The Global Price Rule
Apr 10, 2006
Stephen Roach (New York)
The momentum of liquidity-driven markets always lasts longer than you think. Now it is getting ridiculous. Markets have taken on an almost impervious aura. That continues to be the message from low volatility in equities, generally stable currencies, and historically tight spreads in risky assets such as emerging market and high-yield debt. And so once again, the humble practitioner of orthodox macro is faced with a profound question: Do the markets know something we don’t, or is something about to give?
I suspect we’ll have an answer to this question sooner rather than later. As I see it, the verdict hinges critically on the inflation call. So far, inflationary pressures have remained generally quiescent around the world -- even in the face of an oil shock and a sharp upsurge in non-oil commodity prices. But now, with the global growth cycle on the upswing, there are worries in some quarters that inflation may be about to take a turn for the worse. While the Federal Reserve, the European Central Bank, and even the Bank of Japan continue to express concern over such a possibility, the markets remain skeptical. That’s certainly the inference that can be drawn from a decomposition of the recent back-up in long-term interest rates. Inflation-linked bonds speak of a deterioration that has been almost exclusively concentrated in the real interest rate component; the so-called break-even inflation gauge -- the difference between nominal and real interest rates and, therefore, a good proxy for market-based measures of inflationary expectations -- remains confined to the relatively tight range that has prevailed over the past couple of years. Most bond bears argue that the upsurge in growth means that the pressure on long rates is about to shift from the real interest rate component to the inflationary premium. I am not in that camp -- at least, insofar as the inflation call is concerned. To me, inflation is more a global call than ever before. Such a conclusion is very much at odds with the country-specific assessment of inflation risks that still dominates the thinking of central banks. Recently, I took issue with the closed macro of yesteryear, arguing that the increasingly powerful forces of globalization required more of an open approach to macro modeling (see my 22 February essay, “Open Macro”). The case for open macro stems not just from the explosion of global flows in trade, financial capital, and information but also from increasingly powerful cross-border arbitrages driving global markets for labor, physical capital, and saving. Open macro has particularly important implications for inflation: With the first-round impacts of globalization profoundly asymmetrical -- initially injecting more supply than demand into the global economy -- price pressures could remain subdued for a lot longer than a closed macro framework would suggest. There is persuasive statistical evidence in support of the emergence of a global price rule. Interestingly enough, researchers from the Bank for International Settlements have led the charge in presenting this evidence. As such, this self-described “bank for central banks” finds itself very much at odds with its biggest clients. In its 75th annual report published in mid-2005, the BIS stressed the breakdown of many of the traditional linkages of closed macro -- namely, sharply reduced correlations between labor costs and prices, between currencies and import prices, between import prices and core inflation, and even between domestic “output gaps” and core inflation. The BIS stressed that this breakdown has been global in scope and particularly evident during the past decade, when globalization has been on the ascendancy. BIS researchers have recently extended this analysis, arguing that a “globe-centric” framework now does a much better job in explaining inflation than does the traditional “country-centric” approach (see Claudio Borio and Andrew Filardo, “Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation,” March 2006). Their major contribution is a careful construction of several alternative versions of a “global output gap” -- in effect, a measure of the difference between aggregate supply and demand for the overall global economy. In looking at a sample of 15 major industrialized countries, Borio and Filardo find that the global output gap does a much better job in explaining fluctuations in inflation of individual economies than does the domestic output gap. In other words, to the extent that there is slack in the global economy, inflationary pressures could well remain in check -- even for those nations that have run out of spare capacity in labor and product markets at home. This is a powerful and perfectly sensible conclusion, in my view -- but one that has been generally ignored by the macro establishment. It is particularly relevant in the context of the current upturn in the global economy. The US, by conventional measures, is now starting to enter the zone of full utilization in labor and product markets. At least, that’s the signal from an unemployment rate of 4.7% in March 2006 and a manufacturing capacity utilization rate of 80.4% in February. In days of yore, those thresholds could well be worrisome insofar as domestically-driven inflationary pressures might be concerned. In an era of globalization, however, that need not be the case -- especially with aggregate demand long subdued elsewhere in the global economy. The fact that Japan and even Germany now seem to be on the mend is an encouraging and welcome development, but such reawakening comes after years of protracted sluggishness in both economies. As such, it hardly speaks of global demand instantly straining against the limits of aggregate supply. At the same time, supply-driven growth in the export- and investment-led Chinese economy, along with a persistence of externally-driven growth elsewhere in Asia, underscore the existence of ample margins of slack still available in the broader global economy. Putting it more formally, Borio and Filardo’s broadest measure of the global output gap -- a GDP weighted construct -- paints a picture of good balance between worldwide supply and demand in 2005. That stands in sharp contrast with earlier periods of cyclical excess when the global output gap tipped into the danger zone, with aggregate demand exceeding supply by anywhere from 1.25% (2000) to nearly 3% (1973). That’s not to say that that the global output gap will stay constructive in the years ahead -- especially if there comes a point when the growth dynamic in the supply-driven non-US world draws increasing support from internal demand. In my view, however, that day is still very much in the future. Consequently, with the global price rule still flashing an all-clear sign, the bond market may have a very difficult time pushing nominal long-term interest rates much above current levels. Moreover, in the event of a downside surprise in global growth -- still a distinct possibility, by my reckoning -- bond markets actually could rally quite sharply (see my 3 April dispatch, “The Great Global Growth Surprise”). Still, I would be the first to concede that there may be a good deal more to the bond market call than just focusing on inflation risks. The pyrotechnics of a disruptive US current account adjustment are especially worrisome in that regard -- particularly as Washington now ups the ante on protectionism. The risk of a sharp decline in the US dollar can hardly be ruled out in a normal global rebalancing scenario -- let alone in one that is accompanied by increased frictions on the free flow of trade and capital. In the event the dollar starts to slide sharply, America’s foreign creditors -- be they private or official -- could demand to be compensated for taking currency risk. Given that the bulk of recent foreign capital inflows into the US have gone into fixed income instruments, that compensation would probably take the form of wider spreads on longer-term US real interest rates relative to those elsewhere in the world. Depending on the outlook for non-US rates, that could well imply significantly higher levels of US real interest rates. It may be that we’re guilty of making too much out of the great bond market conundrum. Given the extraordinary accommodation of major central banks in recent years, long rates simply may have been pinned down by the mother of all liquidity cycles. Those days are now over. Monetary authorities are leaning the other way in attempting to normalize their policies. So far, the impacts of these efforts have largely been confined to the short end of yield curves. But now, for the first time in 15 years, the world’s major central banks are all on the same side of the policy equation. That may be “all” it takes to push normalization out to the long end of the yield curve. What worries me most about such a scenario is the possibility of discontinuous adjustments -- with simmering pressures at the long end suddenly vented by a sharp upward movement in real long-term rates. That implies that there could be important nonlinear threshold effects that stem from shifts in the liquidity cycle -- sharp adjustments that exact considerable collateral damage on other asset markets. Given the extraordinary compressions in spread markets, those risks can hardly be taken lightly. Perhaps the biggest risk in all this is that central banks do not fully understand how to set monetary policy in an era of globalization. If they do not appreciate the power of new structural constraints on inflation, they run the risk of unleashing what Borio and Filardo call “undesirable side effects, such as … the build-up of financial imbalances, notably excessive credit and asset price increases that could raise material risks for the economy further down the road.” Interesting advice from the bank for central banks! I would take that critique one step further: If monetary authorities tighten when inflation is well-contained, they run the risk of taking real interest rates up to onerous levels that could take a surprisingly severe toll on the global economy. In an era of globalization, I suspect it will pay to heed the global price rule.
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Turning Neutral
Apr 10, 2006
Richard Berner and David Greenlaw
Forecast at a Glance | | 2005E | 2006E | 2007E | | Real GDP | 3.5% | 3.5% | 3.2% | | Inflation (CPI) | 3.4 | 3.1 | 2.2 | | Unit Labor Costs | 2.6 | 2.6 | 3.0 | | After-Tax “Economic” Profits | 9.4 | 11.9 | 3.9 | | After-Tax “Book” Profits | 34.5 | 10.3 | 4.0 | Source: Morgan Stanley Research E = Morgan Stanley Research Estimates Since February, the swift backup in bond yields and bearish resteepening of yield curves both at home and abroad has produced the worst bond-market selloff in a year. In the US market, the yield on the new bond that Treasury auctioned in February jumped by 34 basis points (bp) in the past two weeks and 54 bp in the past month and a half; 10-year Treasury yields have surged comparably. Moreover, unlike the US yield backup in the spring of 2005 or the much larger yield rise in the spring of 2004, both of which proved to be bond-buying opportunities, there is no sign yet of a trough in bond prices. Indeed, the selloff could continue for a while longer as investors unwind positions in long-dated securities and flattening trades. There are three bits of good news for bond investors, however: First, bond bulls are beginning to capitulate amid evidence of strong global growth and a growing sense that declines in housing may not be the US economy’s Achilles heel. A bearish consensus among bond investors is almost always the sine qua non for a rally. And the level of yields is getting more attractive, especially for those of us who have been bearish for a while. Indeed, with yields just short of our long-standing call for a move to a 5%-5¼% range, discipline requires that we begin to turn neutral on bonds. Moreover, we fully expect that a US spring “payback” in growth will erode perceptions that the Fed cannot pause in its tightening campaign. Those developments may allow yields to settle in a trading range for a while. Beyond the immediate outlook, however, an upcreep in inflation and the reemergence of stronger growth in the summer and fall will probably mark the peak in yields and thus better buying opportunities. As we see it, four fundamental factors argue for somewhat higher US yields and steeper yield curves. First, global growth has improved significantly in the past few months, and the step-up appears to be sustainable. The improvement in Europe and in Japan is sufficient that the ECB and the BOJ have begun or will soon begin to renormalize interest rates. While the ECB has proclaimed publicly that they are on a once-per-quarter timetable for that renormalization, our colleagues Elga Bartsch and Eric Chaney note that the strength of business surveys is signaling European growth that could be running above 3%. And the combination of positive inflation, a solid Japanese expansion, and 14-year highs in Japanese equities has in the view of our colleague Takehiro Sato brought forward the end of the Bank of Japan’s zero interest rate policy to this summer. Stronger growth abroad is lifting US real interest rates in two ways: It is helping US exports and is absorbing into overseas domestic demand the saving that has for the past three years helped finance the US current account gap on attractive terms. A second factor lifting US yields, again in real terms, is that the income-generating capacity of the US economy is gathering momentum, thus supporting growth in consumer spending. The combination of stronger job growth and rising wages has over the past year gradually contributed to accelerating wage and salary income, restrained in real terms by the ongoing sharp rise in energy quotes. Nonetheless, in March, a proxy for such real income has picked up to 3.2% — a six-year high — and to a 5.1% annual rate over the past six months. We think there’s a good chance that job growth will catch up with the economy, producing a cyclical slowing in productivity growth (see “The Coming Productivity Undershoot,” Global Economic Forum, March 30, 2006). Moreover, dwindling slack in labor markets — confirmed by the dip in the jobless rate, a stable participation rate, and rising job openings — points to further firming in wage growth (see “Will Labor Markets Tighten Further?” Global Economic Forum, April 3, 2006). More broadly, this evaporating economic slack is a third factor that may push up yields in both nominal and real terms. Slack in US product and labor markets has dwindled to the point that at least an upcreep in inflation is a tangible risk. We agree with those who argue that globalization is a powerful, secular disinflationary force. But cyclical inflationary forces also matter, and now they are starting to get the upper hand, in our view. Yet firmer labor markets alone won’t push inflation higher; companies need pricing power to pass rising costs through to higher prices. The rise in industrial operating rates to 5½-year highs in February and March and the rise in non-manufacturing operating rates to almost a six-year high in the fourth quarter go a long way to facilitate such pricing power. We still expect that the combination of rising costs, eroding economic slack, and the unwinding of statistical quirks in hotel rates and owners’ equivalent rent will promote a half-point increase in core inflation to 2.6% measured by the CPI this year (for details, see “Tweaking the Fed Call,” Global Economic Forum, March 13, 2006). And even before the inflation uptick materializes, this “utilization risk” is ample reason for the Fed to keep a tightening bias. Finally, distant-horizon term premiums appear to be rising, as uncertainty over the stopping point for Fed tightening has increased, and higher term premiums are translating into higher yields (see “The Term Premium Case for Higher Yields,” Global Economic Forum, January 20, 2006). Policy is no longer measured, and the policy stopping point is entirely and appropriately dependent on the inflation and economic outlook. Declines in housing activity and a deceleration in home prices are still risks to the prognosis, but the strength of global growth and US labor markets has provided a significant offset (see “Acid Test,” Global Economic Forum, March 27, 2006). Those factors, together with the faster backup in yields, led us this month to shave a mere tenth of a point from our forecast of 2006 growth (on a Q4/Q4 basis) to 3.8% from 3.9% in March. But that’s still slightly above trend, and likely to keep the unemployment rate at or below 5% well into 2007. Near-term, however, yields may stabilize as a spring slowdown in US growth looms, reinforced by the effects on discretionary income of rising gasoline prices. There’s little doubt in our minds that first quarter growth got a boost from the post-Katrina recovery in demand and from exceptionally warm January weather. And judging by the recent surge in wholesale gasoline quotes to $2/gallon, nationwide pump prices could hit $3/gallon by Memorial Day, clipping spending power by about $50 billion in three months. As a result, a “payback” in the spring seems highly likely; judging by February and March retailing results, it is probably already under way. Final sales should decelerate by 130 bp from an unsustainable 5% in the first quarter. In our view, however, the payback will be limited in both scope and duration because the fundamentals supporting both demand and production are strong. Recent developments virtually assure a Fed move to 5% in May. But given that the Fed will likely have raised rates by 400 bp in less than two years, the incipient spring slowing in final demand should trigger a pause thereafter. Moreover, term premiums seem to be rising, which makes financial conditions less accommodative. In that context, the more that yields increase and the curve re-steepens, the more the Fed will be inclined to pause. Why just a pause and not the end to this tightening cycle? In our view, inflation will crawl higher and growth will rebound to an above-trend 3¾% pace in the second half of 2006. Those will be the triggers for the Fed to move again to a slightly restrictive stance — a funds rate of 5¼% — and to stay on hold through much of 2007. Rising real rates that accompany strong growth should not hurt equities, however. So long as the Fed contains inflation, in our view, that stance is unlikely to cause lasting damage to risky assets. The forces now driving global growth seem entrenched, and growth might be even stronger than we expect. But three factors pose downside risks: First, the ongoing rise in gasoline prices could take prices even beyond their post-Katrina surge, hurting consumer discretionary income. Second, an overshoot in long-term yields could depress housing by even more than we expect, and could also spell trouble for US equity markets. And lurking protectionism could make global investors more wary of US financial markets.
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Review and Preview
Apr 10, 2006
Ted Wieseman (New York) and David Greenlaw (New York)
The Treasury market saw a second straight week of big losses at the back end and a major further bear steepening of the curve the past week as investors continued to shun the long end as confidence in a global growth surge further solidified -- punishing long bonds globally -- and the employment report highlighted risks of excess “resource utilization” leading to higher inflation domestically. A dovish ECB exacerbated fears of an overheating global economy, contributing to big steepening in yield curves across key markets and convincing U.S. investors that, with less help from Europe and the domestic labor market potentially overheating, the Fed would have to do more to reign in growth. After the 20 bp spike in the 30-year yield and 9 bp steepening in 2’s-30’s the prior week, the Treasury market initially managed to rebound a bit the past week, helped by worse than expected results from the ISM and motor vehicle sales reports released Monday. But when longer dated JGB yields moved to new highs overnight Thursday as Japanese stocks spiked to 14-year highs and longer dated European government bonds crumbled heading into and then after the ECB meeting following which President Trichet surprised the market by all but ruling out the May rate hike investors had fully priced in, the Treasury bear steepening resumed with a vengeance. Thursday’s big long end losses that were driven more by overseas markets were extended through Friday after the solid employment report provided a domestic reason for intensifying investor bearishness. It was seemingly just a few weeks ago that widespread thinking in the market was that 5% would likely mark a ceiling on yields, as it was thought that a move to this level would bring in significant extension demand by pension funds and other duration hungry investors. Well, now not only has the entire bond sector blown through 5% -- far through 5% in the 2023 maturity peak range -- but highs in long zero rates have breached 5 1/4%. And, at least so far, there seems to be minimal interest by real money investors to step in and buy this flailing market at what would have been considered highly attractive yields as recently as February, when investors seemingly couldn’t get enough of the new long bond at just over 4 1/2%. Benchmark Treasury yields rose 6 to 14 bp over the past week (after having been in slightly positive territory for the week through Wednesday’s close). This wasn’t quite as bad as the prior week’s 11 to 20 bp sell-off, but the steepening in the curve was the same, 9 bp in 2’s-30’s in both cases, with the 2-year yield up 6 bp the past week to 4.88% and the long bond yield up 14 bp to 5.04%. The 30-year yield has now risen 34 bp in the past two weeks and 54 bp since the end of February. Looking at the rest of the curve, a milestone was reached Friday when the entire benchmark Treasury curve from the 4-week bill to the 30-year bond closed fully disinverted for the first time since December 15. The 3-year yield rose 6 bp to 4.885%, the 5-year 8 bp to 4.89%, and the 10-year 11 bp to 4.96%. Although the 10-year just barely held below 5%, every Treasury bond with a maturity beyond it was through that level, with the peak in regular bonds at 5.21% for the August 2023 issue and the peak in long principles at 5.28% in February 2023. In the futures markets a more hawkish near-term and less dovish medium-term Fed continued to be priced in. The May fed funds contract was off 2.5 bp to 4.945%, a level that is approaching a point where the market will be starting to price some risk of a 50 bp move at the May 10 FOMC meeting. The July contract was off 4 bp to 5.115%, nearly pricing in a 50/50 chance of a move to 5.25% at the June meeting. And the September contract was off 4.5 bp to 5.195%, so if the move to 5.25% doesn’t come by June it is now essentially fully priced to come by the September 20 FOMC meeting at the latest. In contrast to ECB President Trichet, St. Louis Fed President Poole called these expectations “reasonable” in a Bloomberg interview Friday afternoon. Eurodollar futures pricing still shows a quick reversal off this September peak, but the inversion was moderated a bit more in the latest week, with the Sep 06 to Sep 07 spread steepening 1 bp to -11.5 bp, with the former contract off 4 bp to 5.305% and the latter 5 bp to 5.19%. Just as the max inversion in this market was pushed from June 06 to June 07 to Sep 06 to Sep 07 over the course of Q1, we are now very close to it being pushed out again, to Dec 06 to Dec 07. This latter spread closed a half bp steeper on the week at -11 bp. Economic data released the past week were mixed, with a robust employment report but softer results for other key reports. Main focus was on the employment report, which was quite solid. Nonfarm payrolls rose 211,000 in March, bringing the average gain in the first three months of the year to +197,000, up from an average +165,000 in 2005. Robust job gains in March were seen in retail trade, business services, leisure, healthcare, and government, while construction flattened out after extremely strong gains the prior two months and manufacturing posted a second straight decline. Other details of the report were positive. The unemployment rate fell a tenth to 4.7% (and very nearly rounded down to 4.6%), matching the cycle low, and raising investor fears of the risks for inflation from the excess “resource utilization” of which the Fed has recently been warning. The average workweek held at an upwardly revised 33.8 hours, leaving aggregate hours worked up a robust 3.0% annualized in Q1. And average hourly earnings increased 3.4% Y/Y, up from +2.7% six months ago, continuing to suggest that the tightening labor market is leading to a robust upswing in income growth that should enable consumer spending to remain on a solid track even if a likely sharp deceleration in home price gains (we continue to look for about zero growth this year in home prices in real terms) inspires an increase in the personal savings rate. Other key data were not as strong. The headline ISM composite diffusion index fell 1.5 points in March to 55.2, a significantly weaker result than had been suggested by upside in all the key regional surveys. The recent surge in metals and energy prices appeared to explain the divergence, as the prices paid gauge rose 4 points to 66.5, the high since November, contrasting with pullbacks in the regional polls. Despite the pullback in the headline gauge, factory activity continued to show widespread growth, with 15 of 20 industry groups reporting expansion in March. Looking at the key activity gauges, orders (58.4 v. 61.9) and employment (52.5 v. 55.0) recorded pullbacks from unusually elevated readings last month, but production (57.5 v. 57.4) held steady. Early indicators of March consumer spending were on the softer side. Motor vehicle sales held steady at 16.5 million units annualized. This was only a bit less than expected, but the mix was more negative as a dip in domestically produced vehicles (13.0 million v. 13.2 million) was offset by an uptick in imports (3.5 v. 3.3). Chain store sales results for March overall were also disappointing. We calculate that weighted average chain store comps for the 30 or so largest companies rose 2.2% year/year, matching the smallest rise since November 2004. This outcome was boosted by a relatively strong performance by drug stores; ex drugs comps rose 1.7%, also the low since November 2004 and below industry expectations for a rise of around 2% to 2.5%. Based on these results, we forecast a 0.5% gain in March retail sales, both overall and ex autos. Most of this gain, however, is likely to come from a price-related surge in gas station sales; we expect sales ex autos and gasoline to be up only 0.2%. There were a number of releases the past week directly bearing on first quarter growth estimates, which on net led us to up our Q1 GDP forecast to +4.3% from +4.1%, with the adjustment just about entirely explained by stronger construction. Construction spending rose 0.8% in February, and January (+0.4%) and December (+1.9%) were revised higher. Upside in February was led by a 1.3% jump in the residential category, apparently a lagged response to the 16% surge in housing starts in January. Private nonresidential spending also posted a solid 0.8% gain, led by power plants, hotels, and office buildings. Over the past four months, private nonresidential activity has surged at a 20% annual rate, the largest rise over such a period in almost six years. On the negative side, public spending fell 0.5% in February, with a pullback in transportation spending the biggest contributor. Other data bearing on GDP were mixed. The auto and chain store sales results and our resulting retail sales estimates were marginally lower than we had been assuming in our consumption forecast, which we trimmed to +5.0% from +5.1%. Wholesale inventories rose a significantly larger than expected 0.8% in February and January was revised up a tenth to +0.2%. Although the relationship between wholesale activity and trade is loose at best, we decided to be conservative and up our estimate of February imports in response to this outcome, raising our February trade deficit forecast to $69 billion from $68 billion. Note that with this adjustment we are now building in a very large subtraction from Q1 growth from net exports. We forecast that real final domestic demand will surge about 5 3/4% and that net exports will subtract about 1 1/4 points from Q1 GDP growth (with a small additional subtraction from inventories). We would consider this to be a conservative stance on the trade picture, so at this point would see the risks to our GDP forecast as being to the upside. The upcoming week will be shortened by the Good Friday holiday and preceding early close on Thursday, and there are only a few noteworthy economic data releases, highlighted by retail sales on Thursday. Supply will be a focus early in the week, as Treasury announces a reopening of the 10-year TIPS Monday for auction Wednesday. We look for an unchanged $8 billion size. This issue has had a rough time since being initially auctioned at 2.025% in January, closing Friday at 2.41%. More Fed speakers will be on the tape after the fairly busy schedule of the past week. Governors Olson and Bies will speak on banking issues Monday, but then Minneapolis Fed President Stern will address the economic outlook Tuesday as will Governor Kohn on Thursday (though not until the futures close at 1:00). The key upcoming Fed appearance will be testimony by Fed Chairman Bernanke on April 27 to the Joint Economic Committee. On the data calendar, key releases include the trade balance and Treasury budget Wednesday and retail sales, Michigan consumer confidence, and business inventories Thursday. The Fed will also for some reason be releasing the industrial production report to the sounds of crickets chirping on Friday’s market holiday: We look for a half billion dollar widening in the February trade deficit to $69.0 billion, with both exports (-0.9%) and imports (-0.3%) expected to correct a bit after surging in recent months. On the export side, most of the decline should be accounted for by a sharp pullback in capital goods outside of the aircraft and high tech sectors. This result would be consistent with the recent shipments data. On the import side, we look for a price related drop in natural gas and a reversal of the odd spike in autos seen last month. Based on conflicting indications from other data -- strong wholesale trade but a significant slowdown in growth in inbound containers at the key West Coast ports -- we’re assuming little change in other goods imports. On the upside, a one-time surge in service imports tied to royalty payments for the Olympic broadcast rights is likely. We expect the March budget deficit to widen $16 billion from a year ago to $88 billion. However, this is actually a few billion dollars less than we had originally built in, and the swing is fully accounted for by calendar quirks. Specifically, an extra Friday during the month means an additional mailing of individual tax refunds. Also, due to the fact that April 1 fell on a weekend, some regular monthly payments were mailed at the end of March. We continue to look for a $375 billion deficit for the fiscal year as a whole, with the upcoming tax season representing an important swing factor. We look for a moderate 0.5% rise in March retail sales, overall and ex autos, following the wild swings seen in the first two months of the year. However, a significant portion of the jump is attributable to a price-related rebound in the gas station category. Indeed, excluding gas stations and auto dealers, sales are expected to rise only 0.2% with the chain store reports pointing to sluggishness at both general merchandisers and apparel outlets. Meanwhile, the unit sales results from the automakers implied only a fractional gain in the motor vehicle dealer component. Outside of gas stations, the only notable upside is expected to be evident in the drug store category. Keep in mind that in assessing this report, it is important to note that the adjustment factors may not fully account for the Easter calendar shift. Thus, it will be difficult to get a good read on underlying sales performance until we see the April results. We forecast a 0.2% increase in February business inventories, as a drop in stockpiles at manufacturers should be more than offset by increases at wholesalers and nonauto retailers. Meanwhile, the I/S ratio is likely to post an unusual -- but probably short lived -- jump to 1.27. We look for a 0.3% rise in March industrial production. The labor market report pointed to a modest gain in factory output, with a rebound in the electrical equipment category and gains in the metals sector likely to be offset by a slight dip in motor vehicle assemblies and softness in textiles and chemicals. Meanwhile, the utility component should flatten out on the heels of some sharp, weather-related swings in recent months. Finally, the utilization rate is expected to hold at a 5 1/2 year high.
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Is the Euro Back in the Policy Equation?
Apr 10, 2006
Eric Chaney (Paris)
Gone are the days when the Bundesbank enjoyed taking markets by surprise by acting against markets’ expectations – a philosophy former Buba President Hans Tietmeyer evoked with some nostalgia at the recent seminar in honour of Pr. Otmar Issing. At last Thursday’s press conference, ECB President Jean-Claude Trichet’s words, not actions, took markets by surprise. The purpose was to avoid the unpleasant surprise for the markets of an “on-hold” decision at the early May Council meeting, while everybody was betting on a 25bp hike. As a seasoned central bank watcher who has correctly predicted the ECB behaviour since 2004 and thought that Jean-Claude Trichet would set the table for a rate hike, my colleague Elga Bartsch draws the following lesson: “Don’t pay too much attention to individual data points; it’s the longer-term trend that matters for the ECB, rather than the marginal change”. She is probably right: we and the market may have overestimated the capacity of the ECB to absorb new data. Talking but also listening to the markets As a distant observer of the art of central banking, I sense that the ECB has definitely departed from the Buba style and moved closer to the US Federal Reserve in managing the relationship with the financial markets: “better to have markets on our side” seems to be the guideline. Hence, since the debate within the Governing Council apparently left little chance of a rate hike in May, it made a lot of sense to make that point clear. Hence, the question is what could be the real reason – by real I mean linked to the real economy — behind the cautiousness of the ECB. I hear that the ECB may have reacted to the recent rise of the euro. I concur with Elga, who thinks that the currency has not been “a big factor in the interest rate decision” (see “No Move in May, Now What?”, Elga Bartsch, April 7, 2006) and will explore this issue more in detail. In fact, I believe that the ECB is confronted with the same conundrum as all European business cycle watchers i.e. what I have called the “survey conundrum” (see “Europe: Synthetic Index At All Time High”, Eric Chaney, April 3 2006) and wants to take some time to let the statistical fog dissipate. I’ll elaborate further on this hot topic later and, in the meantime, will probe the currency parameter. Last year’s euro depreciation is still positive for 2006 growth … On a trade-weighted basis (TWI), the euro gained 1.03% since its February 27 2006 bottom and until Mr. Trichet threw cold water on the currency market. Although relatively rapid, the rise was contained within the range visited since June 2005, when the sharp depreciation of the euro ended. Using the multipliers of a quarterly econometric model euro area (MZE-2003), we reckon that the impact of last year’s depreciation on the 2006 average GDP growth is still positive, although by a slim margin (+0.2%). Indeed, most of the boosting effect took place last year (+0.5%). Our simulations indicate that it would take another 3% appreciation of the euro TWI to nullify the impact of the currency on GDP growth this year and build a negative drag on 2007 GDP (-0.2%). … But EUR/USD significantly above 1.25 would raise concerns about the recovery If such appreciation took place, pushing EUR/USD above 1.25, GDP growth would probably slow significantly in the second half of this year, just ahead of a major fiscal tightening in Germany. This would probably raise serious doubts about the sustainability of the recovery in Europe and would not allow the ECB to normalize interest rates further in order to prevent asset prices to overshoot, if such is its goal. For that reason, it is not impossible that the exchange rate was evoked during the ECB’s council debate, even though it was allegedly not a major issue. Another sign that euro area policy makers are becoming sensitive to exchange rate issues is the position taken by the EU Commission, the Council of finance ministers and the ECB about Asian currencies. In sharp contrast with the US Congress leaders, EU policy makers made clear that they are in favour of more flexible exchange rates in Asia (the Chinese Yuan), but in an “orderly fashion”, as both euro group chairman and ECB President have repeated in Vienna on Friday April 7. Why is Europe opposed to a sharp appreciation of the Yuan? The macro rationale is clear: a one off and large appreciation of the CNY and associated currencies would trigger a disproportionate sell-off of the USD, which would propel the effective exchange rate of the euro higher. The critical parameters here are the weights of the currencies entering in the basket used by the ECB to gauge the effective exchange rate: the Yuan takes 4% of the basket vs. 17% for the USD (double weights based on the competitive power on third markets of producers of each foreign currency). To take an example, if the Yuan appreciated by 20% against the US dollar and by 10% only against the euro, the euro would gain 10% vis-à-vis the USD and closely related currencies (21% of the basket with Mexico and Canada) and the effective exchange rate of the single currency would rise by 1.6%, other currencies remaining stable against the euro. A 20% appreciation of the Chinese currency might raise the euro TWI by 3% If, in addition, the British pound (18% of the basket) experienced half of the depreciation of the USD, a scenario that has some credibility given the large financial links between the two main English speaking economies, the euro would rise by 2.6%. All in all, I think that a 20% unilateral appreciation of the Yuan against the USD, the goal pursued by Senator Schumer for instance, would lift the euro effective exchange rate by around 3%, enough to endanger the European recovery. The knee-jerk reaction of the currency markets to the unequivocal message from the ECB was a 1% correction of the EUR/USD. This is in my view — testimony that we are bordering the region where the exchange rate is likely to re-enter in the monetary and, more generally, in the economic policy equation in Europe.
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Dollar Bear, Shekel Bull
Apr 10, 2006
Serhan Cevik (from Tunis)
The shekel’s appreciation is not just because of the dollar’s fall. The US dollar is losing ground against all the major currencies and Morgan Stanley’s currency economics team expects further downside, mainly stemming from cyclical developments, in the rest of this year (see Stephen Jen’s Dollar-Bearish-but-not-Too-Bearish: A Forecast Update, April 6, 2006). Even though our assessment is not a reflection of structural arguments like America’s growing current account deficit or a widespread diversification out of dollar-denominated assets, cyclical factors are still enough to bring a ‘gentle’ correction in the global foreign-exchange markets. Of course, the dollar’s weakness and monetary normalisation around the world will have diverse implications for emerging-market currencies. Take, for example, the case of the Israeli shekel — a fundamentally undervalued currency. In our opinion, the shekel should appreciate on strengthening macroeconomic fundamentals against the dollar and even more so vis-à-vis the euro. Instead, it seems that the dollar’s recent slide, along with a constructive election outcome in Israel, has initiated the much-awaited, structurally justifiable correction in the shekel’s valuation. The real exchange rate index is still as weak as it was in the midst of the crisis. With the simultaneous collapse of the global technology bubble and the Oslo peace process, the Israeli economy experienced a stagflationary period during which the shekel moved radically away from its fair value. Despite the country’s improving economic and financial prospects, the shekel has remained almost as weak as it was in the midst of the crisis. According to our calculations (based on relative consumer prices), the shekel is undervalued by 17.5% against the dollar and 42.5% against the euro. Alternative models incorporating productivity differentials and changes in real wages show even a more compelling case in favour of a marked appreciation of the shekel. Especially, given the election outcome that is reasonably supportive of macroeconomic stability, the shekel should appreciate on a sustained basis (see As Good As It Gets, April 3, 2006). Consumer price inflation should remain within the central bank’s target range. The consumer price index posted a year-on-year increase of 3.1% in February, up from 2.4% at the end of last year. The lagged pass-through from higher energy quotes and the shekel’s weakness made a significant contribution to the highest reading of the last three years. However, it would be a mistake to ignore the role of above-trend income growth in reshaping the behaviour of inflation. According to our projections, real GDP growth, reaching 5.2% last year, will be around 4.5% this year, as domestic demand becomes a leading engine of economic expansion. This means a gradual closing of the output gap that used to be a source of deflationary tendencies. Indeed, the sustained acceleration in money supply growth and credit to the private sector is a clear sign of prolonged monetary accommodation. Even with the shekel’s appreciation helping to ease inflationary pressures in exchange rate-linked sectors, we expect consumer price inflation to move around the upper limit of the target range of 1-3% in the first half of this year. Monetary normalisation would support the shekel and ensure price stability. Although disinflationary forces in the global economy provide a cushion against inflationary pressures in the domestic economy, there is an unmistakable upward trend in inflation, even if we exclude the effects of currency fluctuations (see A Clear and Present Danger, March 21, 2006). In our view, the policy rate is still below the neutrality zone and keeping inflation within the target range by the end of this year and in 2007 requires further tightening of the monetary policy stance. Given a degree of tightening in monetary conditions due to the shekel’s appreciation, we expect the Bank of Israel to raise short-term interest rates by another 50 basis points in the remainder of this year. That would normalise the policy stance, while still maintaining real interest rates at an accommodative level. And, in today’s global conditions, this is as good as it can get for Israel’s financial markets. With a gradual increase in short-term interest rates and strong demand for long-dated assets driving the 10-year bond yield below the 6% mark, a flatter yield curve should help keeping the economy on a sustained growth path.
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Sino-Japan Relationship Is on a Slippery Path
Apr 10, 2006
Andy Xie (Hong Kong)
The tension between China and Japan is not yet affecting bilateral economic ties: Japan’s FDI to China rose by 20% in 2005. China’s share in Japan’s total trade increased to 20.4% in 2005 from 20.1% in 2004. The economic ties between the two countries have withstood the political tension. There seems no end in sight to the bilateral political tension: The frontrunners for the position of Japan’s next prime minister support the current government’s stance on the Yasukuni Shrine. The political tension could last for years and may escalate. The combination of close economic ties and cool political relations does not seem sustainable: Japan may be betting that China needs Japan more than it cares about how history is interpreted and that it will eventually have to accept Japan’s position. This would be a misconceived view, in my opinion, and the continuing stalemate could destabilize economic ties within the next five years. Summary & Conclusions The combination of close economic ties but cool political relations between China and Japan does not seem sustainable. Unless the status quo changes, China and Japan may head towards confrontation not only about how the past is interpreted but also on economic and security issues over the next five years. The tense relationship between China and Japan could become the biggest destabilizing factor to the economies of Northeast Asia. The frontrunners for the position of Japan’s next prime minister seem to support the current policy regarding the Yasukuni Shrine. Prospects for improving the bilateral relationship are dim, in my view. While the political tension between the two countries has not damaged economic ties so far, the situation could change in the coming years. Negative sentiment among the Chinese toward Japanese products and businesses may increase if the tension continues, and Japanese businesses may have to prepare for a breakdown in economic relations between the two countries. Economic Ties Continue to Tighten China reported a 20% increase in realized FDI from Japan in 2005 and a 27% rise in signed FDI in the first three quarters of 2005 from the previous year. Japan’s trade with China plus Hong Kong increased to 20.4% of its total trade in 2005 from 20.1% in 2004. There is no evidence that bilateral economic ties have suffered as a result of the sustained political tension between the two countries. Sino-Japanese economic ties have come a long way. Five years ago, the Japanese were concerned about losing jobs to China because of the increasing integration of the two economies. Integration has taken place rapidly. Bilateral trade increased from 12.4% of Japan’s total trade in 1999 to 20.4% in 2004. China is now by far Japan’s largest trading partner. Instead of taking away Japanese jobs, integration has revitalized the Japanese economy. Japan’s corporate sector has boosted its profitability by shifting labor-intensive production to China. Chinese demand for equipment and upstream materials has revitalized a big part of Japan’s manufacturing. Even Japanese consumer companies are making headway in China’s domestic market. The number of unemployed in Japan has declined by 12.4% since 1999. The potential for further gains in economic ties is huge. China wants to shift away from a quantity-driven growth model that consumes too many resources and generates too much pollution. Japan is the most frugal industrial economy in both respects and has much to offer in providing China with the right equipment and technology in this transformation. At the same time, the supply of cheap consumer products will remain an important force in revitalizing Japan’s consumption. Political Ties Continue to Deteriorate Despite the strengthening of economic ties, political relations have deteriorated. The two governments are barely on speaking terms. Japan has recently put some aid projects on hold and has announced the ending of yen loans by 2008. China allows only some ministerial meetings between the two countries and refuses higher level meetings. Negotiations over the exploration of gas in the East China Sea have not been productive. China says that visits by the Japanese prime minister to the Yasukuni Shrine must stop before normal relations can be resumed. The Japanese government says that this is not a China matter and claims that China is trying to extract natural gas from Japan’s controlled waters. The Sino-Japanese relationship has never been on solid ground. When Japan normalized the diplomatic relationship with China three decades ago, China was so isolated that the government made an extraordinary effort to support the relationship. It waived the right of compensation to war damages (probably over one trillion dollars at today’s value) and toned down domestic discussions of the Sino-Japanese War. The Chinese government has placed hopes on an improvement in the relationship on the possibility that the next prime minister would not visit the shrine. This now looks unlikely. The frontrunners to be the next prime minister seem to be committed to continuing the visits. A breakthrough in the bilateral relationship no longer seems probable. The Fragile Foundation of the Bilateral Relationship The fact that the Chinese government needed to control public discussions on the past to stabilize the bilateral relationship indicates how fragile the relationship has been. However, covering up the past to build a relationship with Japan just does not seem sustainable. The Chinese government has reduced the dispute about the past to one issue – the Japanese prime minister’s visit to the Yasukuni Shrine. Among the tombs in the shrine are those of convicted Class-A war criminals. If Japan agrees to stop the visits, the Chinese government could claim to the Chinese people that it has been able to get the Japanese government to recognize the past. The difficulties in the bilateral relationship go well beyond the shrine issue. Modern China was born during the period of anti-Japanese war sentiment. Only unequivocal acceptance of guilt by the Japanese people, not just occasional apologies by some Japanese politicians, would settle Chinese angst about the past, I believe. However, Japanese society has been deemphasizing the past. The main considerations seem to be not to damage the confidence of future generations. The fundamental differences between the two countries mean that the bilateral relationship will always be fragile and will require intensive management to remain stable. The periodic apologies from Japanese politicians have been the main ingredient in stabilizing the relationship. These have been relayed to the Chinese people as the view of Japanese society. The visits to the Yasukuni Shrine have made a puncture in this perception and forced the Chinese government to adopt a tough line. If Japan’s next prime minister adopts the same policy regarding the shrine, the bilateral relationship could deteriorate for another four to five years. The odds are high that economic ties would also be affected. In China, the Japanese war remains an emotive issue in the youth culture that is otherwise not ideological. The youth considers the economic relationship with Japan as much less important than the historical issue. This trend is likely to push the Chinese government further in adopting a hard line towards Japan. Many Japanese politicians, on the other hand, think that, as time goes by, the past will become less important to the Chinese and the dispute about the past will just dissipate. But the opposite seems to be happening in China. While the consensus is that the most likely area of conflict in Asia would be between China and the US over Taiwan, I disagree. I think escalation of the current tensions between China and Japan, while undesirable for everyone, is a distinct possibility in the coming decade.
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TRADE GROWTH - THE EXCITEMENT MAY BE OVER
Apr 10, 2006
Denise Yam, CFA (Hong Kong)
March trade data disappoint:Heightened optimism for the trade sector following encouraging data for the first two months of 2006 is meeting with disappointment over the latest trade report for March. Export growth dipped back to single digits, at 7.1% YoY (totaling US$17.7 bn), the slowest since July 2005 (excluding the Lunar New Year-affected January), while imports fell YoY again by 0.5% (totaling US$16.2 bn).
IT sector the lone star: Within the export space, the IT segment was the only bright spot. Electronics exports rose 29.8% YoY, totaling US$4.9 bn or 28% of the total, similar to the pace in the first two months. Shipments of information and communications products (5% of total) continued to decline (-9.9% YoY in March) amid the structural shift towards outsourcing in the segment. Precision instruments, which have over the past couple of years become an increasingly dominant sector (9% of total), saw exports up 50.9% YoY in March to US$1.6 bn, though decelerating from the 80% gain in the first two months. In sharp contrast, traditional industries, such as metals (-6.7% in March vs -1% in Jan-Feb) and textiles (-5.4% in March vs +0.9% in Jan-Feb) saw shipments decline, though the chemicals sector still saw support (+7.7% vs +7.5% in Jan-Feb).
Japan was the latest source of demand: Demand from the US and Europe disappointed in March. Shipments to the US edged up only 0.6% YoY (vs +11.5% in Jan-Feb), while exports to Europe even fell 1.6% (vs +7.5% in Jan-Feb). Japan was the only major market that still stepped up imports from Taiwan, up 8.6% (vs +8.1% in Jan-Feb). Intraregional exports continued to outperform for structural reasons, amid strengthening manufacturing relationships. Shipments to Singapore (US$0.7 bn) and Korea (US$0.6 bn) rose 30% and 22%, respectively, while exports to Hong Kong and China combined grew 12.3%, nevertheless slowing from 18.2% in the first two months.
Weak imports reiterate weakness in domestic demand: The unexpected plunge in imports in December 2005 raised concerns on Taiwan's growth outlook. The rebound in January-February (+15.3%) appears to be only temporary. Raw materials imports, which help predict exports ahead, gained only 5% YoY in March, down from 24% in the first two months. The YoY decline in the imports of consumer goods, by 6%, reversing the 5.6% gain in January-February, suggests weakening domestic consumer demand. Capital goods imports, which we follow closely to gauge domestic investment sentiment, continued to drop, by 16.4% YoY in March, extending the 9.5% decline in the first two months, though easing from the 23% plunge in 4Q05.
1Q06 GDP growth supported by import compression: For 1Q06 as a whole, exports grew 11.5% YoY, slowing from 14.2% in 4Q05. IT exports enjoyed 29% growth, versus only 1.9% in the non-IT sectors. Although imports showed some recovery, from the 1% YoY gain in 4Q05 to 9.3% in 1Q, their compression relative to exports yielded a trade surplus of US$3.2 bn, a 57% expansion from the year-ago period. We estimate that this already contributed 5.4 percentage points to real GDP growth in the quarter, cushioning against weak domestic demand, although this contribution is down from 8.4 percentage points in 4Q05. The 1Q06 GDP report will be released in the second half of May.
Weak currency and loose monetary policy ever more important now: We have highlighted in our previous reports that amid sluggish domestic demand, slowing export growth and limited inflationary pressure, a weak currency and loose monetary policy are vital in supporting the economy. The Central Bank of China has comfortably allowed the yield gap between NT$ and US$ to widen to limit appreciation pressure on the currency. We had expected the CBC to maintain a conservative stance in monetary tightening this year, namely continuing to raise rates this year, but by a smaller magnitude than the Fed. However, we think the latest reports on inflation (see our report Inflation is Mild, April 6, 2006) and trade, together with the ongoing concerns with regard to the consumer credit situation, may prompt the CBC to end the rate hike cycle sooner. We maintain our 3.6% real GDP growth forecast for Taiwan this year, which is more conservative than the consensus (4.1%).
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1Q06 Advance Estimate in Line with our Expectations
Apr 10, 2006
Sweetina Chiang
1Q06 Advance Estimate: The Ministry of Trade and Industry released the 1Q06 advance estimate, which stands at 9.1% YoY. This is in line with our expectation of 9.2% YoY. The market consensus was 8.9% YoY. On a sequential seasonally adjusted annualized basis, the economy was estimated to have grown 1.2% QoQ (vs. 4Q’s 12.5% QoQ). Strong Industrial Production: The strong growth was primarily underpinned by a strong manufacturing sector performance (+16.0% YoY), which was not surprising given that industrial production in the Jan-Feb period already expanded 17.4% YoY on the back of the electronics, transport, engineering and biomedical segments. Construction Segment Still Contracting but Services Expansion Continues: Though HDB resale prices are still contracting -4.3% YoY, private property prices continue to firm out in 1Q06 (+4.7% YoY) for the sixth consecutive quarter. Nonetheless, the construction segment is still in contraction (-0.6% YoY vs. -0.8% YoY in 4Q05) in 1Q06. On the property side, we do not expect a significant pick-up due to our view of oversupply in the private property segment (the vacancy rate is 9.0%) and the currently lopsided incremental demand in the high-end market. However, government infrastructure plans should help strengthen the construction sector going forward. Meanwhile, the services segment is estimated to have expanded 7.6% YoY, accelerating from 7.2% YoY in 4Q05. Monetary Policy Shift Likely Tomorrow: MAS will release their monetary policy statement tomorrow at 8.00am. Given that the SG$ has been trading above the upper policy band since January, a policy shift towards further tightening could be likely in our view. Technically, there are three options MAS could undertake: 1) Widen bandwidth – unlikely given that volatility remains subdued, 2) increase the appreciation slope – potentially; and 3) re-centering the mid-value upwards – most likely. The difference between (2) and (3) would be that comparatively, (3) represents a sharper degree of tightening in the short term (which has mostly been played out already) but a smaller degree of tightening in the medium term. Given the current strong growth and our expectation of a likely moderation ahead, option (3) would be most consistent with the growth trajectory we are expecting.
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