pips, in which case they will buy offshore NDFs and sell onshore USD forwards. Two types of players are on the buying side of USD onshore forwards: a) those banks who have capability of borrowing USD onshore can buy the swap and lock in CNY funding, therefore they can buy CNY dominated bond/bills at locked-up cheap funding; and b) for these corporate accounts who do not have access to offshore NDF market, they can buy onshore forward instead of offshore NDF. Effectively their cost will be higher (as onshore forward is 1,000 pips higher than NDFs). But it still results in cheap funding for them compared to doing funding directly from CNY loan.
Understanding the incentives behind players on the offshore USD/CNY NDF market helps predict how the NDF market moves when circumstances change. A few takeaways are as follows:
First, the offshore USD/CNY NDFs are largely determined by the expectations of future USD/CNY rates formed by onshore players - who tend to be on the long side of USD/CNY trade - instead of by offshore players, who tend to be on the short side of USD/CNY trade. This is in part because the potential size of the position of the former is much bigger than that of the latter.
Second, while a majority of offshore players are from speculative ‘fast money' community, most onshore players are from ‘slow money' corporate treasury accounts. At the risk of over-simplification, we believe that while speculators tend to be driven by expectations of events (e.g., a renminbi revaluation), corporate players tend to be driven by realization of events (e.g., a renminbi revaluation). While speculators are seeking absolute returns from the trade, onshore corporate accounts are seeking to lock in relatively low funding costs.
Third, the asymmetry of demand- and supply-side players on the offshore NDF market suggests that this is not a zero-sum game: if the USD/CNY rate were to move in the direction favoring the speculators, the speculators would make money while the onshore corporate accounts would simply save less money than otherwise but still save money. It is the PBoC which ultimately suffers the loss. In a sense, offshore speculators are betting against the PBoC, and this game is facilitated by the arbitrage activity of onshore players. Alternatively, from a different perspective, PBoC has effectively also intervened in the offshore NDF market to prevent the offshore USD/CNY forwards from getting too low. And this ‘stealth intervention' is facilitated by the arbitrage activity of onshore players.
Fourth, the asymmetry of demand- and supply-side players on the offshore NDF market and the indirect influence by the PBoC also suggests that the prevailing offshore CNY NDFs do not reflect the true underlying expectations of future USD/CNY rates by market players. It means that when the policy intention shifts, the offshore NDFs can easily drop much below than the current levels.
Fifth, a rise in the interest rates for the onshore renminbi loans will, ceteris paribus, encourage demand for FX loans and thus more demand for long USD/CNY trade on the offshore NDF markets. Conversely, a rise in the interest rates for the onshore USD loan - due to a US Fed rate hike - will, ceteris paribus, discourage demand for FX loans and thus less demand for long USD/CNY trade on the offshore NDF markets.
Sixth, a key source of USD funding is repatriation of FX assets by onshore financial institutions. If the Chinese authorities were to tighten controls over this type of capital inflows (which are typically and mistakenly classified by many market observers as ‘hot money' inflows), it would result in onshore USD shortage and drive up onshore USD interest rates (see China Economics: Counting ‘Hot Money', June 29, 2008) This would discourage demand for long USD/CNY trade on the offshore NDF markets, as was the case during 2005-2007. In other words, tightening controls over capital inflows will effectively block the channel through which the PBoC influences the offshore NDF markets, potentially resulting in large fall of the offshore USD/CNY NDFs. This is similar to a situation where if PBoC were to stop intervening in the onshore spot market, it could easily result in a sharp fall in USD/CNY spot rate.
Equity Market Implications
A renminbi exit from the peg and subsequent gradual appreciation against the USD should be positive to the stock market, despite the fact that a stronger renminbi will likely hurt low-margin exporters who do not have pricing power. First, a renminbi exit from the USD peg would lower the risk premium of the equity market stemming from fear of a Sino-US trade war. Second, it helps contain ‘imported' inflation pressures and therefore reduce the probability of aggressive monetary tightening through heavy-handed credit controls and/or consecutive interest rate hikes. Third, a modest initial revaluation to be followed by gradual appreciation would fuel expectations of further appreciation over time.
For concrete equity investment ideas, please refer to a note produced by Jerry Lou, our China Equity Strategist (see China Strategy: A Revisit to RMB Reval's Market Implications, March 17, 2010).
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US Growth Outlook: Upside Risks
April 07, 2010
By Richard Berner & David Greenlaw l New York|
Baseline unchanged... We are sticking to our baseline view that US economic growth in 2010-11 will be moderate but sustainable. We see growth at 3.25% from 4Q09 to 4Q10 - a forecast we have maintained for more than a year - and growth of 2.5% over the four quarters of 2011. Despite widely discussed headwinds precluding a traditional V-shaped recovery, we continue to think that four factors will support our prognosis of sustainable growth: Improving financial conditions, the lagged benefits of fiscal stimulus, strong growth abroad and dwindling excesses. Together with our view that core inflation will bottom in the next several months, our above-consensus growth outlook underpins our call that the Fed will begin to raise the policy rate later this year.
...but it's getting more cyclical. In a sharp contrast with a consensus that is still worried about downside risks for growth, we now think the risks are shifting to the upside through 2011. Three factors are contributing to the potential for a brighter outlook: (1) New foreclosure mitigation proposals could dramatically improve prospects for housing; (2) The administration appears likely to extend current tax rates for all but upper-income taxpayers; and (3) Incoming data have been stronger than expected, supporting our view that a spring snapback from harsh winter weather is underway. The upshot: The recovery still looks sub-par by historical standards, but courtesy of some not-so-traditional key drivers, it is beginning to look more like a time-honored cyclical upswing.
Upside risk #1: Reducing housing tail risks. The first source of upside risk to growth relative to our baseline is the housing market - the biggest wildcard and still the most troubled part of the US economy. We have long recognized that slowing household formation, a "shadow inventory" of yet to be foreclosed homes, the likelihood of strategic defaults and rising joblessness posed downside tail risks to home prices and housing activity. These are the key reasons our forecast for US housing starts has continued to be the lowest of any in the Blue Chip survey of economic forecasts. For example, in the March Blue Chip canvass, our forecast for starts in 2010 was 560,000 (up only about 1% from a brutal 2009) compared with the median expectation of 700,000.
Negative equity is the key factor. It's been clear for years that a cure was needed for the rising tide of mortgage foreclosures. Policies to mitigate them have until now relied on affordability - reducing monthly mortgage payments for delinquent or at-risk borrowers. Under the Treasury's Home Affordable Modification Program (HAMP), all permanent modifications through February 2010 involved a reduction in mortgage rates. About 25% of these mods did receive some form of principal forbearance, but none entailed principal write-downs by the lender. Not surprisingly, in our view, the HAMP and other mitigation programs relying on monthly payment modification have struggled, with ‘redefault' rates as high as 50-60% following modification. This is because improving affordability is helpful but willingness to pay when loan values significantly exceed home values is essential. We and our colleagues Vishwanath Tirupattur and Oliver Chang have talked about this in previous notes. With 10.7 million, or about 23%, of homeowners underwater, the willingness of borrowers to walk away - to default strategically on their mortgages even if they have the wherewithal to pay - has increased significantly. This lack of willingness to pay on the part of the borrowers has upheld our team's bearish view on housing and home prices.
New initiatives. That is now changing. Two policy changes announced on March 26 - a new ‘earned principal forgiveness' initiative in HAMP, and the short refinance program through the FHA - will help reduce the risks of foreclosure. (Bank of America separately announced a similar principal forgiveness program called the Homeownership Retention Program on March 24.) ‘Earned principal forgiveness' gives the borrower a strong incentive to stay current on modified payments by turning a portion of initial principal forbearance into principal forgiveness for each year the borrower stays current. The new short refinance program is meant for currently performing but underwater mortgages and provides for FHA refinancing of such mortgages after the lender agrees to principal forgiveness. If implemented effectively, these changes, by requiring lenders to consider principal write-downs for all HAMP-eligible borrowers that owe more than 115% of the current value of their home, will help reduce the ‘shadow inventory' of yet to be foreclosed homes and the likelihood of strategic defaults. Another new program requires a temporary reduction in mortgage payments (to 31% of income) for unemployed homeowners. This may also help to stem the tide of looming foreclosures.
Game-changer for housing. If these programs meet with even moderate success, they will change the bleak housing landscape for the better. Mortgage modifications involving reduced principal will lower or eliminate negative equity for many homes, making such mortgages far less likely to redefault, and result in those homes dropping off the shadow inventory. These programs will reduce the overhang of supply that burdens the housing market. If, as we expect, principal write-downs permanently reduce the shadow inventory, it will reduce the excess supply in housing and limit downward pressure on home prices. They will significantly lower the incentive for strategic default because earned principal forgiveness addresses the negative equity issue. Finally, the new initiatives should reduce loss expectations on both performing and delinquent loans in non-agency mortgage pools; defaults in the former and redefaults in the latter should both decline. Such a decline in tail risks should boost the values of RMBS, keep mortgage spreads relatively narrow now that the Fed's mortgage purchase program has ended, and help restart the normal flow of housing credit.
While these proposals could represent a game-changer, they will not magically solve our housing problems. The target size of the programs is 3-4 million borrowers - a far greater number than has been addressed so far, but there are currently 8 million delinquencies and we were expecting an additional 2-3 million before these changes were announced. The key point is that, if successful, these programs are a highly positive step, but home prices will only start to rise consistently when housing imbalances are reduced significantly further.
Upside risk #2: Tax breaks for consumers. The second source of upside risks to growth comes from a prospective fiscal policy change. Looking beyond 2010 and reflecting the pressing need to get started on reducing massive federal deficits, our fiscal assumptions over the past year have been conservative. Specifically, we have long assumed that the administration would sunset the Bush tax cuts and increase the tax rate on dividends and capital gains on January 1, 2011, resulting in roughly a US$120 billion tax hike for individuals. That is one reason why we expected growth to slow to a trend-like pace in 2011 despite several favorable fundamentals.
In his FY2011 budget, however, President Obama has proposed ending the individual income tax cuts begun under EGTRRA and JGTRRA only for upper-income taxpayers. For example, the top marginal tax rate for married couples filing jointly with incomes above US$250,000 would go from 33% to 39.6%, levels last seen in 2000. Married couples with incomes below that threshold would enjoy current tax rates. The Congressional Budget Office (CBO) estimates that this proposal would cost the Treasury US$67 billion in FY11 relative to current law. If implemented, the resulting extra spendable income would likely boost consumer spending and, taking account of the ‘multiplier' effects of such income and spending, we estimate that it would add about half a percentage point to overall 2011 growth.
Could we be overestimating the effects? After all, at first blush this ‘stimulus' seems paltry compared with the US$787 billion in the American Recovery and Reinvestment Act of 2009 (ARRA). Such a comparison is invalid, of course, because the US$67 billion represents the impact over just one year, while ARRA is a multi-year package. Looking at the 10-year window budgeteers use for apples-to-apples comparisons, and assuming the change is permanent, the CBO estimates the cost of this tax change at US$1.169 trillion. Over time, that's real stimulus, and theory suggests that permanent tax actions have bigger and more lasting effects than temporary ones.
In addition, these tax ‘cuts' would benefit lower-income consumers, who would likely spend more of it than would upper-income taxpayers. We believe that multipliers from fiscal actions vary depending on other circumstances. For example, in the heat of the crisis in early 2009, wary consumers saved more of their income; however, as financial conditions and wealth improved, they opened up their wallets a bit more. With market healing likely to be even more advanced in 2011 than it is today, this pro-cyclical fiscal action would probably get substantial traction. More bucks and more bang for each one leave us comfortable with the idea that this change would be one you can believe in.
Upside risk #3: Hearty incoming data provide support for sustainable growth. The third factor pointing to upside risks is the gathering strength apparent in incoming data. The data point to stronger 1Q growth - by about 0.5pp more than we forecast a month ago - and to upside growth risks going into 2Q and beyond. The effects of harsh winter weather on the economy were smaller than we thought. Healthy March levels for domestic and overseas orders and other forward-looking indicators suggest additional momentum for sustainable growth. With inventories getting leaner, there is scope for inventory accumulation. With employment and hours now rising, we see ‘core' wage and salary income beginning to sustain both gains in consumer spending and a rise in thrift.
Domestic upside. Several domestic spending components have recently outperformed our cautious expectations. First, consumer spending excluding motor vehicles through February has been materially stronger compared to the pace we expected a month ago. The strength has lately appeared in discretionary items like big-ticket durables, clothing and restaurant meals. That speaks to a consumer benefitting from improved income, better access to credit and increasing financial wealth. Second, vehicle sales have bounced back sharply to new, post-cash-for-clunkers highs without heavy incentives by legacy OEMs, and upside prospects have improved. We now expect light vehicle sales of nearly 12 million units in 2010, up from our forecast of 11.6 million last month. Third, while construction activity has been weak, February's winter storms did not depress construction activity, infrastructure outlays, hours at work, or production elsewhere by as much as we thought (although December's downward revision to construction activity did reduce the ‘ramp' going into 1Q).
Forward-looking data. Healthy March levels for domestic and overseas orders and other forward-looking indicators suggest additional momentum for sustainable growth. To be sure, orders have a long way to go to reach pre-recession levels, and orders for capital goods have taken a breather with the demise of bonus depreciation at the end of last year. But diffusion indexes of new domestic orders from the ISM and our own business conditions survey are strongly in expansion territory. Further, underscoring our theme that strong global growth will be a key support for US exports and output, ISM export orders in March hit the highest level since 1989.
Leaner inventories. Inventories are getting leaner in relation to sales as the level of demand continues to outpace production, thus drawing down stocks and setting the stage for inventory accumulation a bit sooner than expected. In manufacturing and trade, the real inventory-sales ratio excluding motor vehicles now stands at a four-year low, and will continue to head lower as demand outpaces the growth of inventory. With vehicle sales picking up and OEMs remaining cautious about production, vehicle inventory will likely slip below 60 days' supply soon. Given that we expect the swing in inventories to add only 0.4pp to growth both this year and next, and see outright inventory accumulation beginning consistently only in 3Q10, following liquidation in eight of the nine quarters ending in 2Q - a record unmatched in post-war history - there is scope for upside here as well.
Employment starts closing the loop. Employment has begun to grow and hours have started to rise. Despite slow wage gains, we expect these increases will boost ‘core' wage and salary income needed to sustain consumer spending and a rising saving rate. Although March payrolls rose by a less-than-expected 162,000, the level through February was revised up by 62,000. Excluding the effects of bad weather and Census hires, we estimate that payrolls rose by 14,000 in March versus +71,000 in February and +5,000 in January.
While the March gain as measured above is puny, we believe that March employment may be revised higher and that employment growth is poised for a significant pick-up in the coming months, given the recent spike in government tax collections. Employment measured in the household survey (and adjusted to be compatible with non-farm payrolls) has surged in the first three months of 2010, rising by a monthly average of 459,000 compared with 54,000 for payrolls. Indeed, the jump in household employment has held the jobless rate at 9.7%, well below October's peak of 10.1%. Despite an expanding labor force, we now think that the unemployment rate will rise back to only 9.9% in 2Q, 0.1% lower than our expectations last month. We continue to look for average monthly payroll gains (ex-census) of 150,000 or so over the balance of this year.
As important, the workweek ticked up in March and estimates for prior months were adjusted higher. The average workweek has risen by 18 minutes from the low in September. That may sound trivial, but in fact it is powerful because it applies to the whole workforce, and has turned a 0.2% annualized decline in private payrolls into a 1.1% annualized increase in hours worked. Thus, personal income is likely to show a solid gain in March despite the unusual dip in average hourly earnings, and we think that real after-tax wage and salary income will rise by an annualized 4% in the first half. Given the recent pattern of revisions, there is probably upside risk to this estimate.
Finally, we believe that the recent pick-up in individual withheld taxes may be a sign of strengthening job growth. The tax collection series, from the Daily Treasury Statement (DTS), is a timely gauge of movements in aggregate wages and salaries - and therefore employment. Another advantage is that it is hard data and thus it is never revised (unlike other measures of labor market activity that are based on statistical samples collected at a certain point in the month and are subject to frequent revisions). The disadvantage of the DTS series is that it is very noisy and is heavily influenced by calendar effects. Also, there will be a break in the relationship when significant changes in tax withholding are implemented - as was the case with the 2001, 2003 and 2009 tax cuts. We like to look at a 3-month average of tax payments in order to smooth out some of the statistical noise and the calendar effects. The year-over-year change in the tax collection series (on a 3-month average basis) improved from -5.9% in February to -0.5% in March - and close to +8% for the month alone!
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