United States
Will Labor Markets Tighten Further?
Apr 03, 2006

Richard Berner (New York)

Judging by the decline in the US unemployment rate to below 5% and the recent acceleration in wages, labor markets have firmed significantly.  The overall jobless rate has hovered at 5% or lower for the five months ended in February, and both survey evidence and results from the weekly canvass of jobless claims suggest that it may have dipped lower in the past month.  Average hourly earnings (AHE), meanwhile, have accelerated to a 3.5% clip over the year ended in February — a 5-year high.  While AHE is a flawed wage indicator, it likely does accurately indicate the direction of change (see “Will the Real Wage Measure Please Stand Up,” Global Economic Forum, January 6, 2006). 

Tighter labor markets and faster wage gains have obvious consequences for incomes and labor costs: They have promoted a pickup in nominal “core” consumer income growth to a 5-5½% rate, and have begun to lift the pace of unit labor costs (adjusting for the 2004 surge in option exercise that boosted taxable wage income in that year).  The question now: Will labor markets tighten further?  The standard US economic forecast calls for slower growth and a gradual rise in the jobless rate after midyear.  In contrast, I think the combination of stronger growth in hiring and relatively slow growth in labor supply will at a minimum keep labor markets tight through 2006, and that the risks point to further tightening.  Here’s why. 

Both demand and supply matter for the balance in labor markets.  Regarding demand, I think employment will quicken in coming months — though perhaps not in every month — as companies satisfy strong pent-up demand for hiring.  As one measure of pent-up demand, job opening rates (the availability of unfilled jobs relative to employment) from the Job Openings and Labor Turnover Survey (JOLTS) have reached new cycle highs in January, especially in information, transportation, finance, and manufacturing.  As I see it, therefore, what were hiring excesses now are deficits.  As a result, I believe that job growth will catch up with the economy this year, implying an “undershoot” in productivity growth (see “The Coming Productivity Undershoot,” Global Economic Forum, March 20, 2006).  Prospective job gains, nonetheless, are unlikely to match those in the hiring boom of the late 1990s.

While labor demand has lagged cyclical norms in this expansion, labor supply has lagged even more.  The labor force participation rate has declined by 1.2 percentage points from its peak six years ago, following a four-decade-long uptrend.  Whether this decline is a temporary or more lasting development is critical to the analysis of labor-market slack.  Some argue that lower participation, especially among younger workers, is largely cyclical, and that there is thus a reservoir of hidden and discouraged workers constituting substantially more slack in labor markets than the unemployment rate suggests (see Katharine Bradbury, “Additional Slack in the Economy: The Poor Recovery in Labor Force Participation During This Business Cycle,” Federal Reserve Bank of Boston, Public Policy Briefs, No 05-2).  And there are cyclical elements in the falling participation rate, which gathered momentum in the 2001 recession.

In contrast, I’ve long felt that the decline in the participation rate is mainly secular (see “Are Labor Markets Tight?” Global Economic Forum, July 22, 2005).  At work are three significant structural changes in labor markets.  First, the aging of the population is boosting the share in the population of groups that historically have had lower participation rates; this shift in composition is depressing aggregate labor force participation.  A new Federal Reserve study calculates that such shifts added about 0.6 percentage point to the aggregate participation rate between 1980-95, and subtracted about 0.4 percentage point between 1995-2005 (see Stephanie Aaronson, Bruce Fallick, Andrew Figura, Jonathan Pingle, and William Wascher, “The Recent Decline in Labor Force Participation and its Implications for Potential Labor Supply,” Brookings Panel on Economic Activity, March 2006).  More important, those demographic shifts may continue to depress labor force participation.

Second, the long upswing in female labor-force entry began to abate in the late 1980s and ended in the late 1990s.  The participation rate for women 20 years and older rose by more than 20 percentage points in the 40 years ended in 2000 but has since declined by nearly a point.  The peaking is especially obvious among women aged 35-44: Relative stability between 75-78% in that participation rate followed a rise of more than 30 percentage points through the 1990s.  That secular plateau in female participation probably won’t reverse.  Many women are apparently deciding to leave the labor force either to start families or to spend more time with their children.  Women with their own children under 18 years of age numbered about 36.5 million in 2004, and account for roughly half the female labor force between the ages of 20 and 54.  Their participation rate has dropped two percentage points in the past five years, and participation for those with kids under 6 years old has declined by even more.  Whether due to poor job prospects, greater affluence, or other reasons, women in greater numbers are choosing families over paying jobs.

Nor is a third secular factor reducing the labor force likely to change.  Teenage labor-force participation has been in decline for nearly 30 years; it’s safe to say that the trend is well established.  From a peak of 72% in the mid-1970s, teen (ages 16-19) participation rates plunged to 53% last year.  A study by the Bureau of Labor Statistics suggests that, at least since 1994, teens are putting more emphasis on school, both in the summer months and during the school year (see “Declining Teen Labor Force Participation,” Bureau of Labor Statistics, Issues in Labor Statistics, September 2002).  While those data may exaggerate the focus on scholastic endeavors, summer school teen enrolment rates jumped from 19.5% to 27% between 1994 and 2000 — a period of booming job growth.  Clearly this trend has little to do with jobs being easy or hard to find.

Cyclical factors also matter, and as I see it, labor force participation likely will get a cyclical lift.  But participation rates will only rise as labor markets tighten and pay rises enough to make the payoff from looking for a job worthwhile.  It’s possible that this upswing has begun already, with the participation rate for adult men up about half a point from its recent trough.  Closer inspection, however, reveals that the increase is concentrated among men 55 years and over.  That is partly the product of shifts in the age profile of the population, as the oldest baby boomers, who are likely to keep working, approach 60 years of age.  While working longer will be an important new trend, that cohort is still small and is unlikely to change quickly.  In addition, Fed authors cite evidence that labor force participation may have gotten a temporary cyclical lift in the 1990s from welfare reform, and the end of that boost may have unmasked the underlying trend in participation. 

In all, while cyclical factors may boost labor supply, labor markets likely will remain tight and wages probably will accelerate further.

For fixed-income investors, these developments have a clear bearish bias.  But with the recent sell-off in bond markets, much of our previously above-consensus calls on inflation and the Fed are now in the price.  For now, that rise in yields warrants a neutral investment stance; indeed, weak data could promote a near-term rally.  But markets are still vulnerable to a further tightening in labor markets and acceleration in wages.  The combination would probably fan concerns that inflation risks are rising and consequently that the Fed has still more work to do.

Near-term economic risks point to somewhat slower growth and no immediate inflation pickup.  In fact, a pre-Memorial Day surge in gasoline prices — boosted by recent refinery shutdowns and shortfalls in supply resulting from changes in gasoline additives to meet new environmental standards — may magnify the coming spring growth “payback.”  Beyond that period, however, strong job and income gains, hearty global growth, and a rise in term premiums point to upside risks to US growth, inflation, and interest rates.

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United States
Review and Preview
Apr 03, 2006

Ted Wieseman (New York) and David Greenlaw (New York)

The Treasury market had its worst week in five months the past week, taking big long-end led losses as investors significantly raised their expectations for the near-term hawkishness and lowered expectations for the medium-term dovishness of Fed policy after the FOMC left the key part of its official policy statement unchanged following its universally expected hike in the funds target to 4.75%. This outcome was right in line with our expectations — and from our perspective the current language affords the Fed plenty of freedom to pause the rate hiking cycle as early as May, if the data call for such a step, though we expect it won’t. Investors, for some reason, were looking for a significant dovish shift in the language pointing to an imminent end to rate hikes. The bear steepening nature of the ensuing sell-off was a bit surprising in the context of a major ramping up of near-term Fed expectations. The market now sees a hike in May as essentially assured, we think, and a move to 5.25% not long after as likely.  Apparently it had some more technical elements to it tied to supply, curve flattening trade stop outs, and swaps paying. But increasing inflation jitters were also in evidence as the market fell hard after an upward revision to the Q4 core PCE price index, despite almost all of the adjustment being in quirky non-market components. And in a notable change in investor behavior, when a large swath of the off-the run bond sector broke through the 5% yield level, the move was met with investor liquidation rather than the buying that had on previous occasions during this year’s bond bear market seemed to mark 5% as a ceiling on yields.

Benchmark yields surged 13 to 20 bp over the past week, and the curve steepened fairly uniformly, with just a minor relative underperformance by the 5-year. Inexplicably, just before the FOMC’s announcement on Tuesday afternoon, all the benchmark yields were sitting below 4.75%.

But within seconds afterwards, they were all well above it -- they kept moving farther above over the next two days until a very small bounce off the lows Friday. Looking at the old 2-year, 2’s-30’s rose 7 bp, as the old 2-year yield rose 13 bp to 4.84%, and the long bond yield spiked 20 bp to 4.90%. March was a brutal month for the revived 30-year, whose yield closed at just above 4.50% on February 28, bringing its total return for the month of March to nearly -6%. The 3-year yield rose 15 bp to 4.82%, the old 5-year 17 bp to 4.835%, and the 10-year 18 bp to 4.85%. The new 2-year and 5-year issues each ended the week about 2 bp rich to the old issues and both were in the red. The new 2-year closed Friday at 4.82% after being auctioned Monday at 4.73%, while the new 5-year ended the week at 4.81% after being auctioned Wednesday at 4.785%. Note that in late trading Friday, off-the-run bond yields all the way from 2018 maturities through the old February 2031 benchmark were yielding more than 5%, while peak yields in long dated strips were near 5.15%.

  From our perspective, the outcome of the FOMC meeting was just as expected. The FOMC hiked the fed funds rate by 25 bp to 4.75% and maintained the “further policy firming may be needed” language. Indeed, this portion of the statement was identical to the January version, also including the phrasing that made clear what Fed officials have been stating publicly for months: that policy is becoming increasingly data dependent – “the Committee will respond to changes in economic prospects as needed” to achieve its growth and inflation objectives. We believe that the current statement contains sufficient flexibility to allow the Fed to pause if the incoming data point it in that direction. But we expect the key releases leading up to the May 10 FOMC meeting – specifically, Q1 GDP, Q1 ECI, and the April employment report – to provide sufficient ammunition for another 25 bp rate hike. And while we believe that the Fed will then pause at 5%, we look for a gradual pick-up in core inflation over the balance of the year, leading to at least one more rate hike at some point down the road.

By week end, after a big adjustment, this view was in large part mirrored in near-term futures pricing. The May fed funds contract sold off 3.5 bp to 4.92% and the June contract 4.5 bp to 4.98%, just about fully pricing in a 25 bp hike to 5.00% at the May 10 FOMC meeting. While we believe this will indeed happen, we do not think it is the sure thing the market now seems to believe. If the data were to disappoint over the next five weeks, the current Fed language would certainly seem to provide enough flexibility to remain on hold at 4.75% in May. Beyond May, the futures market now sees 5.25% as the likely peak in the funds target at one of the next few meetings, with the July fed funds contract off 9 bp to 5.075% and the September contract losing 13 bp to 5.15%. The market also ratcheted back a bit its expectations for the dovishness of Fed policy beyond that likely 5.25% peak. The September 06 to September 07 eurodollar futures spread steepened 2 bp on the week to -12.5 bp, with the former contract off 14 bp to 5.26% and the latter 16 bp to 5.135%. Quite sensibly, in our view, the biggest unwind of the eurodollar inversion was in late 2006/early 2007, with the spread between the Sep 06 and Mar 07 contracts steepening 4.5 bp to -5.5 bp, as the March 07 contract sold off 18.5 bp to 5.205%. While we expect the Fed to go on hold after hiking the funds target to 5.25% in September, we expect that for some time they will be on hold with a tightening bias. A move to 5.25% would put policy in a modestly restrictive stance, in our view, and eventually set the stage for some modest easing well down the road in late 2007 as growth slows toward trend and inflation pressures abate, but we believe it unlikely that any such reversal will come as early as 2006Q4 or 2007Q1 and think that that Sep 06 to Mar 07 spread should continue to disinvert over time and, in general, the starting point of the inversion in the eurodollar curve be shifted further forward.

Aside from the FOMC meeting, economic news the past week was light and somewhat mixed, with significant strength in consumer confidence and regional manufacturing surveys, but a worse than expected composition of the fourth quarter GDP revision that led us to trim our Q1 estimate marginally. Uniform strength was seen across all three major consumer sentiment surveys. The Conference Board’s measure rose 4.5 points in March to 107.2, the highest reading since May 2002. The University of Michigan index for all of March was revised up to 88.9 from the early month reading of 86.7. This represented a similarly solid 3.2-point gain on the month. And the ABC News/Washington Post poll improved to -7 in the four weeks through March 26 from -12 in the four weeks through February 26, matching the best reading since late 2004. Improvement in the Conference Board survey was broadly based, with the current conditions index up 3 points to 133.3 and the expectations gauge 5.7 points to 89.9. Views of the current job market showed modest improvement, with the percentage of respondents describing jobs as “plentiful” up a point to 28.4% and the percentage describing jobs as “hard to get” up a half point to 20.7%. Expectations for future job growth showed a larger improvement, with the percentage of respondents expecting “fewer jobs” in six months falling 3 points to 16.6% and the percentage expecting “more jobs” up a half point to 13.9%.

Ahead of Monday’s ISM report, more good news on manufacturing conditions came in from the Fed Districts, with very strong results from Richmond and Kansas City adding to the prior week’s upside in Philadelphia and New York. Converting all these surveys to ISM-comparable weighted averages of the key components rebased to a 50-breakeven scale, we calculate that the Kansas City Fed index would have risen to 58.6 from 54.9, Richmond to 58.6 from 50.4, Philly to 57.5 from 56.9, and Empire State to 62.7 from 58.8. With these regions unanimously pointing to strength in manufacturing sector activity in March, we upped our ISM forecast a half point to 57.5 (v. the surprisingly strong 56.7 reading in February), which would be the high since the post-hurricanes spurt in activity in October.

Real GDP growth was revised up to +1.7% in Q4 from the +1.6% preliminary reading. This was very close to expectations, but the details were not, with a surprising downward adjustment to final sales to -0.2% from 0.0% offset by a larger than expected upward adjustment to inventories (+$37.9B v. +$30.4B). This was the first decline in final sales since 2000Q1 and resulted from small downward adjustments to consumption (+0.9%) and business investment (+4.5%). Incorporating this negative mix shift, mixed results from the factory orders and personal income and spending reports, and our estimate for the February trade deficit (-$68.0B v. -$68.5B in January), we trimmed our Q1 GDP estimate a tenth to +4.1%.

Inflation news from the GDP and personal income reports was negative on a headline basis, but much less so looking at the underlying details.

With the negative tone the market adopted post-FOMC, however, regardless of any mitigating details, an upward revision in the Q4 core PCE price index to +2.4% from +2.1% helped spark a significant sell off Thursday.

  From our standpoint, this change was not all that big a deal because it mostly reflected adjustments to a couple of quirky, non-market based items — nonprofit hospitals and imputed financial services. The more reliable market-based core PCE measure was revised by only a tick — from +1.8% to +1.9%. Carrying these data forward into February in the monthly personal income and spending report, the core PCE price index rose 0.1% in February, matching the core CPI outcome. On a year/year basis, the core rate held at +1.8%, the low since March 2004. The market-based core PCE measure has been more benign, rising 0.1% the past four months and holding at +1.5% year/year in February, right in the middle of the Fed’s 1% to 2% “comfort zone.” We expect core inflation to drift higher over the course of the year and look for the market based core to reach +2.2% by year end. But current benign readings are not providing any barrier to the near-term pause in the Fed’s rate hiking cycle we expect after May.

There are a number of key data releases due out in the coming week, highlighted by the employment report on Friday and ISM Monday. Key early indicators of March consumer spending will seen in motor vehicle sales results Monday and chain store sales Thursday. Construction spending will also be released Monday.  We expect the March ISM to rise a bit less than a point to 57.5. The regional surveys for March pointed to some broadly based improvement in conditions — especially after adjusting to an ISM-weighted basis. So we look for a modest uptick in the ISM diffusion index on top of the solid rebound posted in February. The price gauge is expected to show some modest slippage, as it continues to retrace from the October peak.

We look for a 0.8% rise in February construction spending. The January data showed a considerable disconnect between housing starts (which soared nearly 16% — the sharpest jump in more than a decade) and construction activity (which inched up 0.2% — the smallest gain in seven months). Historically, the construction data sometimes appear to be impacted by reporting lags. So even though housing starts plunged in February as weather conditions turned much less favorable, we look for some catch-up in construction expenditures.

Industry reports point to a slight uptick in motor vehicle sales in March to 16.7 million units annualized from the 16.5 million unit pace seen in February. Sales are expected to be restrained by a further pullback in fleet deliveries along with a reported delay in availability of a new line of SUVs. Still, underlying activity appears quite healthy despite the apparent lack of pent-up demand.

We forecast a 160,000 gain in March nonfarm payrolls. Even though the underlying pace of job growth appears to have accelerated in recent months, we remain surprised by the sharp 243,000 gain in February payrolls. In particular, the 41,000 jump in construction jobs does not seem consistent with the deterioration in weather conditions and other February data — such as housing starts. In addition, the nearly 40,000 rise in government jobs posted last month is unlikely to be repeated. So, even if the underlying pace of employment growth is now running at 200,000+ per month, we look for a below-trend result in March.

Meanwhile, the workweek is likely to rebound following a suspected weather-related downtick in February. And, average hourly earnings should show some moderation on the heels of some recent acceleration. We look for the monthly jobless rate to tick back down to 4.7% due, in part, to a seasonal quirk that should help depress the labor force participation rate. Finally, keep in mind that this report is being released shortly after the March FOMC meeting, whereas the next report will be published a few days ahead of the May meeting and thus is likely to have more influence on the policy landscape.

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Currencies
A Lower USD/KRW Through Contagion
Apr 03, 2006

Stephen Jen (Tokyo) and Sharon Yeshaya (Hong Kong)

Divergence in Domestic and International Factors

From the perspective of Korea’s domestic factors, downward pressure on USD/KRW is abating.  If anything, in the near term, there is the risk that lumpy outflows may push USD/KRW a bit higher.  However, if we are right and USD/JPY and USD/CNY trade lower by year-end, USD/KRW will likely trade lower in sympathy.  In other words, we believe that international factors will overwhelm domestic factors in Korea.  We maintain our year-end target of 920 but are now looking for modest upside risks in the coming two to three months. 

A Restatement of Our View on USD/KRW

In January, we declared our constructive outlook on all Asian currencies, against both the USD and the EUR.  A strong global economic backdrop, a gradual decline in USD/CNY and a sharper fall in USD/JPY are all important factors in our consideration for the trajectory for USD/KRW.  USD/KRW itself is not that mispriced.  In fact, its median fair value is around 1,030, according to our fair value framework.  However, a meaningful appreciation in both JPY and CNY will likely push USD/KRW deeper into slightly overvalued territory.  Our year-end target is 920.

Key Thoughts on USD/KRW

Reassessing our call for USD/KRW, although we reaffirm our bullish view on KRW by year-end, we now see some upside risks to USD/KRW in the coming two to three months.  We make the following points:  

Point 1.  The economy and the balance of payments (BOP) are fairly balanced right now.  Last year, domestic demand was weak while external demand was strong.  With the resurgence of the housing market and the delayed effects of monetary stimulus from the past two years, consumption has begun to recover, leading to a healthy increase in imports.  Though capex has remained weak, it is expected that strong consumption will encourage firms to invest.  Inflation remains well contained and the inflation targeting policy appears successful. 

On the external front, despite the KRW’s strength, exports have continued to perform well.  But, as mentioned above, imports have accelerated, leading to a compression in Korea’s C/A surplus.  Thus, from both the balance of growth and the balance of payments perspectives, downward pressures on USD/KRW are abating. 

Point 2.  Exporters are under some pressure from the strong KRW.  Many exporters are complaining that the recent range of 960-985 is too low and is near their tolerance threshold.  This perception has affected the way exporters hedge through forward USD/KRW sales.  Last year, exporters were reported to have been quite aggressive in selling USD/KRW forward.  But there are signs that exporters are, at the current levels, more ‘picky’ on price, and interest in selling USD/KRW at 970 has abated sharply. 

Point 3.  Two motivations for capital outflows that could lead to upside risks to USD/KRW in the short term.  As we discussed in KRW: Dividend Remittances Resurface, March 16, 2006, Korean officials have suggested KRW strength may moderate in the coming months as 2005 annual dividends are paid out to foreign investors.  In addition, the impending sale of a foreign shareholder’s stake in KEB (Korea Exchange Bank) to a Korean bank may lead to a fairly large-sized capital outflow.  Most expect that the foreign stakeholder will try to complete this transaction by end-June, amid new tax measures that will take effect on July 1, 2006.  Although we identify some risks to these flows, if they do materialise, they are likely large enough to impact prices and sentiment.  Thus, in the coming two to three months, there could be some upward pressures on USD/KRW. 

Point 4.  However, we continue to believe that USD/KRW will eventually trade to 920 by year-end.  First, we are not convinced that today’s exchange rate reflects a major KRW overshoot.  The current misalignment is not big enough to be a powerful driver for USD/KRW.  Some have described the sell-off in USD/KRW in January as unjustified by the economic fundamentals.  However, if the sell-off in USD/KRW were really unjustified, why has it not traded back above 1,000?  Second, export growth has remained fairly healthy, despite the strong KRW.  The non-price-competitive factors have kept the more innovative and productive exporters profitable, and a stronger KRW should continue to facilitate the ongoing restructuring and upgrading of Korea’s corporate sector.  Third, with declining USD/JPY and USD/CNY and it will be difficult for KRW not to follow.  Even though the precise economic mechanism behind this move is unclear, international investors are likely to push USD/KRW lower. 

Bottom Line

From the perspective of Korea’s fundamentals, downward pressure on USD/KRW is abating.  If anything, lumpy outflows may lead to modest upward pressure on USD/KRW in the next couple of months.  Further out, however, we continue to expect USD/KRW to trade towards 920, if USD/JPY and USD/CNY trade lower as we believe they will.

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Currencies
CAD in Overshoot Territory
Apr 03, 2006

Stephen Jen (Tokyo) and Luca Bindelli (London) and Charles St.-Arnaud (London)

CAD Is Quite Expensive

With the recent sell-off in AUD and NZD, CAD is now one of the more overvalued G10 currencies.  In our view, it is increasingly difficult to justify a new low in USD/CAD.  From a structural perspective, USD/CAD should trade in the mid-1.20s.  Our March 2007 forecast remains 1.22, primarily to reflect this view. 

Impressive Performance of CAD Since 2003

In the past three years, USD/CAD has declined from 1.56 to a low of 1.13.  While, AUD and NZD also appreciated strongly against the dollar since 2003, CAD has continued to rally against USD, AUD and NZD in the past year.  Some of the earlier move in USD/CAD reflected general weakness of the dollar.  However, we believe that CAD is now in overvalued territory, and it will be difficult to justify further CAD strength. 

CAD Overvalued

Our standard 13-models fair valuation (FV) framework has long suggested that the FV of USD/CAD is likely to be in the mid-1.20s. In an attempt to better capture the country-specific considerations for Canada, we propose an alternative FV specification.  Yet, we find that CAD is even more overvalued according to this unique specification.

Why Some Investors Are Still Bullish on CAD

First, most investors don’t put too much emphasis on fair value calculations, as they assume that markets always efficiently price in the economic fundamentals, and the future movements in USD/CAD are driven by the expected evolution of the ‘right-hand-side’ variables. 

Second, the Canadian economy is performing strongly. Unemployment has fallen to a 30-year low, while underlying inflation has been contained.  Both the fiscal and trade balances are in solid surplus.     

Third, commodity prices, particularly energy prices, are generally expected to stay strong.  There has been a long-run positive relationship between non-energy commodity prices and CAD, while energy prices do not show consistent support to the CAD until recently. If the world’s appetite for commodities remains strong and Alberta’s immense oil sands reserves remain financially viable, then CAD should remain strong, in our view. 

Fourth, generally bullish expectations on the future trends in commodity prices and angst concerning shortages of energy supply may continue to propel FDI inflows into Canada.   

Fifth, the CAD is distinguishable from AUD and NZD in the important respect that the former is a capital-surplus currency, while the latter are currencies of countries with large C/A deficits.  As the central banks of the capital-surplus countries tighten, the currencies of the capital-deficit countries should suffer. 

Why Do We Suspect USD/CAD May Have Bottomed

While we agree with the fourth and fifth points above, we take issue with the first three reasons to be bullish on CAD at these levels. 

•              Point 1.  Valuation matters, because exchange rates get misaligned, more often than not.  According to our 13-specification FV framework, CAD has been overvalued since late 2004, and the alternative FV model actually shows that USD/CAD may be up to nearly 15% mispriced.

Further, a source of misalignment may be due to speculative short positions in USD/CAD.  Long CAD positions have been very sizeable for some time.  In fact, CAD long positions have been substantial since April 2005, when CAD began to outperform everything else.  As these CAD long positions are unwound, we expect CAD to converge toward its FV. 

•              Point 2.  The BoC may now be sensitive to CAD strength.  Exchange rates matter for commodity exporters, as we can see by looking at New Zealand. While we are not arguing that the strong CAD will push Canada into a recession, we believe that the impact of a strong CAD on Canada’s exports is meaningful. 

When USD/CAD approached 1.10, the BoC may have been more concerned about the CAD than many realize.  In fact, this concern was probably one important reason behind the latest change to the statement and its direct reference to CAD.  We suspect that the BoC’s strategy could be to talk down the currency to remove some speculative pressure.  Its signaling of a pause, in this light, does not seem surprising to us. 

Furthermore, there has been a subtle but important shift in the underlying dynamics supporting CAD.  In the past few years, commodity prices were strong and rising.  This was supportive for Canada’s aggregate demand.  However, more recently, support for the CAD has shifted to capital flows going into Canada.  Whether CAD is supported by higher commodity prices or capital flows makes a big difference for monetary policy, in theory. 

•              Point 3.  While the argument that the higher the commodity prices, the stronger the CAD should trade is correct, the market seems already to have an overly aggressive expectation on the future trajectory of non-energy commodity prices.  It is far from clear that, as the US housing cycle soft lands, and central banks normalize rates, commodity prices will surge substantially higher.  This is a judgment call, we concede.

Bottom Line

We believe that CAD remains in overvalued territory; the medium-term fair value of USD/CAD is in the mid-1.20s, in our view.  We are likely to have seen the low in USD/CAD.  Our March 2007 target remains 1.22.  

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Turkey
(Dis)appointment
Apr 03, 2006

Serhan Cevik (Istanbul)

The (dis)appointment of a new central bank governor has turned into a source of uncertainty. As the latest national accounts show, the Turkish economy remains on a strong growth path. Real GDP grew at an annual rate of 7.4% in 2005, even exceeding our above consensus estimate of 6.2%, and posted a cumulative increase of 33.5% in the past four years. Although economic normalisation will keep sustained growth and disinflation intact, the uncertainty surrounding the appointment of a new central bank governor may still lead to an adverse shift in expectations (of not just market participants but all economic agents) and consequently may have a disproportionate influence on economic and financial outcomes. The risk of such an expectation shock — always present, especially, in a dollarised system — is now higher because of global portfolio reallocations. In our opinion, Turkey has come a long way in terms of macroeconomic stabilisation and is strong enough to withstand ‘unexpected’ exogenous shocks. Nevertheless, the consolidation of past gains and the internalisation of new targets still need further institutional progress and policy continuity.

Monetary policy credibility is necessary for price stability and lower risk premium. With a history of macroeconomic instability and, especially, after a devastating crisis, the only possible way to put the Turkish economy back on a sustainable growth path was fiscal consolidation addressing distorting excesses and the introduction of a credible monetary policy focusing exclusively on price stability. And it has indeed worked even beyond the most sanguine expectations. The independent central bank, supported by prudent fiscal policies and structural reforms, has been successful in lowering Turkey’s chronic inflation from the post-crisis peak of 73.2% at the beginning of 2002 to single-digit territory in just two years. The resulting improvement in credibility of monetary and fiscal policies has in turn helped anchor long-term inflation expectations to price stability and further influenced the behaviour of inflation. In other words, the expectation-driven regime switch from the vicious circle of the 1990s to today’s virtuous paradigm has become the foundation for sustained disinflation and economic growth.

The central bank is and must remain the guardian of economic and financial stability. With the narrowing credibility gap, both nominal and real interest rates have declined to the lowest levels in decades, lowering the Treasury’s borrowing costs and improving the efficiency of investment decisions in the private sector. Therefore, achieving — and maintaining — price stability must remain the ultimate objective of monetary policy. In addition to volumes of international studies, Turkey’s own experience has shown that the least costly route to price and output stability requires the central bank’s independence from political cycles. Indeed, the independent central bank, with an unambiguous mandate to maintain price stability, has overcome the problem of time inconsistency and brought inflation expectations in line with multi-year targets. In return, we have witnessed a dramatic reduction in the volatility of inflation dynamics and its sensitivity to currency fluctuations. This is why we are concerned by political challenges to the institutional integrity of the central bank and the continuity of monetary policy that has been exceptionally capable in stabilising the economy.

Even the prospect of reputation loss would damage policy credibility. Policy credibility takes a long time to build, but can be easily compromised. Unfortunately, recent disappointments, turning into a war of attrition, may have already resulted in a loss of reputation. The central bank, unlike other state institutions, has the unique responsibility of safeguarding economic and financial stability, especially when politics compromise price stability. This is why the quality of leadership is as important as the strength of the institutional framework of the central bank. A governor who is considered a party associate would probably not be able to convince market participants that his or her actions are solely based on economic considerations, not political priorities. That would distort expectations and lead to a higher risk premium.

So who should be at the helm of the Central Bank of Turkey? The law is clear on the required qualifications, but the smoothness of the appointment process also depends on four circles of power — economic priorities, the ruling party’s internal politics, the presidential oversight and the perception of market participants. In other words, the real qualification map of a successful candidate overlaps all four circles of influence. There are, of course, a number of trade-offs in determining the most appropriate candidate. For example, the government’s first choice —a reflection of party politics, we think — failed because of the presidential veto, but would probably not have been successful, even if appointed. In our view, among all the available candidates, two names — Erdem Basci, the acting governor of the central bank, and Ibrahim Canakci, the Treasury undersecretary — fulfil the formal and de facto requirements. Since Mr. Canakci’s appointment would lead to the challenge of finding a new undersecretary to the Treasury, we think Mr. Basci should become Turkey’s new central bank governor.

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Israel
As Good As It Gets
Apr 03, 2006

Serhan Cevik (from Tel Aviv)

The election result may be weaker than poll predictions, but is as good as it can get in Israel. Opinion polls, even just a day before the election, were predicting a consolidation in voting behaviour and a decisive victory for Israel’s new centrist party, Kadima, formed late last year by Ariel Sharon. However, judging from the outcome, it seems that the pollsters’ hit ratio does not rank highly, even compared with the prediction record of meteorologists and, let’s be honest, economists. Kadima’s success, albeit enough to become the leading party with 28 seats in the 120-seat Knesset, was not as overwhelming as polls predicted. Seismic shifts in the political landscape, such as Sharon’s disengagement from Likud and a left-wing leader in charge of Labour, resulted in an unprecedented number of undecided voters and made the task of prediction more challenging. In addition, the record low voter turnout influenced the distribution of parliamentary seats in favour of sectarian and single-issue parties. Nevertheless, the election results — making a four-month-old party the leading player and giving a bunch of pensioners unexpectedly strong presence in the parliament — clearly show that the great majority of voters, moving away from the ‘Greater Israel’ demagogy, is interested in security and prosperity.

Israel has always been governed by a coalition, and this time is no exception. Because of the country’s electoral regime that limits the extent of political consolidation, no party has ever won an outright majority of 61 seats in the Knesset and marginal groupings usually play a critical role in coalition negotiations. The latest election outcome presents a similar outlook, but there is one major difference that will shape the strategy in dealing with territorial conflicts and economic policies. That is, Israel’s political establishment — Likud and Labour getting 11 and 20 seats in the Knesset, respectively — can no longer dominate the agenda. This means that even though sympathy votes supporting the Sharon legacy was not enough to push Kadima above the ‘victory threshold’ of 35 seats, the ‘right’ is not strong enough to block new political openings and the size of Kadima’s presence relative to other groupings is still enough to maintain stability in the foreseeable future. At this juncture, the widely-expected scenario is a pro-withdrawal coalition of Kadima, centre-left parties (Labour, Meretz and Gil) and some of the religious groupings (like Shas). Of course, forming a coalition is never an easy assignment, especially in country where 12 different parties have representation in the 120-seat parliament, and therefore may involve some degree of deviation from the existing set of policies, hopefully, for the greater good.

Increasing ‘social spending’ would not automatically address socio-economic problems. The election was seen as a referendum on unilateral withdrawals from the Palestinian territories, but also showed that voters care about socio-economic issues. The way politicians opt to address such concerns will of course have economic and financial implications. Religious parties, for example, demand ever-increasing transfers and subsidies, while the ‘new’ Labour wants to introduce a whole new social contract including a dramatic increase in the minimum wage. Even though market participants would not necessarily object a pro-poor growth agenda, the authorities need to explain the sources for (and long-term economic benefits of) funding such ‘social’ schemes. In our view, Israel’s two-track growth performance and social problems arise from structural shortcomings and therefore cannot be addressed, on a sustainable basis and without damaging the fiscal stance, by welfare transfers. Take, for instance, the issue of poverty and income inequality. If you exclude the ultra-orthodox segment of the society in which poverty is by choice, Israel’s socio-economic conditions are actually improving at a gradual, but steady pace.

The state of the economy is strong enough to withstand limited political jolts. Regardless of rational assessment of campaign promises, the post-election negotiations to form a working coalition will no doubt necessitate some changes in the current set of fiscal policies. Nevertheless, social spending must remain within a sustainable budgetary framework and not result in economic distortions. All in all, we believe that the Israeli economy is strong enough to withstand limited political jolts and the election outcome indeed presents an opportunity to address the biggest threat of all — peace and security.

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Thailand
February Trade Acceleration
Apr 03, 2006

Deyi Tan and Denise Yam

February Acceleration: On a balance-of-payment-basis, exports rose 23.3%YoY (vs +14.5%YoY in January), partly on a weak base.  Imports expanded 15.3%YoY (vs +0.4%YoY in January).  The trade deficit was smaller than expected at US$24mn (vs US$388mn in January).  For the Jan-Feb period, export momentum accelerated to 18.9%YoY (vs +11.0%YoY in 4Q), although imports moderated to 7.4%YoY (vs +19.7%YoY in 4Q).

Strong Performance in Machinery Exports: On a customs basis for which product breakdown is available, the key export segment, machinery, leapt 31.9%YoY (+14.2%-pt).  Meanwhile, manufactured goods expanded 7.3%YoY (+1.3%pt).  Meanwhile, given the 65-85% import content in electronics and electrical appliances exports, machinery imports also rose 18.8%YoY.

Demand Contribution Broad-Based Across Markets: The export growth contribution across markets was quite even. In particular, exports to the US (+22.9%YoY and +3.5%-pt), China (+41.1%YoY and +3.0%-pt) and the EU15 (+15.4YoY and +2.2%-pt) were robust. Meanwhile, net services and transfers stood at US$690mn, likely reflecting the tourism rebound we are seeing.

Political Impact: The current political gridlock could cause the mega infrastructure projects to be delayed, likely until the new government is formed under the new constitution.  As it is, the scheduled investment amount has been cut from the original Bht$250bn to Bht$150bn for 2006.  A delay in the projects would soften the need for capital intake and moderate the current account deficit, which we are now expecting at US$4.0bn or -2.1% of GDP

 

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