New Game
Mar 06, 2006
Stephen Roach (New York)
The message from the recent sell-off in global bond markets should not be ignored. The great conundrum of unusually low real long-term interest rates may now be a thing of the past. If so, that could have profound implications for the liquidity cycle and an interest-rate-dependent global economy.
I remain convinced that central banks are always in control of the liquidity spigot. And the biggest news in close to a decade is that the Bank of Japan now appears to be on the cusp of abandoning its policy of über accommodation. In doing so, the BOJ would be following the lead of the other two major central banks in the world -- the Federal Reserve and the European Central Bank. Each of these institutions abandoned standard operating procedures for extraordinary reasons. For the Fed, it was the post-bubble deflation scare of the early 2000s. For the ECB, it was in response to the near stagnation of the European economy arising form fierce structural headwinds. And for the BOJ, it was the ultimate nightmare for any central bank -- confronting the corrosive perils of an outright deflation. One by one, these special circumstances appear to have been overcome -- allowing the monetary authorities to remove policies of extraordinary accommodation. America’s Fed, in a determined effort to learn the lessons of Japan, moved quickly and aggressively to provide excess liquidity to a post-bubble US economy. Once this policy achieved traction, the Fed moved at a “measured pace” over the past 20 months to “renormalize” its policy rate. Similarly, as the European economy has improved in recent months, the ECB has embarked on a comparable journey, with last week’s 25 basis point tightening the second installment in what our Euro team believes will be a multi-step adjustment entailing at least another 75 bp of rate hikes by the end of this year. But the biggest move of all has to be the BOJ. On the heels of three consecutive months of positive and accelerating y-o-y inflation in Japan’s core CPI, our crack BOJ watcher, Takehiro Sato, now believes the Japanese central bank may move as early as this week to begin its own normalization campaign. This represents a shift in Sato-san’s thinking -- he had previously been looking for the adjustment to begin somewhat later. Given the extremely delicate nature of this operation -- namely, the lingering post-bubble fragility of the Japanese economy -- the BOJ’s normalization campaign will undoubtedly be managed with great caution. As has been widely advertised, this will be a two-step process -- with this week’s likely action entailing the end of “quantitative easing” -- the provision of excess reserves to the Japanese banking system. The second shoe to fall -- the end of the infamous zero-interest rate policy (ZIRP) that has been in place for seven years -- is still not expected for another year. Financial markets are impatient beasts. As soon as the broad consensus of investors gets a whiff of a major change brewing in the underlying macro fundamentals, they begin to re-price securities accordingly. As such, they have little tolerance for the analytical justification of slow, or glacial, adjustments such as the coming policy change of the BOJ. The fact that we and other macro teams are in the process of bringing forward our calls for the onset of monetary policy normalization in Japan is reason to suspect that we may end up doing the same thing with respect to ZIRP. With the Japanese economic recovery gathering momentum and with inflation now “breaking out” into positive territory, investors take the old adage very seriously: They move quickly -- and ask questions later. That message has not been lost on global bond markets in the past couple of weeks. From their recent lows on 22 February, yields on 10-year Treasuries have moved up by 16 bp, whereas those on comparable-maturity Bunds and JGBs are up 17 bp and 12 bp, respectively. While yields in all three cases remain quite low in a broader historical context, the normalization of central bank policies provides good reason to ponder whether we have now seen the secular bottom for long rates. Equally important is the possibility that the BOJ -- long the low-cost source of funding in world financial markets -- is about to change the rules on the multitude of “carry trades” still popular for yield-hungry investors. If that’s the case, a normalization of spreads in what traditionally have been the more risky segments of world financial markets -- namely, high-yield corporate credit and emerging market debt -- may also be close at hand. All this takes us to the burning question of the hour: What happens to the world economy if the bond market conundrum is suddenly resolved and real long-term interest rates revert toward historical norms? My guess is that this is not good news for what has been a liquidity-driven, increasingly asset-dependent global economy. I don’t think it’s been a coincidence that global growth has strengthened in recent years as real long-term interest rates have been trending to the downside. Nor have these been minor deviations from historical norms. If our global baseline forecast comes to pass and world GDP rises 4.2% in 2005, this will mark the fourth year in a row of above-trend growth (3.6%) in the world economy -- marking the strongest four-year global growth spurt since the early 1970s. At the same time, a composite gauge of real long-term interest rates for the major countries of the industrial world has moved further and further below its post-1985 average of 3.7% -- hitting a 20-year low of 1.8% in 2005. In my view, there can be little doubt that the real interest rate conundrum has paid a handsome dividend to the world economy. The transmission of that impact has been well documented. In a world dominated by an ever-widening US current account deficit, there can be no mistaking the global impacts of the great American growth engine -- and its consumer-led dynamic. Driven by an unprecedented consumption binge by US households who suffer from a seemingly chronic shortfall of labor income, asset-driven wealth effects have played an increasingly important role in fueling aggregate demand. That’s where the bond-market conundrum comes into play -- not just by providing the high-octane valuation support to asset markets but also by serving as the functional equivalent of a subsidy for low-cost equity extraction from those assets. Yet that’s a sword that cuts both ways: The interest rate dividend ultimately gets drawn into question if and when the policy normalization driving rates at the short end of the global yield curve finally gives way to normalization at the long end of the curve. That’s precisely the risk that’s now in play in world financial markets. While the recent upward move in bond yields is tiny when compared with the anomalous moves of recent years, it certainly bears watching insofar as the prognosis for the interest-rate-dependent global economy is concerned. Given the US-centric character of the global economy, that pretty much puts the focus of the debate on the asset-dependent American consumer. In that vein, the Fed tightening campaign of the past 20 months has already led to important shifts in several key aspects of the macro landscape that are key to the US consumption outlook. That’s especially the case with respect to the property-driven wealth effect. Not only do home sales appear to be topping out, but there has been a dramatic downturn in home mortgage refinancing activity -- with the refi loan application index having fallen to less that one-third peak levels hit in 2003, according to the Mortgage Bankers Association. This points to a likely downturn in home equity extraction, which Alan Greenspan estimates ran in excess of $600 billion in 2005. In a climate of anemic growth in labor income -- with private sector compensation increasing only about 2% over the 12 months ending December 2005 -- surging equity extraction was critical in boosting consumption growth to 3.5% last year. In my view, the Fed tightening cycle has already taken a toll on the housing market, with significant implications for prospective growth in personal consumption. As the monetization of the property wealth effect now slows in accordance with the downturn in refi activity, the only way to avoid a significant downshift in consumption would be through a spontaneous revival of labor income generation. That might be expected from the old closed-economy models of yesteryear -- especially with the US unemployment rate now having fallen below 5%. But in the “open economy” models of globalization, both hiring and real wages should remain under pressure -- constraining the growth in worker compensation and leaving income-short, asset-dependent American consumers with little choice other than to rein in excess consumption (see my 21 February dispatch, “Open Macro”). To the extent that upward pressures on interest rates now move from the short end of the yield curve to the long end, risks to overly-indebted US consumers could be compounded. There’s another key piece to this puzzle that is much harder to quantify -- the potential unwinding of the global carry trade. In the current liquidity-driven climate, the search for yield has all but taken the risk out of the price of risky assets. That has shown up in the form of an extraordinary compression of spreads in emerging market debt and corporate credit -- to say nothing of sharply reduced volatility in global equity markets. The consensus has swung to the belief that this spread compression is supported by vastly improved fundamentals -- inflation control, reforms, and debt repayment in the developing world and surging cash flow and balance sheet repair in the corporate sector of the developed world. While these improvements should not be taken lightly, I continue to worry that markets may have gone too far in dismissing systemic risks in these assets -- especially for emerging market securities. A US consumption shock would be especially worrisome in that regard -- a development that would reverberate quickly into Mexico, China, Asia’s China-centric supply chain, and even a China-linked Brazilian economy. Absent the incentives of the carry trade, a normalization of the pricing of macro risk also seems likely. The bearish bond call has been met with repeated frustrations over the past several years -- and far longer than that for the so-called “JGB short.” The problem may be traceable to focusing on the wrong issue -- inflation -- and paying too little attention to the global liquidity cycle. In that latter regard, a key shift has now occurred -- the central bank anchor of cheap money has finally been hoisted out of the waters. It was one thing for the Federal Reserve to remove its extraordinary accommodation, but it’s another matter altogether for the Bank of Japan to begin implementing its exit strategy. It’s a new game for the global liquidity cycle -- and possibly a new game as well for real long-term interest rates and an asset-dependent global economy.
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Will the Real Slim Saving Rate Please Stand Up?
Mar 06, 2006
Richard Berner (New York)
The US personal saving rate by any metric has declined steadily for three decades, and as measured in the National Income and Product Accounts (NIPAs), plummeted below zero last year for the first time since the Great Depression. Improvement, moreover, seems remote; January’s reading was minus 0.7%. That shocking lack of thrift and its presumed causes — a rising tide of easy credit and a liquidity-fueled housing bubble — has triggered concerns that the beleaguered American consumer will finally retrench — that is, as soon as US home prices decelerate sharply with a decline in housing activity. I believe that such fears are misplaced. As I see it, saving will recover steadily over the next several years as consumers adjust to slower gains in wealth, but the adjustment is likely to be gradual. Home prices are likely to decelerate but not plunge, and the influence of housing wealth (or for that matter, any form of wealth, including equities) on consumer spending is more limited and takes longer to show up than commonly thought. Most important, income growth is strengthening. Indeed, I think income gains will be sufficient both to maintain spending growth and rebuild saving at the same time. Here’s why. Let’s start with housing and home prices. For four years, I’ve maintained that the pace and acceleration in home prices was unsustainable, but that the coming deceleration would be gradual — home prices would rust, not bust (see “Housing Prices: A Bubble Ready to Burst?” Global Economic Forum, January 28, 2002). And for the past year I’ve tried in vain to pick the top in both housing activity and price gains (see for example, “Housing: Bubbly?” Global Economic Forum, February 28, 2005). That activity and home prices have continued to advance changes my views only slightly: I believe that housing activity will decline somewhat more sharply than before, because there is now a bigger mismatch between demand and supply than previously. That’s evident in the slide in housing affordability and sales, and rising inventories of both new and existing homes. In turn, the deterioration in affordability is largely the product of rising home prices, in contrast with Australia and to some extent the UK, where rising interest rates have played a bigger role (for a comparison of the three markets, see “Housing, Mortgages and Consumption: Comparing Australia, the UK and the US,” Global Economic Forum, March 3, 2006). Thus, the case for a faster decline in home prices than the return to 2-4% nominal gains in the next 18-24 months that I expect must hinge on a significantly larger and faster rise in interest rates than we anticipate. That’s certainly possible; for example, booming global growth and a more rapid tightening of monetary policy abroad could promote higher rates here. But it would also probably boost US job and income growth by more than we expect, which would offer support to housing demand and consumer spending. And our analysis of the three major English-speaking markets also convinces me that the housing-wealth-spending connection is looser in the US than in the other two venues. It’s worth noting that my colleagues David Miles and Melanie Baker think that the link is weaker in the UK than in Australia (see also “Housing Wealth and Consumer Spending,” Global Economic Forum, October 7, 2005). Yet many are unconvinced. They believe that roughly half or more of the change in aggregate mortgage-equity-withdrawal (MEW) has incrementally boosted consumer spending. According to former Fed Chairman Greenspan ( “Mortgage Banking,” September 26, 2005), “if indeed this is the case, the implied increase over the past decade in consumption expenditures financed by home equity extraction…would account for much of the decline in the personal saving rate since 1995.” Greenspan acknowledges that there is another paradigm: “a significantly different approach … concludes that the decline in the saving rate over the past decade can be explained by the decline in interest rates and by the increase in overall household wealth.” That’s essentially my paradigm, and it predicts a similar qualitative outcome to Greenspan’s, but the magnitude and speed of adjustment are very different. Saving will recover steadily over the next several years, but neither on empirical nor analytical grounds should analysts expect saving rates to move in lockstep with net worth, much less with MEW. Empirically, while its general movement indicates the direction of saving, the personal saving rate is a flawed measure of individual thrift, so it shouldn’t be taken literally as a guide to consumer behavior. About a third of the decline in the measured saving rate since the peak 25 years ago reflects the composition of income and spending, and has little to do with saving behavior. Rising durables outlays depress the measured saving rate because they are lumpy; a better treatment would use the service flow from durables. In fact, there are several measures of the personal saving rate derived from the Fed’s flow of funds accounts that adjust for these factors. Finally, I think a downward bias in rental income resulting from the overstatement of mortgage interest payments has depressed the measured saving rate by 40 basis points or more. Analytically, moreover, most models of saving behavior predict a slow adjustment of saving to changes in wealth and income. The saving rate will rise, in my view, because investors likely face single-digit returns in financial assets and real returns in real estate that hover around zero over the next several years. The growth of real household wealth resulting solely from its returns should slow to perhaps 1–3%. That stands in sharp contrast with the 4½% of the past decade. Ultimately, such slow growth in wealth will promote a gradual increase in personal thrift, as it did in the late 1970s and early 1980s. Thus, the saving rate may rise back to 3% by the end of 2007 and perhaps 4–6% by the end of the decade. The analytical framework behind this prediction is, of course, the so-called “life-cycle” model of consumption and saving, in which consumer spending is a function of both income and wealth. However, many seem to think that this model will yield a much more abrupt increase in personal saving and thus a sharp retrenchment in spending. That’s partly because the ratio of net worth to disposable income is still well below its peak in 1999 — in fact, some 50 percentage points below that peak. Extrapolating the dynamics of the relationship between that ratio and the saving rate implies a current saving rate of perhaps 2½% and one that quickly goes to 6% or higher. But the life-cycle model predicts no such increase. That’s because estimates of the model consistently produce propensities to spend out of income that are 13–15 times larger than those from wealth, including housing wealth. Together with the lags in response to a change in wealth, these relationships imply a slow adjustment of the saving rate, consistent with the slow adjustment of consumers as they defend their lifestyles in the face of higher energy prices and uncertainty. Not surprisingly, well-specified life-cycle models have accurately forecast the decline in the saving rate. In part, that’s because they also take into account differences in the composition of income as they affect thrift. The steady, 550-basis-point decline in interest and dividend income as a share of disposable income since their peak in 1989 has reduced the saving rate because such income tends to be saved rather than spent. And the steady rise in the share of government transfers like Medicare has reduced the saving rate because such “income” is 100% spent rather than saved. Thus, Joel Prakken of Macroeconomic Advisers, LLC shows that these compositional effects have reduced the saving rate by about 250 bp since the mid-1980s, while the rise in wealth/income has reduced it by about 500 bp. Most important for both saving and spending in the coming year, income growth has begun to accelerate sharply. Facing stronger business conditions and having been extraordinarily disciplined about hiring in this expansion, Corporate America and small businesses are both filling pent-up demand for hiring. As a result, a key measure of labor inputs — hours worked for nonsupervisory workers — rose by 2.6% from a year ago, close to the fastest pace in the current expansion. Moreover, firming labor markets have boosted average hourly earnings; they rose by 3.3% over the same period, to a 3-year high. The combination suggests that a proxy for real private wage and salary income rose over the past year at a 2.8% rate — close to a 6-year high. While these measures are flawed and incomplete, if anything they may understate pay gains, which are increasingly going to professional, technical and engineering workers (see “Will the Real Wage Measure Please Stand Up? Global Economic Forum, January 6, 2006). (The official data now show real private wage and salary income up 2.3%, but I expect that revisions will bring it closer to the proxy measure.) And faster job and pay gains and the prospect of stable energy quotes suggest an even brisker real income pace over 2006. The improvement in state and local budgets also suggests more hiring and pay gains in the coming year. In addition, other income sources are also growing strongly. Rising interest rates and dividend payouts are boosting property-type income at a 9.4% rate, and proprietors’ income is up 6.9% over the past year. And both Social Security and Medicare transfers are rising strongly this year, the former boosted by the adjustment to last year’s inflation rate (a 4.1% increase per beneficiary effective on January 1, 2006), and the latter by the introduction of the Medicare Prescription Drug Benefit. The upshot: The 5.6% rise in real disposable income we expect over the four quarters of 2006 would be the strongest such gain since 1998, and would finance healthy gains in consumer spending and a rise in the personal saving rate from its current below-zero level to 1½% by the end of 2006. Despite past resilience and the income improvement, market participants are still skeptical of the staying power of the US consumer. The February/March “payback” in spending may fuel those doubts. For example, we expect retail sales to retrace a significant part of January’s 2.3% jump. If job and income growth continue to improve, however, I think consumer spending will retain its vigor. Coupled with the unfolding vitality of global growth, even moderate strength in US consumer outlays may reinforce the backup in global interest rates. When pondering whether such a rate backup will in turn hurt growth, it’s important to remember that rates are rising because global growth is strong, and not because of some exogenous shock. For me, the principal sources of risk continue to stem from geopolitics, energy and inflation. Indeed, a supply-driven energy price spike or a meaningful surge in inflation pose the biggest threats to this upbeat scenario. Contrariwise, if energy prices stabilize or revert to long-term levels, the risks of a stronger-growth, higher-inflation outcome are not insignificant.
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It's Not 1914, but It Smells Like 1930
Mar 06, 2006
Eric Chaney (London) and Vincenzo Guzzo (London)
There are objective reasons behind the political fireworks caused by hostile cross-border M&As in the euro area. First, we think that the acceleration of pan-European restructuring is a lagged effect of EMU. Second, that French policymakers enrol under the banner of ‘economic patriotism’, a code word for protectionism, is no wonder, given that France is significantly more open to foreign direct investment (FDI) than its neighbours, including the UK. Third, that Italian policymakers are frustrated by the French reaction is not surprising, given that Italy is the laggard of Europe in terms of outward FDI. To that extent, the burst of economic nationalism can be seen as the political dark side of otherwise positive developments. In addition, political posturing may hide a different reality, as we will show in the French case. Nevertheless, we fear that politicians may be playing with fire. Italian Finance minister Giulio Tremonti made a reference to the political tensions of 1914 that led to the First World War. Although there is some electoral hyperbole in this statement, we think it is not totally irrelevant: there are several possible non-cooperative equilibriums in this game, and some of them are nasty. Instead of 1914, we would rather evoke the ominous Smoot-Hawley Tariff Act of 1930: raising barriers to capital movement may initiate a vicious cycle of retaliations. This is what EMU was supposed to deliver Surprisingly, cross-border flows of direct investment did not pick up significantly after monetary union. In theory, removing the exchange rate risk should have boosted cross-border investments. Why this did not happen is straightforward: one year after EMU started, the ICT bubble burst and European companies focused on restoring balance sheets, instead of looking for acquisitions. From this macro angle, we believe that the current wave of M&A is largely the lagged impact of the monetary union: Now that companies have clean balance sheets and are cash rich, they are concentrating on growth and market shares and, quite naturally, on the large internal market of the euro area, second only to the US market. The French paradox Contrary to beliefs well entrenched in the markets, France is the most open country to FDI, among comparable European countries. Central bank data gathered by the IMF show that the stock of FDI in France was 41.8% of GDP in 2004, compared with 36.0% for the UK, 24.6% for Germany, 21.3% for Spain (in 2003) and 13.2% in Italy. Foreign direct investment from overseas in the euro area itself takes only 28.9% of GDP, according to ECB data. A recent study by the French Statistical Office indicates that, in France, one worker out of seven is employed by a foreign company, versus one out of 10 in the UK, Germany or the Netherlands, and one out of 20 in the US (2003 data). This may explain why foreign ownership of French companies is such a politically sensitive issue. Italyis just opening its borders FDI data show that Italy, and Spain to a lesser extent, are at the other end of the spectrum: in 2004, FDI in Italy took only 13.2% of GDP (21.3% for Spain). Over the last 20 years, most of capital inflows into Italy were invested in debt instruments, because of the size of the Italian public debt and the entry of Italy in the euro club. However, now that spreads on EMU government bonds have narrowed considerably, investors and corporate headquarters are taking a fresh view on Italy and Italian companies. This is already showing up in the sharp rise of FDI flows. Being a potential prey, Italian companies are quite naturally becoming hunters. In the long run, no structural macro factors may justify that FDI in France should be four times higher than in Italy, other things being equal. Political posturing may hide different agendas Morgan Stanley & Co. Limited, an affiliate of Morgan Stanley, is acting as financial advisor to Suez SA in connection with the proposed merger with Gaz de France SA, as announced on 27th February 2006. In accordance with its general policy, Morgan Stanley currently expresses no Rating or Price Target on Suez or Gaz de France. This report was prepared solely upon information generally available to the public. No representation is made that it is accurate and complete. This report is not a recommendation or an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report. The proposed merger of Suez and Gaz de France (GdF) is seen very differently in Italy, Brussels and Paris. While both the centre-right and the centre-left political parties in Italy are denouncing unfair French protectionism (after all, the French state-owned utility EDF has a large stake in Italy’s main power company) and the EU Commission is expressing strong reservations, the French internal debate is different. French unions are vocally opposed to the deal, while the government is beating the drum of ‘economic patriotism’ and pro-market leaders such as Mr. Fillon celebrate the deal. The explanation of this paradox is simple: the merger, if approved by Brussels (not a done deal at this stage), would result in the privatisation of GdF, as the state’s stake would drop to 34% from 80%. Unions are fiercely opposed to that and so was Prime Minister Villepin until the Italian bid. If this is indeed the plan, we would welcome it from a French market point of view. In addition, former state monopoly EDF would face serious competition from this new utility company. The danger of popular backlash and escalation While interference between politics and business is not new, we find the current developments alarming. Because elections are coming (in one month in Italy, 15 months in France), politicians are using the anti-Europe / anti-free-market popular sentiment (often the same thing in continental Europe) to defend or build national champions or simply to protect local managements. We think that the national champion strategy is at best ineffective, at worst negative for welfare and jobs. Its well documented negative effects are 1) reducing management incentives to perform better by reducing competition; and 2) provoking a vicious round of protectionist retaliations — exactly what the Smoot-Hawley Tariff Act triggered around the world in 1930. What worries us is that politicians may be fuelling anti-market and anti-Europe forces that they do not fully control. Benign or malign outcome? These political fireworks might be short-lived. Italian elections are close and cross-border acquisitions and restructuring have already gone a long way. Once the dust settles, governments and businesses may come to terms and cross-border mergers and acquisitions may resume, with some restrictions. This is the benign scenario. There are other possible outcomes: elections may reinforce the weight of nationalistic political forces and, as a consequence of ever-higher political barriers, cross-border FDI flows may dry up. The efficiency gains associated with the single market and the free movement of capital would be lost and, in a worst-case scenario, the protectionist virus could also infect trade, as a result of retaliations. This is the danger to which Mr. Tremonti was alluding when evoking 1914. Beyond the hype, he had a point.
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A State of Mind
Mar 06, 2006
Elga Bartsch (London)
“We are very much in the same state of mind as we were after the December decision” JC Trichet We viewed the ECB press conference following the widely anticipated decision by the Governing Council to raise interest rates by 25 basis points to 2.5% as being on the dovish side. Meanwhile, many market participants seem to consider the press conference as having being on the hawkish side. Part of the discrepancy in perception might be rooted in our call that the ECB will likely raise rates again as soon as May, which would be earlier than the market expects. Based on our call for a May rate hike, we had hoped to hear that the Bank saw a need for ‘continued vigilance’. However, ECB President Trichet carefully avoided using the word ‘vigilance’ last week. The ECB has used ‘vigilance’ in the past to signal an imminent interest rate hike. In fact, Jean-Claude Trichet sidestepped ‘vigilance’ throughout the press briefing, despite the fact that he was being probed on the ECB’s state of vigilance on several occasions during the Q&A session. Instead, he consistently stuck to the formulation that the ‘ECB continues to monitor all risks to price stability closely’. Hence he also omitted ‘very’ as in ‘monitoring very closely’ — the wording used at the January press conference. So, despite the assurances that the ECB would do everything it deemed necessary to maintain price stability and firmly anchor inflation expectations, we came away with the impression of a dovish tone. Over the last two weeks, the money market has priced in nearly an additional 30 bp of ECB tightening by year-end, nearly 10 bp of the additional tightening being priced in since the ECB press conference. But at a total of 60 bp of additional tightening from present levels, the market still only assigns a less than 50-50 probability to a last rate hike up to 3.25% in December — our long-held central case. While our official call remains for the 3.25% level being reached in December, the balance of risks suggests to us that this level could be reached earlier — say, sometime in the autumn. Longer-dated government bonds also reacted negatively on the day of the press conference. At 3.57%, 10-year Bund yields are now close to our end-of-March target of 3.65%. The press conference seems to come as a wake-up call to the remaining sceptics out there, who thought that the ECB was unable to raise rates beyond 2.5%. By stating that interest rates remain very low by historical standards and that monetary policy in the euro area remains accommodative, the ECB clearly indicated that a tightening bias remains in place. But, as in December, the Bank doesn’t want to commit to a specific course of future interest rate action. Any future interest rate action remains data-dependent. Against the backdrop of an ongoing economic recovery, which, contrary to popular belief, is driven mainly by domestic demand rather than net exports, the ECB should feel comfortable to normalise interest rates further, we think. While the ECB’s state of mind might be the exactly the same as after the December rate, as Mr. Trichet indicated repeatedly, the state of the economy is not the same. In our book, the state of the economy is considerably better today than it was back in December. On balance, we therefore believe that another 25 bp rate hike in May is on the cards. We would only be willing to throw in the towel on our call for a slightly accelerated pace of ECB tightening if there were no signal at the April press conference that another rate hike was coming. At the very latest, however, we would expect another ECB rate hike to come in June, coinciding once again with the release of a fresh set of staff projections. The fact that the June meeting is one of the ECB’s regular out-of-town meetings, this time taking the Governing Council to Madrid, should not have any bearing on whether or not the Bank pulls the trigger on interest rates again.
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Review and Preview
Mar 06, 2006
Ted Wieseman (New York) and David Greenlaw (New York)
The Treasury curve saw a major bear steepening last week, as support for the long end outright and in curve flattening trades faded badly after the end of significant buying (and anticipation of such) tied to month-end index duration extensions on Tuesday, while overseas markets continued to exert additional pressure on the broad market. The market’s hawkish interpretation of ECB President Trichet’s press conference following the ECB’s universally expected 25 bp hike in its refi rate to 2.50% on Thursday proved more important in the latest week, in contrast to the previous week’s important driver — the prospect of an early end to quantitative easing in Japan (which our BoJ watcher Takehiro Sato now expects to come on March 9) and the impact on Japanese markets. While Mr. Trichet’s remarks were viewed as a bit dovish by our European economics team, our team had already expected the ECB to continue hiking rates to 3.25% this year, a prospect about which the market was too complacent and forced to adjust towards after Mr. Trichet’s remarks. The recently emerging trend of bunds and JGBs driving Treasuries rather than the other way around could mark the beginning of a key turning point for the Treasury market, but it is not too surprising, given that the ECB and BoJ are just at the beginning of tightening cycles while the Fed is nearing the end. And considering that, as of the end of 2005, a huge 64% of publicly held (ex Fed) Treasuries were owned by foreign investors, conditions in overseas markets are going to be of high and rising — perhaps increasingly dominant — importance to the Treasury investor base. The technical, flow-driven influence of fading long-end demand post month-end — which resulted in big, gapping bear steepening moves in the curve on Wednesday and Thursday and a smaller move on Friday — and knock-on effects of more hawkish expectations for overseas central bank action, appeared to overshadow any consideration of the domestic economic fundamentals, which were not on balance market negative over the past week. Early signs of a February weather payback emerged in soft consumer spending results in the chain store and motor vehicles sales reports — incorporating these data, we forecast a 0.8% decline in overall retail sales in February and a 0.6% drop ex autos — while a negative monthly revision pattern to 4Q consumption and much weaker-than-expected January construction spending results led us to cut our 1Q GDP estimate to +5.0% from +5.6%. Consumer confidence and home sales reports were also soft. And core PCE inflation remained well contained, presenting, at this point, no barrier to a pause in the rate hiking cycle were the Fed inclined in that direction, which it may well be after the March or May FOMC meetings. On the other side — and in probably a key sign of the bearish tilt to the market — the only data release that seemed to prompt much immediate market reaction, the ISM report, showed surprising strength in February, indicating that, while demand appears to have slipped notably in February, factory output apparently held up well. In the coming week, the key focus will be on the delayed February employment report, where we expect more signs of weather payback, forecasting a relatively soft 100,000 gain in nonfarm payrolls. Last week, benchmark Treasury yields rose 3-14 bp, with 2’s-30’s surging 11 bp to -9 bp — the smallest inversion since the new 30-year debuted — on a 3 bp rise in the 2-year yield to 4.75% and a 14 bp rise in the 30-year yield to 4.66%. The 2-year/old long bond spread actually disinverted over the course of the week. In retrospect, the long end seems clearly to have derived major support in the period leading up to the end of February from anticipation of and, especially on Tuesday, the reality of significant month-end related buying tied to an unusually long Treasury bond index duration extension. But after running up to 4.50% at Tuesday’s close, the long end crumbled when this support disappeared on Wednesday with the start of March, with a particularly violent curve unwind seen early on Wednesday, which was then followed by just as big a move, but over a longer period on Thursday. In less than an hour, very early on in Wednesday’s US trading, 2’s-30’s gapped 6 bp steeper, before bouncing back a bit. And then a similar-sized move took place during the morning and early afternoon of Thursday, with the weakness initially exacerbated by a collapse in Bunds during the ECB press conference. The other benchmark issues performed in line on the curve relative to this 2’s-30’s surge, with the 3-year yield up 5 bp to 4.74%, the 5-year yield up 8 bp to 4.71%, and the 10-year yield up 11 bp to 4.68%. Our interest rate strategy group has been predicting in recent weeks that the 10-year yield will move towards 4.75% as we close in on the March 28 FOMC meeting, believing it will prove unable to hold an inversion to the 4.75% funds target, seemingly assured to be in place after that meeting, and after the past week we are well on the way there. Note also that the very front end of the market has now nearly unwound both its current inversion and its prospective inversion with respect to the soon to be 4.75% overnight rate, with the 6-month bill’s bond equivalent yield and 2-year yield both ending the week at 4.75% and the 3-year yield at 4.74%. This is the closest 2’s-3’s has come to disinverting since mid-December. Despite the overall softer tone of the week’s economic data, there was no move of significance in near-term Fed pricing in the futures market, and actually a slightly less dovish medium-term view, as the prospects for more hawkish ECB and BoJ policy apparently fed through to Fed views. The May fed funds contract was flat on the week at 4.885%, continuing to price a roughly 75-80% chance of a hike in the funds target to 5% at the May 10 FOMC meeting, while the July contract rallied a half bp to 4.995%. The eurodollar futures inversion moderated significantly, however, with the Sep 06 to Sep 07 spread steepening 4.5 bp to -14.5 bp, a four-week high, with the former contract off 2 bp to 5.18% and the latter losing 6.5 bp to 5.035%. Also of note in the eurodollar market, the June 06 to Sep 06 spread steepened 2 bp to +7 bp, the highest level since last May, as the market began to slightly question its long-entrenched view that the rate hike cycle would be over by the June FOMC meeting at the latest. The past week was a heavy one for economic releases, and while there were mixed results, overall the tone of the numbers was market friendly and not obviously supportive of the week’s price action. Looking at GDP data, fourth quarter growth was revised up to +1.6% from +1.1%, right about as expected, but with a significantly more positive than anticipated final sales/inventories mix. We had expected most of the revision to come from inventories, but final sales were adjusted up to 0.0% from -0.3% and the inventory contribution to +1.6 percentage points from +1.45 pp. Normally, this would have had a positive impact on our 1Q forecast, but a significant contributor to the final sales surprise was a “corrected seasonal adjustment” that resulted in the originally reported and very surprising 13% plunge in federal defense spending being adjusted up to -9%. With this anomalous result moderated, we scaled back our expected 1Q rebound in defense, and the 4Q GDP revision thus ultimately had little impact on our 1Q forecast. And subsequent early indicators for 1Q were not positive. The pattern of revisions to 4Q consumption growth (with December real PCE revised to +0.7% from +0.9%) provided a more negative starting point, leading us to reduce our 1Q consumption estimate to +5.1% from +5.4%. Meanwhile, construction spending rose a much less than expected 0.2% in January, a shocking result after the 14.5% spike in January housing starts and record warm temperatures in the month. Even assuming a lagged catch up in February, this led us to trim our first quarter growth outlook further. We now see 1Q GDP growth tracking at +5.0% vs. our prior +5.6% estimate. As we look to February, early signs emerged last week of the weather payback we expect to affect a number of releases after the record warm national average temperatures experienced this January, most importantly the upcoming employment report. In particular, early indications of February consumer spending reported last week were soft, with negative weather effects appearing to play a role. Motor vehicle sales fell to a 16.5 million unit annual rate in February from 17.6 million in January. Though significant shifts in fleet versus retail sales will likely mute the impact on consumer spending significantly (with the reverse impact on business investment), we still expect consumer spending on autos to be down. Meanwhile, overall chain store sales results were sluggish in February, as expected, after very strong January results. Weakness was concentrated in clothing stores, with the weather swing likely playing a key role. Incorporating these results, we forecast a 0.8% decline in overall retail sales in February and a 0.6% drop ex autos, with the latter expected to be depressed at least partly by weather-related paybacks in clothing, building materials, sporting goods, and restaurants. Some other indicators of consumer activity were also softer last week, with weaker consumer confidence and home sales. The Conference Board’s measure of consumer confidence fell to 101.7 in February from 106.8 in January. Meanwhile, the University of Michigan gauge was revised to 86.7 for all of February from the early month reading of 87.4, down from 91.2 in January. In the Conference Board report, the current conditions index ticked up a half point to 129.3, a four-and-a-half-year high, but the expectations gauge fell 8 points to 83.3. Sharply diverging views of the current and future job market explained the gap. Looking at current conditions, 27.3% of respondents said jobs are “plentiful” and 20.7% “hard to get”. But in six months, only 13.4% expect more jobs compared with 20.0% expecting fewer. Worries about future job losses also hurt the Michigan results. Regarding housing, new home sales fell 5.0% in January to 1.233 million units annualized, the lowest level in a year, though there were partly offsetting upward revisions to December and November. Surprisingly, there did not appear to be any positive impact from the unusually warm weather in January, as sales in the Northeast and Midwest were down sharply. Inventories continued to surge — the actual number of new homes available for sales was up 21% year on year to a record high, while the months supply rose to a nearly decade high of 5.2 from 4.8 in December. Meanwhile, existing home sales fell 2.8% in January to 6.56 million, a two-year low. An 11% plunge in condo sales — where months supply has now surged to 6.7 from 3.7 less than a year ago — accounted for much of the drop. These run-ups in home inventories should eventually pressure prices, but it’s not happening yet. The Office of Federal Housing Enterprise Oversight’s (OFHEO) house price index, the best available measure of underlying price trends (since it uses Fannie and Freddie’s data to analyze repeat sales and thus avoid problems with mix shift in other measures) showed a surprising reacceleration. The index was up 13.0% Y/Y in 4Q versus +12.5% in 3Q. This compares with the 26-year high of +14.1% hit in 2Q. Twenty-six (of 275) metropolitan areas posted record increases in 4Q, led by a 40% surge in the Phoenix area. Not all the economic news last week was negative. The manufacturing ISM composite diffusion index rose to 56.7 in February from 54.8 in January, with upside in the key orders (61.9 vs. 58.0), production (57.4 vs. 56.6), and employment (55.0 vs. 51.3) gauges. Factory sector expansion was very broadly based in the month, with 17 of 20 industry sectors reporting growth, up from 13 in January and 10 in December. The nonmanufacturing ISM showed similar strength in February, rising to 60.1 from 56.8. And looking beyond the near-term weather payback, there were some positive indications on consumer incomes, which we expect to show significant acceleration over the coming year, keeping consumption well supported even in the face of fading wealth effects and thus rising personal savings rates. Looking ahead to the next inflation report, we expect the recent upswing in nominal income growth to get a significant lift in real terms from an incipient reversal in energy prices, as we forecast a flat headline CPI for February on a significant pullback in energy prices that should extend into future months given recent trends in natural gas and gasoline futures prices. The 4Q GDP revision showed a sizable upward adjustment to 3Q wage and salary income growth (+6.5% v. +5.0%) and a solid further gain in 4Q (+4.7%). Average hourly earnings results have also pointed to a significant acceleration in nominal wages through the second half of 2005 and into early 2006. Now relief on the price front should allow this to start translating into much stronger growth in real incomes, supporting consumer spending in the face of a likely slowdown in housing wealth support. Focus this week will be on Friday’s employment report, where we look for an outcome well below consensus as a result of negative weather effects. In Fed news, Chairman Bernanke will be speaking Wednesday at noon to a community bankers group on the topic “Community Banking”, and in supply news the Treasury will announce the 10-year reopening Monday for auction on Thursday (we look for an unchanged $8 billion size). Regarding Treasury supply, we are approaching the point when the Treasury will be running out of room under the debt limit freed up by disinvesting of the G-Fund and Exchange Stabilization Fund. If there is no imminent action by Congress (which goes on a St. Patrick’s Day recess mid-month), we may see some near-term disruptions to auction schedules before the Treasury takes the next, politically tricky step of disinvesting the Civil Service Retirement fund. In addition to employment, other data releases due out this week include factory orders on Monday, revised productivity on Tuesday, the trade balance on Thursday, and the Treasury budget balance on Friday: * We forecast a 5.5% plunge in January factory orders. A sharp fall-off in the volatile aircraft component is expected to lead to one of the largest monthly declines in overall factory orders on record. On an underlying basis, however, order activity appears to be holding up quite well. * We expect 4Q productivity to be revised up to 0.0% and unit labor costs down to +3.3%, as the upward revision to 4Q GDP growth points to corresponding adjustments to both productivity and costs. Still, we expect productivity to post its weakest showing in nearly five years. Moreover, the productivity-related reduction to unit labor costs will be offset partly by a small upward revision to compensation. In fact, the most significant aspect of this report will be a noteworthy adjustment to compensation in 3Q. This is expected to push unit labor costs up by 1.5 percentage points — to +1.0%. So, the year-on-year growth rate for unit labor costs in 4Q should be adjusted up to +1.3%. * We expect the trade gap to widen $1 billion in January to $66.7 billion, with exports ticking up 0.1% and imports rising 0.6%. On the export side, industry data point to a sharp rise in overseas aircraft deliveries, but the durables report pointed to a pullback in other capital goods exports, while consumer goods are also likely to be depressed by a reversal of last month’s spike in the extremely volatile drugs category. On the import side, price-related upside in petroleum products should be more than offset by a sharp price-related drop in natural gas, resulting in a decline in overall energy imports. But strong growth in inbound container shipments through the key West Coast ports points to a significant offsetting rise in non-energy goods imports. * We look for a sub-par 100,000 rise in February payrolls tied to weather-related factors. First, a major blizzard battered the East Coast just as the survey week was about to begin. A comparable event — at least from a timing perspective — occurred in January 1996. In that month, payrolls were originally reported to have declined by 201,000 followed by a 705,000 rebound in February (note: over the years, these data have been smoothed out and the official series now shows -8,000 in January and +435,000 in February). Admittedly, the severity of the 2006 blizzard did not match the January 1996 event. However, even were it not for the winter storm, we would have expected to see some payback following an unusually mild January. Statistics show that this past January was the mildest in more than a century. And our proxy for weather-related effects on the employment data — the “not at work due to bad weather” component of the household survey — posted its first December to January decline in 20 years. The bottom line is that we expect about a 100,000 subtraction from payrolls tied to the weather. Assuming that conditions return to normal in March, we would anticipate a solid bounce-back in the job tally. Finally, we expect other components of this month’s employment report, such as hourly earnings and the average work week, to be at least somewhat affected by the weather. * We expect the February federal government budget deficit to come in at $124 billion, about $10 billion wider than a year earlier. This reflects a slight acceleration in the processing of tax refunds and a pick-up in Medicare outlays tied, at least in part, to the new prescription drug benefit. We still see the deficit for the fiscal year as a whole tracking at $375 billion — or 2.9% of GDP.
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2006 NPC
Mar 06, 2006
Andy Xie (Hong Kong)
A key feature of the ongoing annual National People’s Congress has been a policy shift towards rural, social, and economic sustainability issues and away from fixed asset investment. The proposed increase in fiscal revenues between 2005 and 2010 (which we estimate at 68% over the five-year period) will go mostly into such items. The government’s 2006 macro targets are to achieve an 8% GDP growth rate, keep inflation rate below 3%, increase urban employment by 9 million, and maintain stable credit and exchange rate policies. Decreasing energy consumption by 4% per unit of GDP and unifying tax rates between domestic and foreign companies are the main sector initiatives in 2006. Fiscal Trends Total fiscal revenue reached some Yuan 3,134 billion, or 17.2% of GDP in 2005. The split between central and local government revenue has been stable at 55:45 in the past four years. Total revenue grew by 18.5% per annum or 1.4 times the nominal GDP growth rate between 2000 and 2005 compared with 16.5% per annum or 1.6 times the nominal GDP growth rate between 1995 and 2000. China’s fiscal revenue bottomed at 10.3% of GDP in 1995 and recovered to 17.3% of GDP in 2005. The success of VAT has been responsible for the turnaround. The dependency on direct taxes remains a weakness in China’s revenue structure, as it makes public revenues highly cyclical. China’s consolidated fiscal deficit was Yuan 300 billion in 2005, or 1.6% of GDP. The export VAT rebate increased by Yuan 104.4 billion in 1H05 from 1H04. The real budget situation is obviously much stronger than what the notional fiscal deficit indicates. The government targets a budget deficit Yuan 295 billion for 2006, or about 1.5% of GDP. On the expenditure side, local governments account for about 70% of the total expenditure. The reason for the big mismatch in the shares of local government revenue and expenditure is the role of the central government in inter-provincial subsidies. The export-oriented provinces along the Eastern Seaboard remain the main sources of revenue for the central government to subsidize the interior provinces. In shifting the national priority to supporting the countryside, not alienating the coastal provinces that create most of China’s wealth will be the most important challenge, in my view. China could and should, I believe, increase central government borrowing to support the countryside and focus on other social issues. Leaning towards the rural sector Stabilizing the countryside is the greatest challenge for China’s development over the next five years, in my view. The declining terms of trade between rural and urban products, and lagging agricultural productivity are the main factors for the rural distress. The high labor-to-land ratio makes China’s rural problems difficult to solve. The government budgets Yuan 340 billion (1.7% of GDP) for rural support in 2006, up 14% from last year. This amount of money is equal to 15% of the agriculture sector GDP in 2005. Because the rural population is 745 million, the support is relatively small at Yuan 456 per person. The rural revival strategy under the slogan of ‘building the socialist new countryside’ has three components. First, increase spending on rural infrastructure and technology to boost productivity. The Ministry of Communications announced last month that it would spend Yuan 1.2 trillion on rural roads between 2006 and 2010. Irrigation is another area for investment. Second, boost the competitiveness of rural youth in the urban economy. Rural education has declined relative to urban education in recent years. This has been the most important constraint in the upward mobility of rural youth in the urban economy. The government intends to spend Yuan 218 billion between 2006 and 2010 on rural education. Third, improve rural living standards using capital subsidies. Most villages do not have modern housing, and healthcare in rural areas tends to be too expensive and of poor quality. The central government has budged Yuan 4.7 billion for 2006 or seven times that in the previous year to finance rural medical cooperatives, for example. Rural institutional effectiveness, rather than money, will decide whether China’s rural revival strategy will succeed or not, in my view. Premier Wen announced in the report that the government would launch a campaign against commercial corruption that focuses on construction, land sales, medicine trade and government procurement. While an anti-corruption campaign will likely enhance administrative effectiveness temporarily, I believe that rural institutional reforms are still urgently needed to ensure the money is well spent. Reforming healthcare, education, and property Healthcare and education, together with housing, have become the most important economic factors that cause social discontent. The three sectors were funded by state-owned enterprises or governments a decade ago but have become the biggest expenditure items for urban households today. Previous healthcare and education reforms have had serious flaws. The most important conflict is that China has given schools and hospitals pricing flexibility but has not introduced effective market competition to ensure low prices. A joint study between the WHO and Chinese government last year concluded that China’s healthcare reforms had not worked. While the problems are widely recognized, the government has not come up with reforms to change the system. Premier Wen raised both healthcare and education as serious social issues in his report. An anti-corruption campaign has been the government’s policy response to the social discontent. A long-term solution still needs to be found, in my view. Property is probably the most contentious social issue today. In a market economy, an affordable housing market is the foundation for a healthy economy. China’s property prices remain out of the reach of average income earners, while a vast amount of properties remain vacant. In his report, the Premier emphasized again the need to shift property construction to low-cost housing; however, concrete policies are yet to materialize. Controlling fixed asset investment The main structural theme in Premier Wen’s report involved changing China’s current development model from a quantity to a quality-driven one. The quantity-driven aspects include over-dependence on investment, low efficiency in energy consumption, and a high level of pollution. Premier Wen recognized overcapacity, declining prices, rising inventory and low profitability in some industries, and stated the need to control investment in those industries. But he also emphasized the need to be flexible when looking at investment. The overall tone suggests that China will still be cautious in approving new investment projects but would not introduce new tightening measures. The decelerating trend in fixed investment is likely to continue under the current policy direction, we believe. In 2006, fixed asset investment growth rates will be considerably less than last year’s 25.7% and could be 15%, I believe. Reducing energy consumption by 4% per unit of GDP per annum is a key objective in the current five-year plan. The government has not yet come up with concrete proposals to achieve this goal, and it remains to be seen whether this goal can be achieved without raising energy prices.
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ZIRP's Termination and USD/JPY
Mar 06, 2006
Stephen L. Jen (Amsterdam)
For USD/JPY, ZIRP matters, not QE I believe the equilibrium value of USD/JPY is around 100, and that talk of the BoJ terminating ZIRP could be a trigger for the USD/JPY to trade lower. However, I continue to challenge the popular view that the end of QE will also be highly disruptive for USD/JPY and other foreign assets. In my view, recent talk of an early end to QE has led to downward pressure on USD/JPY because the BoJ has not drawn a clear distinction between QE and ZIRP. Our year-end forecast for USD/JPY remains at 106. USD/JPY may stay supported until the Fed funds rate (FFR) peaks and ending ZIRP becomes a tradable theme. This suggests to me that a sell-off in USD/JPY is likely to be a 2H story. Where should USD/JPY be trading? There are two centres of gravity for USD/JPY: one at around 100, reflecting real economic fundamentals, and the other at around 120, reflecting nominal factors. I believe the real fundamentals will win this tug-of-war by the end of the year. But with a negative carry of more than 450 bp and rising, it is important to get the timing right on this prospective sell-off in USD/JPY. How should BoJ policy changes affect USD/JPY? In theory, ending QE should not matter, but ending ZIRP would be an important event for USD/JPY. I suspect that ZIRP will only be terminated if the BoJ has ample confidence that the economy is embarking on a sustained recovery and inflation will stay positive over the medium term. But if Japan indeed finds itself in that situation, the market will almost certainly start to price in a series of rate hikes. This change in expectations could lead to heavy pressures on USD/JPY. This also implies that ZIRP should be terminated later rather than sooner. What I think the BoJ will do I wholeheartedly support the expectation of my colleagues in Tokyo that QE will be terminated in March or April, while ZIRP will only be lifted in 2Q07. However, a critical issue here is the uncertainty surrounding the dates of these two policy changes. While markets anticipate that QE will end between early March and early April, the market’s view on the timing of ZIRP’s ending spans over a period of one year! In my view, the BoJ has three basic communication strategies regarding the termination of ZIRP. 1. Remain intentionally ambiguous. The BoJ could maintain the current communication strategy and blur the distinction between QE and ZIRP, and intentionally lead investors to believe that the end of ZIRP will follow the end of QE. Japan’s growth could indeed remain so robust that the BoJ may choose to be vague and force the market to be ‘data-dependent’. In such a case, the market is increasingly likely to anticipate an early end to ZIRP. 2. Provide clear forward guidance through another set of numerical targets. The BoJ could announce explicit and verifiable prerequisites for ending ZIRP. The market would be able to form a relatively precise view on the likely timing of the end of ZIRP. However, given the lack of clear inflationary pressures in Japan, if the BoJ announces a minimum threshold on inflation, it could actually lead to a rally in USD/JPY. 3. Use qualitative, not quantitative, preconditions. I don’t have a strong view on what the BoJ will likely do, though I believe it should pursue Strategy 2. If I have to guess, I believe Strategy 3 is most likely, for several reasons. First, though most of the BoJ policymakers are inflation-targeters at heart, announcing an explicit numerical inflation target with Japan still struggling to generate inflation could undermine the BoJ’s ability to keep itself away from ‘emergency’ stances such as QE and ZIRP. Second, policy lags are important. Japan has been growing at a rapid pace — around 5.5% in 4Q. The bigger question is on inflation. There is considerable uncertainty regarding the trajectory of goods price inflation in Japan. Judging from the scheduled price liberalizations and the stabilization in oil prices, it is reasonable to expect that CPI may sag lower again later this year. But if growth stays robust, it would be odd if Japan does not experience some inflation. This uncertainty about the nexus between growth and inflation, and the time lag between high growth and rising inflation, could argue for a more vague and subjective rule for ending ZIRP. If the BoJ does choose Strategy 3, USD/JPY will likely be heavy in 2H06, after the FFR peaks. Indeed, our year-end forecast for USD/JPY is 106 partly because we suspect that the BoJ will not give crystal-clear forward guidance on ZIRP. Bottom line The BoJ has so far not drawn a clear enough distinction between QE and ZIRP. If it does not introduce explicit numerical preconditions for ending ZIRP, and opts for qualitative preconditions, USD/JPY could come under downward pressure in 2H due to the high uncertainty surrounding ZIRP. Our year-end target for USD/JPY remains 106.
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