Unravelling the BoJ's Take on 'Price Stability'
Mar 10, 2006
Takehiro Sato (Tokyo)
A calculated decision with consideration for both the government and the markets
The BoJ’s end to quantitative easing, after five years, came hastily and sooner than our original expectation of April. The move itself was not surprising, however. Expectations for a change in the policy have risen since the central bank clearly specified in October 2003 that the trend in the core CPI was a condition for an end to the policy. In addition, the accompanying measures to safeguard against drastic change, namely the maintenance of the Lombard-type lending facility and the amount and frequency of outright buying of long-term JGBs (Rimban) “for some time”, were within the range of expectations. The introduction of a new framework for monetary policy gives the BoJ some policy leeway and showed some consideration for maintaining market stability ahead of the fiscal year-end. For the target on prices, which has drawn the most attention, the BoJ mentioned an approximate range of 0-2% as “generally consistent with the distribution of each board member’s understanding of medium-to-long-term price stability”. Governor Fukui emphasised at the press conference following the policy board meeting that this is different from an inflation target or reference rate. However, the BoJ defined price stability as consistent with the current, low rate of price increases (+0.5% YoY for both headline and core inflation) and thereby underscored the hawkish stance on inflation of the BoJ, which is eager to normalise monetary policy. The central bank allowed for a 0% change in the CPI, without measurement bias, as its understanding of medium-to-long-term price stability. We think that the central bank has succeeded for now in gaining maximum policy leeway while giving consideration to those that have been calling on the BoJ to base its policies on rules. It should also be noted that the BoJ carefully avoided using the phrase “core inflation” in the text of the statement, in contrast with the policy commitments it has made so far. Theoretically, headline and core inflation should converge in the longer term because of the assumption that fresh food prices are generally constant. Our interpretation is that the BoJ did not mention a commitment to the core CPI because it newly committed to medium-to-long-term inflation rather than current inflation. With the new policy framework, the BoJ moves from a backward- to forward-looking stance, that is, a commitment focused on the price outlook for the next one to two years rather than the current price index. We think that this framework is close to the Bank of England’s inflation-targeting framework, which means that a change in the CPI of only 0-1%, the lower end of the range of board members’ understanding of medium-to-long-term price stability, would not be an impediment to rate hikes. Likely timing of rate hikes moved up by half a year In light of the above and Governor Fukui’s hawkish stance on asset inflation risks, as evident in the post-meeting press conference, we can no longer rule out the possibility of an early rate hike (i.e., an end to the zero interest rate policy (ZIRP)) coming before our original expectation of early F2007. We expect a 25bp hike, the first since August 2000, around Oct-Dec this year. The next Outlook for Economic Activity and Prices report, to be released on April 28, may provide some theoretical underpinning for such a rate hike. As Governor Fukui emphasised at the press conference, the direction of monetary policy will depend heavily on future economic activity and prices, however. We maintain our view that price risks are on the downside rather than the upside. In this context, the average for the board members’ understanding of medium-to-long-term price stability is around 1%, which is likely to spur further discussion on the relationship with core and headline inflation. We also expect the BoJ to face greater political pressure when it eventually ends ZIRP than it did this time around. If so, the extent to which the market discounts rate hike prospects is likely to be unexpectedly volatile, depending on the price outlook. In this sense, we believe that the market has gone too far in discounting a rate hike, even as we have moved up our expected timing of a rate increase. We accordingly remain more conservative than the market consensus on the degree of tightening risks. Noteworthy points in the latest statement We think the key technical points in the latest policy statement are as follows: (1) The accompanying measures to keep interest rates from rising are generally within expectations. However, the policy directive somewhat surprisingly mentions an unsecured overnight call rate to remain at “effectively 0%” rather than “as low as possible”, as noted in the first ZIRP directive. In other words, the BoJ intends to continue to supply substantial liquidity to keep the call rate at effectively 0%, meaning that it will supply funds passively, in response to market demand. We thus think that concerns about a pullback in markets worldwide, stemming from a BoJ retreat on excess liquidity, are somewhat overdone. (2) The BoJ intends to reduce the outstanding balance of current accounts to the required reserve level of around ¥6 trillion over the next “few months”, a phrase with a slightly different nuance than the original Japanese. For this reason, overseas investors are more likely to have a hawkish view than domestic investors on the pace at which the BoJ backtracks on liquidity. The current account balances are very likely to be kept at above ¥30 trillion for the rest of the fiscal year, in light of the likelihood of a decline in operational balances. We accordingly do not expect the current account balances to reach the required reserve level of ¥6 trillion until three-and-a-half months after April, or July-August, which we see as the earliest timeframe for a rate hike. With a CPI base revision coming up in late August, we think the BoJ is unlikely to embark on a rate hike until it confirms that the revisions are as expected or not. In addition, for several technical reasons, we think it will be difficult for the BoJ to reduce the current account balances to ¥6 trillion while maintaining ZIRP. This is another reason why we think that a rate hike is likely to come later rather than sooner. (3) The BoJ maintained the applicable rate for the Lombard-type lending facility at 0.1% and the number of days it can be used at unlimited for some time. It also intends to maintain the current amounts and frequency of outright purchases of long-term JGBs (Rimban), again for some time. By using the phrase “for some time”, the BoJ seems to be looking for policy leeway amid all the rising political pressure it has faced. Market implications With US long-term yields backing up, oil prices softening and emerging market spreads widening, the expansion of liquidity worldwide appears to be slowing. However, we believe it is incorrect to link this trend with concerns about a contraction in liquidity because of the BoJ’s latest policy move. Indeed, the Japanese stock market has come under pressure because of these concerns (and in particular an unwinding of the yen carry trades) and the possibly of rate hikes, but the credit ratings of Japanese banks, which supplied substantial amounts of yen funds at a negative carry to much more creditworthy foreign banks in 1998, have improved substantially. We thus have some doubts about whether substantial yen carry trade positions have built up, as in 1998. During our recent visit with European investors, including a number of hedge funds, they all said they had not engaged in yen carry trades. In addition, since the BoJ intends to continue to passively supply substantial amounts of liquidity in response to market demand, to keep the overnight call rate at effectively 0%, we think that any near-term market pullback because of liquidity concerns would be a buying opportunity. The bond market will likely continue to run into headwinds because of speculation on the BoJ, driven by concerns about a prompt rate hike and amid a further uptrend in prices in March-April. An increasing lack of visibility on the short-term money market in conjunction with a reduction of the current account balances at the BoJ could increase short-term market volatility and affect the long-term zone. However, a weak CPI trend following the April CPI release in late May is likely to diminish early rate hike expectations. We accordingly see market weakness towards April-June as a buying opportunity. The yield curve has had a flattening bias, as in the US and Europe, but is likely to steepen, meaning outperformance for the short- and medium-term zones, as rate hike expectations diminish somewhat over the shorter time horizon. We see little likelihood of domestic and overseas investors’ commitment to Japan weakening or the markets coming under pressure from a downturn in stocks, bonds and the yen because of liquidity drying up with the BoJ’s latest policy move. Our equity strategist acknowledges that valuations are somewhat high, but still considers the market attractive in terms of the momentum of change and in light of the pullout from deflation. The decision to end quantitative easing reflects the BoJ’s belief that deflation will not come back again, which should not be a negative for Japan’s asset markets. Also, a slight rise in the policy rate makes it unlikely that investors’ risk preferences will change immediately. We need to remember that the BoJ’s policy rate in the bubble years was 2.5%, much higher than it is now.
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Demand for Duration - Coming Soon?
Mar 10, 2006
Richard Berner (New York) and Graig Fantuzzi (New York)
For the past two years, analysts like us have suggested that increased duration demand, primarily from defined-benefit (DB) pension plans, would contribute to a flatter yield curve. The logic: Looming changes to pension regulations would unmask the unworkable economics, accounting and risks of today’s DB plans, and thus be the catalyst for plan sponsors to shift their pension asset allocation out of equities to bonds, to lengthen bond portfolio duration, and, more broadly, to accelerate the trend away from DB to defined contribution (DC) plans. The combination would — at least temporarily, and other things equal — likely bid up bond prices and trim yields (see for example, “Pension Missiles: Is the Cure Worse than the Disease?” March 2004, and “Financial Market Implications of Pension Reform,” Global Economic Forum, January 18, 2005). So far, however, it’s been hard to find much evidence of such increased demand among US pension plans. To be sure, when a troubled sponsor has “put” its plan(s) in a distressed termination to the Pension Benefit Guarantee Corporation, the quasi-government agency that insures pension plans, the PBGC has shifted assets out of equities into bonds. That shift recognizes the bond-like nature of the cash flows for the terminated plan’s liabilities. But DB plan sponsors apparently haven’t made major changes to asset allocation, although some have sought duration in long-dated swaps and there is anecdotal evidence that some plans are increasing duration in fixed-income portfolios. And, of course, other things aren’t equal: While the yield curve has first flattened, and more recently temporarily inverted, there’s little evidence that pension plan actions were behind the move. That may now be changing. Pension legislation and accounting changes loom closer. Equity returns have often lagged accruals and discount rates are low, and more important, prospective returns seem unlikely to rise significantly. CFOs, in response, are deciding that DB plans are too expensive and are freezing entry to new workers and accruals for active workers. As recently as 2003, a PBGC study found that plan freezes affected only 2.5% of the participants in PBGC-insured plans. More recently, however, Verizon, IBM, Rentokil and GM have frozen or announced plans to freeze their DB plans for salaried employees. In our view, three developments mean that more freezes are on the way. That some large, well-funded plans have already announced or implemented freezes paves the way for others to follow. Congress is moving closer to adopting compromise pension reform legislation, and congressional leaders want to produce a bill by April 15. And the Financial Accounting Standards Board will likely soon publish a draft for public comment on its two-phase proposal to improve pension accounting. Such freezes eliminate the future promises from overall pension liabilities and retain only the legacy cost of past promises. Prospective DB liability cash flows are thus becoming more certain and thus more bond-like, and CFOs increasingly understand that duration-matching plan assets to those liabilities will take the risk out of the plan and eliminate the future volatility in income and shareholders’ equity that accounting changes probably will expose. So while the demand for duration hasn’t yet increased, change is coming. Assessing the prospective impact of such actions on US financial markets amounts to guesswork, because there’s no precedent for it here. And even if there were, disentangling these factors from all others influencing the yield curve is problematic. But we can try a variety of approaches. If they yield similar results, hopefully that suggests we’re on the right track. Among them: A survey-based attempt to scale prospective asset allocation, a look at the elimination of the long bond in 2001, and a look at the UK experience. First, we need to scale the likely size of the cash flows. To do so, we can ask plan sponsors how they would change their asset allocation in response to pension rule and accounting changes and try to gauge their market effect. In the 2004 study cited above, we used a 2003 survey of DB plan CIOs by the Committee on Investment of Employee Benefit Assets (CIEBA) to estimate the impact. Collectively, the asset allocation for CIEBA members is 60% equities, 30% fixed income and 10% alternatives. We calculated from the responses in the survey that changing accounting rules to eliminate smoothing of pension gains and losses and require companies to mark-to-market all pension assets annually for balance sheet and income statement presentation would prompt CIOs to shift 9 percentage points of their portfolios from equities into fixed income. Translated into dollars, private DB plans might reallocate $200 billion out of equities into bonds, and would double bond portfolio duration, in response to such changes. A similar survey conducted last fall echoed those results (see “Pension Reform: Impact on Defined Benefit Plans,” September 2005, http://www.afponline.org/pub/cieba/ciebapressrel.html). The new canvass suggests that accounting changes alone could trigger an 11.2 percentage-point shift from equities into fixed income, and to longer-duration bond portfolios. If lawmakers enacted reforms such as removing smoothing, requiring mark-to-market valuation on assets, and a yield curve approach to valuing liabilities without other changes, some 60% of respondents with ongoing and/or “open” plans indicated that they would freeze their plans. And if state and local pension plans were to mimic their private brethren, the asset allocation shift could be three times as large, or $600 billion, representing more than 3% of US equity market capitalization. But we can only guess at the scope and duration of the market impact of such changes. A second technique involves looking to history to gauge the potential market impact. The elimination of the 30-year bond in 2001 did seem to affect the yield curve, but controlling for the Fed’s aggressive easing, only temporarily, and not by much. The emergence of budget surpluses in 1998 led the Treasury’s debt managers first to buy back intermediate to long-dated Treasury debt starting in 2000, and in 2001 to suspend bond auctions. These actions changed the balance of supply and demand, and thus could represent rough benchmarks from which to judge the likely impact of changes in duration demand. Treasury announced the first buyback of 15 to 20-year debt on March 8, 2000. Between that date and 2002, Treasury conducted 45 buybacks totaling $67.5 billion. On October 31, 2001, Treasury surprised markets by suspending bond auctions. The move to surpluses and buybacks had little if any discernable effect on bond yields and the shape of the yield curve. Of course, the curve steepened dramatically during that period as the economy fell into a mild recession and the Fed eased aggressively. To control for that, we look at the implied regression of the yield spread between 10-year notes and bonds on 2-year note yields. The slope is characteristically negative, as the curve typically steepens as the Fed eases. The scatter plot confirms that the relationship held during the buyback period. In contrast, the surprise elimination of the bond did flatten the 10s-30s spread by 40 bp between October 30 and November 26 of 2001, but only temporarily, as the easing in policy again dominated the curve shape early in 2002. It is worth noting that the relationship may have changed again in February 2006 as pension funds were bidders for the new Treasury bond. "Private Pension and Retirement Funds and Insurance Companies" accounted for $2.9 billion and Investment Funds $5.7 billion of the $14.5 billion auction. In the past, the pension and retirement fund category for any auction has not been any higher than $300-400 million. But the jury is still out on whether it lasts. Finally, we could look to the experience of other countries to gauge the effects of duration demand. In the UK, stricter pension regulations and accounting rules than in the US likely did depress bond yields and invert the yield curve; that experience is thought to be a possible template for the US. Our colleagues David Miles and Melanie Baker show that UK real long-term yields have sunk to 300-year lows, and argue that current and prospective demand for duration by insurance companies and pension plans is the most likely culprit (see “Real Yields, Pensions and Prospective Demand for Bonds,” July 4, 2005). Together, such institutions hold nearly 70% of outstanding gilts (UK government bonds). In 1997, the UK Minimum Funding Requirement may have promoted some asset reallocation into bonds from equities, and since 2000 insurance companies have moved significantly in the same direction. The adoption of a new financial reporting standard — FRS 17 — and the Pensions Act of 2004, which was effective in December, has accelerated perceptions if not reality that UK plan sponsors will allocate predominantly into fixed income. Indeed, David and Melanie estimate that future demand could rise to 2½ times current supply. Analysis of distant forward rates confirms that perception: 10-year zero-coupon real rates 10 years in the future are a little more than 50 basis points, or about 100 bp lower than current 10-year real zero-coupon yields. That constellation of yields points to a significant impact on the UK yield curve from prospective increases in duration demand. All three of these approaches suggest that an increase in duration demand could flatten the US yield curve, but it has yet to begin and its magnitude is highly uncertain. Three factors account for the uncertainty. First, in response to the increased demand for duration and the need to de-risk plans, governments and corporations may increase supply, tempering the effect on bond prices. David’s and Melanie’s work suggests that the duration demand will tail off as DB pension plans shrink, so that governments may try to take advantage of the financing window in the next few years to lock in low-cost, long-term funding. That may be one reason that the US Treasury decided to bring back the bond as the curve flattened and the 10/30 year spread narrowed. For their part, CFOs who begin to think about pension liabilities as part of their capital structure may also step up issuance. In fact, our colleague Michael Peskin advises just that as a way to make explicit and get a market price on debt used to de-risk the pension plan and thus the plan sponsor. A second complicating factor is the response of plan sponsors to changes in interest rates. There’s no question that sponsors are moving to take risk out of DB plans, and duration matching would help them achieve that goal. If rates move somewhat higher, it would make such actions more attractive. But there’s a catch: Higher yields will also trim pension funding gaps, which could lessen the perceived need to de-risk plans. That potential response implies that the timing and magnitude of any portfolio shifts remains highly uncertain. A third set of forces will also make it difficult to assess the impact of increased duration demand, namely the interplay between the fundamentals of inflation, growth, and monetary policy and the behavior of term premiums. Three forces — one secular, and two cyclical — reduced term premiums over the past few years: Declining inflation volatility was a secular force. More recently, the Fed’s forward-looking policy guidance and the search for yield in a low-return world have been twin cyclical forces compressing term premiums and thus long-term yields. A more outlook-dependent monetary policy may reverse that decline. Thus, two opposing forces appear likely to shape the yield curve: A rebound in term premiums will likely drive yields higher in relation to short rates, but demand for duration may restrain the increase. The cyclical forces are now changing again, forcing a reappraisal of global bond prices and a “disinversion” of the yield curve. But stepped-up duration demand could soon limit the ongoing rise in yields and keep the curve flatter than it would otherwise be.
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Inflation, Turnover and RoE
Mar 10, 2006
Robert Alan Feldman (Tokyo)
What’s new: Turnover is starting to rise Turnover ratios (sales/assets) at large Japanese firms are starting to rise. I expect turnover increases to continue in many industries. (1) There remains much room for turnover to rise further. Asset cuts may be a source for some companies or industries. More important, however, will be the lag of asset growth behind sales growth, as deflation ends. (2) Investors may wish to start asking questions about differential effects of inflation on sales, costs, assets and liabilities. Such questions can aid forecasts of margin, turnover and leverage, and thus of RoE. Market implications: The floor under equities is thicker and more cushioned. Higher turnover will help raise return on equity further, and will cushion the impact of adverse movements of either margins or leverage, in my view. Risks: Slow end to deflation If deflation ends more slowly than expected, sales growth might not outpace asset growth by enough to push turnover meaningfully higher. In my view, the rebound of Japanese equities this week is based on more than the relief that the near-term debate on the BoJ is over. Rather, the prospect of continued increases in RoE is probably more important. Earlier, I discussed the pleasant prospects for margin and leverage, two of the three determinants of RoE. This piece discusses the third, turnover. Conclusion: Prospects for turnover increases are also good. The starting point is simple algebra: For turnover (sales to assets, S/A) to rise, either the denominator must fall or the numerator must rise. Let us consider these two possibilities. Bad news: Balance-sheet shrinkage cannot raise turnover Many investors still complain that Japanese companies still have excess cash. They don’t. At least not any more. Cash as a share of the balance sheet has fallen to about 6%, compared with a peak of about 18% in 1990 and an average of about 12% prior to the bubble of the late 1980s. For some firms, cutting cash may help. But in aggregate, I believe that cutting cash is not a good candidate to raise turnover. Nor can holdings of equities be cut easily. First, holdings of equities in the liquid asset category have gone to virtually zero. Second, the very large increase of equities held in the fixed asset category has lowered the flexibility of asset management, due to taxes and corporate relations from the boom in M&A. When cash is low and fixed assets are high, it is hard to raise turnover by shrinking assets. The good news: Sales should grow faster than assets Thus, raising sales will have to do the work in raising turnover. There are two ways that this can be accomplished. One is through better asset efficiency, a method emphasised by my colleague Naoki Kamiyama. From the macro side, another factor will also be important — the end of deflation. Over the last few years, the correlation between sales growth and asset growth has been quite volatile, but has remained sub-par, and well below 1. Hence, for at least a few more years, increases in sales are likely to exceed increases in assets. Thus, turnover is likely to rise further, in my view. Does higher turnover matter for equity valuation? On the surface, higher turnover implies higher RoE, and thus higher equity valuations However, there are two potential flies in this ointment. The theoretical objection relates to the difference between nominal and real values. In perfect markets, investors would ‘see through the veil’ of price changes, adjust all items on the balance sheet and income statement for the inflation rate, calculate ‘true’ margins, turnover and leverage, and value equities accordingly. This objection is valid in theory but fails miserably in practice. In the real world, asset and liability inflation is less volatile than goods price inflation. The next problem is practical: Does the sensitivity of turnover to inflation really make much difference? The effect is not huge, but it can be significant. For example, starting at actual values for sales, profits and balance-sheet composition for the large firms in the MoF Corporate Statistics, an elasticity of 0.7 for asset inflation versus goods price inflation will raise RoE by about 40bp, if sales grow by 10% Q&A for investors This analysis suggests questions for investors to ask companies as deflation ends. (1) What will be the differential between product price inflation and cost inflation? How soon will this differential emerge (or shrink), and how long will it last? (2) What will be the impact of inflation on the valuation of assets? How quickly will this occur? (3) What about liability inflation? Will you lock in long-term financing? (4) Will you adopt any policies to restructure shareholders’ equity, e.g., to reduce equity capital and raise debt capital?
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Euro-credibility Still at Stake
Mar 10, 2006
Oliver Weeks (London)
While the Slovak koruna has been relatively resilient in the recent wave of emerging market FX sell-offs, the National Bank of Slovakia (NBS) has significantly less room than neighbouring central banks to tolerate FX weakness. ERM membership and the 2009 euro entry target bring with them much the toughest inflation targets in the region. The likely exclusion of Estonia and Lithuania from 2007 euro accession underlines the need for the NBS to assert its anti-inflation credibility. Even after February’s 50bp hike, we think the market underestimates the need for further tightening. We are raising our year-end policy rate forecast from 4.0% to 4.5%, though we remain very positive on the longer-term scope for SKK appreciation ahead of euro adoption. Domestic demand booming: Real GDP growth in 4Q, at 7.6% year on year, was the fastest in Slovakia’s (admittedly short) independent history. Even without any revisions to previous quarters, 2005 GDP growth, at 6.0%, is already significantly above the 5.7% expected by the NBS in its January medium-term forecast. More importantly for the NBS, and in sharp contrast to the Czech Republic, the boom was overwhelmingly driven by domestic demand. Consumption by governments and households contributed around 4.0 percentage points to 4Q growth. Fixed investment added another 3.9 percentage points. Officially a rise in inventories added 3.7 pp and net exports made a negative 3.0 pp contribution. We would be slightly sceptical of the latter items. Inventories made a large negative contribution in 3Q when the net export contribution was hugely positive, and we suspect a degree of mis-measurement between the two, as we have seen in Hungarian data. Nevertheless, at best the net export contribution to growth is currently neutral, with the export-oriented FDI boom in Slovakia still at a relatively early stage and Peugeot-Citroen and Kia yet to start full production. Wage growth picking up: Also surprising on the upside has been wage growth. Real wage growth in the whole economy in 2005 was 6.3%, above the 6.1% NBS forecast and well above labour productivity at 3.7%. (The difference is reversed in the Czech Republic, with real wage growth up 3.5% but labour productivity up 5.2%.) While wage growth had appeared to be slowing after a boom in early 2005, December real industrial wage growth was revised up to 3.2%Y, and January has seen a further acceleration to 4.7%. With nominal wage growth back to 8.8%Y, there appears to be a danger that wage setting adjusts to what the NBS would argue is a temporary resumption of inflation. While top-down structural reforms have been rapid and official unemployment has fallen sharply, investment and labour demand continue to be heavily concentrated in the west of the country with its better infrastructure, suggesting to us that the labour market may still be effectively segmented. Although it is possible that micro-level restructuring will continue to restrain core inflation, as seems to be the case in the Czech Republic and Poland, the NBS has less room to take a risk, in our view. Inflation targets look highly challenging: Indeed, core inflation (defined in Slovakia as excluding regulated prices and tax changes) has accelerated from 0.5%Y in July 2005 to 1.9% in January. Taking food prices out of the core measure, (net) inflation had reached 2.5% in January, already in line with the top of the bank’s end-2006 HICP target. Importantly, Slovakia’s inflation targets, a 2.0% ceiling for end-2007 and end-2008, are much tighter than in neighbouring countries, reflecting a much stronger commitment to meeting the harsh Maastricht inflation criteria. The NBS January forecast already had end-2006 HICP at 2.8%, above target, and end-2007 and 2008 at 2.0%. Since then, January inflation has surprised significantly on the upside. We continue to see regional food price risks in particular as to the upside, given harsh recent regional weather and apparently extensive damage to winter crops after three years of unusually good harvests. We expect headline CPI to remain above 4.0% until September, and to end the year around 3.5%. The NBS has acknowledged that its real monetary conditions index loosened through the whole of 2005, and that this policy stance has accelerated the closing of the output gap in 2005 and will continue to do so in 2006. Monetary conditions still accommodative: While the breakdown of the bank’s monetary conditions index is not public, it is clear to us that the exchange rate plays the dominant role. At the time of writing, the SKK was back at early January levels, suggesting that monetary conditions are unlikely to have tightened significantly this year, despite last month’s rate hike. While we remain strongly bullish on the long-term prospects for SKK appreciation, there are several factors besides an EM correction that could restrain currency strength in the short term. Balance of payments data still seem somewhat unreliable, but terms of trade continue to deteriorate and the current account deficit continues to widen, with December trade data suggesting that the final 2005 figure will be closer to 7.5% of GDP than the 5.5% NBS forecast. This remains comfortably financed, albeit officially by short term-lending more than by FDI. However, we believe that privatisation inflows will stop before and likely for a significant time after June’s elections, and the government has hurt its reputation with direct investors by not honouring promises made by the previous Industry Minister. Short-term political risks for SKK: Potentially most significantly for the SKK, June’s election still implies a much greater level of political risk than elsewhere in the region. The overwhelming leader in the polls, Smer, remains strongly populist and at best ambivalent on the 2009 euro entry programme, but still looks more market-friendly than second-placed HZDS. Smer’s economic programme notes that “public debt is approximately 42% of GDP while the Maastricht criteria enables its increase to 60%. But Smer does fully realise the importance of introducing the euro within a reasonable and for Slovakia advantageous time…”. Promises to renegotiate indirect tax rises agreed with the EU, cancel energy price liberalisation, halt privatisation, raise agricultural subsidies, cancel pension reform and reverse labour market liberalisation imply that euro entry could well be delayed. In practice we expect significant compromises from Smer in a coalition with one or more experienced reformist parties. Nevertheless, we believe that Smer will almost certainly be the nominal lead partner and will at least require some reward for its reform-weary electorate, suggesting to us that fiscal risks remain very much on the expansionary side. EMU prospects on the bank’s shoulders: Any loosening of fiscal policy would further raise pressure on the NBS, which remains firmly committed to the 2009 EMU target. The unsurprisingly cold reception in Brussels and Frankfurt for Estonia and Lithuania’s pleas for flexibility on interpretation of the Maastricht inflation criterion underline the (excessively) tough challenge the inflation criterion represents. The NBS still has some credibility to make up in our view, after its failure to meet the quorum for a rate hike in January. New board nominee Tvaroska appears on the hawkish side to us, despite his government background (though any delay to his confirmation would effectively raise the six-vote hurdle for rate moves). Meanwhile, our Euroland colleagues continue to see ECB rates rising to 3.25% by 4Q at the latest. In this case, Slovak rates at 4.5% would raise the rate differential only 25bp between December 2005 and 2006. The risk on the other hand is that FX appreciation comes earlier than we think. We continue to expect euro conversion at a rate well on the strong side of the current central parity. On the generous assumption of a 25% pass-through, a 2pp reduction in inflation would simplistically require a sustained SKK appreciation to 34.5. A likely export boom in 2007-8 makes this eminently achievable, and indeed suggests that the NBS may eventually need to be quick to reverse rate rises, but for now we think credibility requires at least another 100bp of hikes.
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Why Are Nominal Cash Yield Differentials So Dominant?
Mar 10, 2006
Stephen L. Jen (San Francisco)
Yet Another Conundrum The conundrum I have in mind is the curiously tight relationship of the nominal cash yield differentials between countries to spot exchange rates we currently observe. This is a highly unusual relationship because, historically, the relative slopes of the yield curves, the curvatures of the yield curves and the real rates were all important for exchange rates. The simple hypothesis I propose for your consideration is that globalization of the capital markets has led to a world where the gross holdings of cross-border financial assets have expanded sharply. The bloated ‘balance sheets’ crossing different currency spaces have elevated the role of hedging, which is mostly done on a 1-3M rolling basis. Yield Differentials and Exchange Rates Historically speaking, cash nominal yield differentials have not had a systematic relationship with the spot exchange rate. This is not to say that there has been a systematic negative relationship between the cash yield differential and USD/JPY, as UIP would suggest. The shape of the yield curve also matters. The collapse in USD/JPY in 1994/95 was intimately related to the market’s judgment that the Fed was falling behind the curve on inflation. By discriminating the reasons for the rate hikes by the Fed (inflation or growth, reactive or proactive), investors bought or sold the dollar, depending on the situation. Investors certainly had not bought the dollar indiscriminately just because the FFR was high or was being raised. This is clearly not the case now. High inflation prints or high growth prints are all equally positive news for a currency these days. So long as investors think the monetary authority will raise the cash rate, they would buy the currency. A Simple Hypothesis that May Explain this Puzzle • Point 1. Globalisation of the asset markets. As the global financial markets become more integrated, countries’ ‘home biases’ have declined, and cross-border holdings of assets have risen sharply. Even if countries’ net external investment positions remained unchanged, countries now hold more foreign currency assets, and have more domestic assets held by foreign investors. In other words, the ‘balance sheets’ of assets held by domestic investors and foreign investors have grown. Gross security flows into and out of the US have become absolutely immense. Over the past decade, gross foreign transactions of US securities had eight-fold growth. At the same time, US transactions of foreign securities are running at a pace of around US$3.5 trillion, annualized, reflecting a three-fold increase over the past decades. The explosion in cross-border transactions may have led to large ‘balance sheets’ that are sensitive to hedging needs. • Point 2. Widening global imbalances have also been important. Large current account deficits require large external financing. If large C/A imbalances are indeed a natural consequence of a globalizing world, as I believe, then the capital account counterpart should also be a natural feature of a globalized world. As the US C/A deficit has widened, net capital inflows into the US have also risen sharply. (Point 1 is about the gross flows, while Point 2 is about the net flows.) The 12-month moving sum of net foreign capital inflows into the US surge began some time in 2003 and is currently running at around US$860 billion a year, double the amount since 2003. • Point 3. A sharp jump in foreigners’ holdings of Japanese securities. Since 2003, we have also witnessed an explosive surge in foreign investors’ net purchases of Japanese securities, primarily equities. As the Fed raises rates, with the BoJ lagging behind, the opportunity cost of not being hedged rises. Widening US cash yield premium should have pressured foreign investors in the Nikkei to raise their hedge ratios and Japanese investors in the US markets to reduce their hedge ratios. This could, in theory, enhance the tight link between cash yield differentials and USD/JPY. • Point 4. Popularity of carry trades. It is also possible that investors’ keen interest in putting on cash carry trades could have driven the whole process. In other words, investors like high cash yields so much that they push up the high yield currencies. My problem with this thesis is that it does not explain why investors do not care about long-bond yield differentials, only the cash yield differentials – i.e., that they are somehow risk-averse about duration exposure, but risk-seeking about currency exposure. Bottom Line Exchange rates have been unusually sensitive to changes in the nominal cash yield differentials. One possible explanation is that globalization of the asset markets has led to a sharp increase in cross-border holdings of securities. This, in turn, raises the need for hedging, the cost of which is dictated by cash interest rates.
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