Currencies
USD in a Holding Pattern Before a Soft Landing
Jun 02, 2006

Stephen Jen (London)

A cyclical USD soft landing to resume after dust settles

I continue to believe that the USD will likely resume its modest descent later this year for cyclical, rather than structural, reasons, when the latest round of risk adjustment is complete — a process that will take weeks, not months. I still believe that USD/Asia will be the best trades, and warn that EUR/USD is likely to overshoot. In the near term, investors should be aware that the speculative USD shorts have not been unwound in any meaningful sense and that further USD rallies from events such as Fed hikes could occur.

Risk reduction a healthy development

What has taken place in the last two weeks is, in my view, an attempt by the market to reprice risk to incorporate the fact that uncertainty regarding interest rates, inflation, growth and asset prices is higher than investors had assumed. This should be seen as a healthy development, as the Fed, other central banks and many pundits have long warned about the dangers of excessive risk-taking and the market perception that somehow volatility will remain low forever.

The real economy remains robust

The global economy remains robust, and there have been few data that suggest the world is downshifting to lower growth rates. While the US may indeed decelerate toward trend later this year, because of a softening housing market, many parts of the rest of the world continue to enjoy a healthy recovery. As long as the real economic fundamentals of the global economy remain robust, I do not believe that asset prices will go into free-fall.

Recent developments

My central case view remains unchanged. I still believe that the USD will be propelled modestly lower if growth indeed decelerates in 2H. In my view, the dollar will not trade lower because of an ‘inflation scare’ or the perceived ‘credibility’ problem the Fed might have with regard to inflation control: as long as the Fed keeps hiking rates, the USD will be supported. In other words, in my mind, for the USD to depreciate, US growth is more important than inflation.

Here I focus on several recent developments.

1. The market is still very short the USD against the EUR, the GBP and the JPY. Risk reduction has been uneven between developed and developing markets. Risk in the Asian currencies may have been mostly unwound, and reversed in some cases. For the majors, the striking feature is that there has been surprisingly little risk reduction in the USD shorts against the EUR, the GBP and the JPY.

What this means is that if risk reduction continues, there is significant scope for short-term USD rallies against the majors. The USD has already appreciated against most emerging market currencies. Investors who hold a bearish view on the USD will thus need to be cautious in the near term and be watchful of one-sided market positioning.

2. The biggest risk to our cyclically bearish dollar call is inflation in the US. If inflation becomes a bigger worry for the Fed, I have no doubt that the Fed will do what is necessary to stay ahead of the curve. Decelerating growth will drive the dollar lower, while upside inflation surprises will drive the dollar higher, as the Fed’s rate action will overwhelm concerns of credibility. Coupled with the point I made above that there are still substantial USD shorts in the market, we need to be very watchful of inflation surprises and the possibility that the FFR could rise beyond 5.50%.

3. The USD is still a safe haven currency. The fact that the USD rallied against many currencies in the past three weeks is evidence that the USD is still a legitimate safe haven currency, particularly when it has also been the funding currency. This is consistent with my ‘Dollar Smile’ idea that the dollar tends to do well ‘at extremes’: The USD tends to be strong when the US leads the world into a strong economic recovery and when the US leads the world into a recession. My point is that a broad-based USD crash is an extremely unlikely event, because of how reliant much of the emerging world is on the US and because of the hegemonic reserve currency status of the dollar.

4. President Bush now has a ‘dream team’. President Bush has to be given credit for making several good appointments to key positions, in my view, including Mr Bernanke as the Fed Chairman, Mr Kohn as the Fed’s Vice Chairman, and now Mr Paulson as the new Treasury Secretary. I believe that the Fed has the best men in the key seats. We can say the same about the US Treasury, particularly if the White House has made a deal with Mr Paulson to give him more autonomy and say in formulating policies. This cannot be negative for the dollar, in my view.

5. No chance of another ‘Plaza Accord’. Henry Paulson’s structural view on the dollar is actually quite similar to mine: global imbalances are a logical consequence of globalization, and that the choice we faced in the last few years has been between (a) a global recession or (b) outsized C/A imbalances. The C/A deficit of the US can only be gradually normalized by ‘back-tracking our way’, i.e., the core causes of the US C/A deficit must be reversed. Further, using the dollar to do most of the work through another ‘Plaza Accord’ would be counter-productive because the risks outweigh the benefits. The market’s acute reaction to the last G7 Communiqué is proof that the asset market’s reaction to the Treasury adopting an explicit weak dollar policy would likely be violent. In my view, the costs would outweigh the benefits of another ‘Plaza Accord’.

6. The US trade account is turning. The sharp surge in US export growth in March (13.8%) should not be a surprise if we truly believe that the world has finally begun to ‘balance up’. If, in addition, the US housing sector continues to soft land, we will likely see the logical implications for US imports. While it will take some time before the trade deficit/GDP ratio stabilizes, I urge investors to start paying attention to the potential that the US external balance may be reaching an inflection point now.

Bottom line

Despite the risk reduction that has taken place in various markets in recent weeks, there are still substantial USD shorts in EUR/USD, GBP/USD and USD/JPY. Inflation surprises could trigger short-term rallies in the dollar. Having said this, I continue to believe that, later this year, decelerating growth (not a recession) should drive the dollar lower, particularly against Asia. The risk-reduction phase we are in will postpone the timing of the cyclical depreciation in the dollar we have been looking for since last December. Also, we note that the safe haven nature of the USD has been reaffirmed, supporting our structurally constructive outlook on the dollar.

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UK
Pensions Security in Retirement...?
Jun 02, 2006

David Miles (London) and Laurence Mutkin (London)

The UK government’s White Paper on pension reform was published last week. Its focus was on Tier 1 (state) pension provision, including proposals for the eventual return to a link between the basic state pension and earnings, a rise in the state pension age, the creation of a new national pensions saving scheme and other measures; but it also launched a rolling deregulatory review of private sector pensions regulation. Among the provisions mentioned for possible re-examination were the mandatory indexation (in line with prices) of pensions in payment and restrictions on changes to scheme members’ accrued rights. The potential implications of any changes in this area are huge.

But whether this is really a proposal to simplify existing rules, leaving in place mandatory requirements for price indexation of company pensions in payment but in a less complicated form, or a more radical suggestion, perhaps diminishing or even scrapping legal requirements for indexation, is unclear. At the moment, the UK government is merely flagging this as an issue for consultation on which reactions are welcomed and on which a group of stakeholders’ views will be sought.

We doubt that the proposal is aimed at making radical changes to scheme members’ pension rights by further eroding pension indexation. But if this is a possibility, it could have a significant impact on the cost to companies of fulfilling pension obligations and, therefore, on the level of scheme funding. In the extreme and radical case, the proposal could ultimately be that scheme sponsors and pension fund trustees might be able (though clearly not required) to reduce the costs of paying pensions by effectively making pensions a fixed nominal obligation at the point of first payment, rather than the inflation-linked obligation which they presently are. This might become a safety valve for pension schemes that otherwise face large deficits and where the scope of the corporate sponsor to make good the gap between assets and liabilities is extremely challenging. It might mean that companies become more willing to keep defined benefit (DB) schemes open, which is presumably why it is being floated in the White Paper.

Of course, such a radical shift would not actually make scheme members any better off. On the contrary, replacing a long-term inflation-linked liability with a nominal one would certainly have the effect of reducing the present value of a DB pension scheme’s liabilities, and therefore its deficit — but only because it reduces scheme members’ assets. The beneficiaries of the DB system would find themselves with (much) lower future income, which would make them more reliant on state pension provision and/or would mean they had to start making additional pensions savings alongside their reduced DB entitlements.

In our view, a change this sweeping seems unlikely to be the intention of a measure introduced as part of the government’s regulatory simplification plan. Further, we would expect that many of the stakeholders engaged in consultation on this issue would express great hostility to a proposal which might be portrayed as a ‘back-door’ cut in DB scheme members’ pension rights.

Whatever the extent of the proposal turns out to be, we do not see that it would alter the need for DB pension schemes to reduce the mismatch between their assets and liabilities. But it may have potential implications for the mix of assets that pension funds might most naturally wish to hold to match their liabilities. The theoretical option — possibly in extremis — to convert what is now a mixture of a real and nominal liability (given the current UK mandatory price indexation arrangements) into something which is closer to a nominal obligation might affect the desirable split between conventional (nominal) and inflation-indexed bonds in pension fund portfolios, but not the desirability of owning fixed income securities.

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Turkey
Volatility Trap
Jun 02, 2006

Serhan Cevik (London)

Increasing volatility in the global financial markets hijacks Turkey’s disinflation process. Volatility is in the nature of financial markets, but the ballooning volume of speculative positions and heightened inflation fears at the peak of the global business cycle have worsened the effects of recent anxiety, especially on emerging markets. With intensifying risk reduction that has even weakened commodity-based currencies in the midst of a commodity bubble, it is not surprising to see capital outflows from Turkey’s financial markets and consequently the lira’s sharp depreciation — reaching 19.0% against the dollar and 21.3% against the euro — in the last four weeks. And the unambiguous decline in risk appetite will likely keep the lira (as well as other financial assets) under stress, at least until we get a better picture of the direction of interest rates in developed markets. Of course, these ‘corrections’ increase the uncertainty surrounding inflation projections and therefore the monetary policy stance. Given the degree of openness and dollarisation of the Turkish economy, the weakening of the exchange rate, even if it gets corrected later in the year as we expect, will push domestic prices higher. But is this enough to justify an immediate increase in short-term interest rates? We think not at this stage.

The rise in inflation is not because of demand-driven pressures in the domestic economy. Following a rapid decline from the post-crisis peak of 73.2% at the beginning of 2002 to the low of 7.1% in June 2004, the slope of the disinflation process has become flatter in the past year-and-a-half — and actually inflation increased from 7.7% at the end of 2005 to 8.8% in April. However, as the declining diffusion index confirms, this is a result of certain categories, like energy, gold, unprocessed food and clothing, in the consumer price index. As a matter of fact, the ‘core’ CPI excluding energy, gold, unprocessed food and administrative prices declined to 5.3% in April. That may be good news for the long-term outlook, but the lira’s recent fall will no doubt have inflationary consequences. Although the pass-through effect of a one percentage point depreciation on consumer prices has declined from 45bp to 24bp in the post-float period, price indices are still sensitive, especially to a weaker exchange rate. Nevertheless, such effects are not independent of the state of the economy. The unemployment rate of 12% and real wage growth of just 2.9%, compared to a 32.0% increase in output-per-hour-worked in the last four years, show considerable slack in the labour market. Moreover, according to our conservative estimates, the non-accelerating inflation rate of unemployment is now lower and the Turkish economy is still operating with an output gap.

The lira’s weakness has already led to a tightening in financial conditions. Turkey’s economy and financial markets have enjoyed tremendous benefits from increasing integration with the global economy. Of course, greater openness comes with higher exposure to global shifts — mostly favourable, but sometimes unpleasant. This may be challenging from time to time, but also ensures a certain degree of commitment from policymakers and brings efficiency gains. Therefore, we need to be careful in analysing effects of ‘exogenous shocks’ like higher energy prices or risk reduction-driven weakening in the exchange rate. The rise in inflation that we will observe in the coming months is not going to be a result of an overheating in the domestic economy, but a by-product of the lira’s sharp depreciation. Furthermore, this correction will also bring a tightening in financial conditions. Indeed, the 5-year bond yield has already increased by 460bp from 13.4% to 18.0% of late, and anecdotal evidence suggests a sudden contraction in credit availability. This is likely to have a significant effect on consumers who have become accustomed to financing current expenditures with bank credit. In our view, these emerging constraints on the demand side, coupled with the country’s elevated supply frontier, should make inflationary pressures stemming from the exchange-rate weakness temporary and smaller than the ‘rule-of-thumb’ calculations.

If inflation becomes entrenched, there is only one option for an inflation-targeting central bank. Although exchange rate intervention may seem a reasonable response to a currency-driven rise in inflation, it could have unintended consequences by inviting all the punters in the world who want to short or get out of emerging markets. Since this is a global risk-reduction wave, not a result of Turkey-specific developments, the central bank’s reserves (which increased from $21.6 billion in 2002 to over $60 billion currently) would still not be enough to stand against the flood of potential dollar demand. Thus, if the temporary surge in inflation starts becoming a sustained phenomenon, the optimal way to respond for an inflation-targeting central bank is to raise short-term interest rates and, as the latest policy statement clearly highlights, the Central Bank of Turkey is ready to do whatever is necessary to keep inflation within the multi-year target range. However, we believe that the latest developments do not yet warrant such a tightening of the monetary policy stance, even though we do acknowledge the risk of a liquidity shock turning into a self-fulfilling vicious circle. Turkey may have a long history of macroeconomic instability, but prudent fiscal policies and structural reforms that have strengthened the economy and financial markets make the probability of such an adverse shift very low.

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China
Lessons from the Ore War
Jun 02, 2006

Andy Xie (Hong Kong)

Summary and conclusions

Iron ore producers appear to have succeeded in forcing up iron ore pricing significantly despite declining steel prices. China’s fight to contain the price increase has not been fruitful. China’s new macro tightening measures are likely to cool demand ahead, and its steel industry may face a difficult period.

Financial speculation keeps pushing up prices of other commodities without production concentration, like iron ore. China’s RPI rose by 19 percentage points more than CPI between 2003 and 2005, and may rise a further 4 percentage points in 2006. The cost squeeze on China’s downstream industries could increase non-performing loans.

The current cycle has exposed China’s vulnerability in the commodity market. Without adequate preparation, the situation could be much worse in the next cycle. China should try to promote competition in supply through financial investment, maintain adequate inventories to deter speculation, and increase efficiency in using natural resources.

The origin of the ore war

One year ago, Nippon Steel signed an agreement with the main ore suppliers to accept a 75% increase in the ore price. One amazing characteristic in the international ore trade is that the market accepted the price agreed to by one major buyer. The concentration of ore production relative to steel production has led to this practice.

Chinese steel producers were outraged that they were not consulted over the massive increase despite accounting for one-third of the global steel production. They tried to take the lead in the price negotiations this year. As steel prices had declined in the past 12 months, Chinese steel producers bargained for a price cut or at least no increase.

As the negotiations between Chinese steel producers and the main ore suppliers became bogged down, the latter got a middle-size steel producer in Europe to agree to a 19% price increase. That provided the cover for other major steel producers to sign on for the same increase, as they feared that the protracted negotiations could destabilize the market. Even though Chinese steel companies took the lead in the negotiations, they were effectively presented with a fait accompli by the iron ore producers.

The failure magnifies the weakness of China’s system, in my view. Chinese steel mills are mostly owned by local governments. The industry is highly fragmented despite China’s one-third share of global steel output. All local governments want to control their steel companies, which makes consolidation difficult. The fragmentation has decreased the ability of Chinese companies to invest in ore production or to bargain with the main ore producers.

The united front that Chinese producers put up in talking to ore producers was really a government-guided effort. Its failure again illustrates that government power cannot substitute for commercial expertise. I believe that the way out for China’s steel industry is to allow the industry to consolidate. The top ten steel producers in the world should be Chinese instead of just one. When this occurs, the big companies will have the financial wherewithal to invest in ore production.

Helpless before financial speculation

Iron ore is not China’s biggest problem in commodity markets. In 2005, China paid US$18.3 billion (0.8% of GDP) for 275.1 million tons of ore compared to US$58.3 billion (2.6% of GDP) paid for crude and refined petroleum products. Copper is the champion in terms of price, up four times in three years.

China paid US$97 billion for the imports of energy, mineral and metals in 2005 compared to US$27 billion in 2002. 70% of the increase is due to price appreciation, not volume increase. This suggests that China pays 3.4% more for every 1% increase in demand. In the preceding decade, the import value only rose by 1.06% more for every 1% increase in volume.

The big jump in price sensitivity to volume was accompanied by acceleration in China’s imports to 21% per annum between 2002-05 from 13% previously. Most commodity bulls attribute the price rise to China’s volume growth.

I believe that liquidity has played a more important role. Speculation in commodity works if speculative demand can offset the decline in real demand and the increase in supply due to high price. When liquidity is plentiful, the bullish sentiment is self-fulfilling due to the herd mentality. Financial speculation essentially makes a fragmented industry behave like a monopoly in pricing.

If the current trend is sustained for another three years, China would pay US$352 billion for commodity imports in 2009, about 11% of estimated GDP. Of course, global liquidity is receding and the price elasticity for China’s commodities should decline significantly from 3.4% at present. Nevertheless, there is considerable uncertainty as to how much the Chinese economy must pay for raw materials. Financial speculation appears to dictate that.

The need for a comprehensive commodity strategy

Global liquidity is cyclical. There will be a commodity burst when tightening global liquidity brings down the global economy, in my view. When commodity prices are low, governments and businesses tend to forget about taking preventive action against high future prices. China cannot afford to make the same mistake again.

There should be three components to China’s commodity strategy: promote competition, maintain ample inventories, and increase consumption efficiency. On competition, China watched the consolidation of the ore industry and is suffering the consequences today. Other industries like nickel, copper and even oil also have consolidating tendencies.

China is experiencing a capital surplus. While the magnitude is cyclical, the surplus situation could last for three decades until China becomes a mature economy, in my view. One of the best uses for China’s surplus is to promote production of commodities like oil, iron ore and copper through financing exploration and production projects outside of the main producers. In iron ore, for example, China should not partner with the main suppliers in project development. It would only increase industry concentration, contrary to China’s interest.

On inventories, it is the only effective weapon against speculation. Inflation is likely to force the Fed to raise interest rates aggressively, which could cause the commodity bubble to burst in 2007. The low prices may not last long. If central banks flood the world with liquidity during the next downturn, commodity speculation would come back.

China should allocate a major share of its forex reserves for commodity inventories to be implemented during a global downturn. China should build a one-year supply of inventories for most metals. The deterrent effect from a huge inventory could stop financial speculation for good.

Lastly, China has to economize on using commodities, in my view. China’s economy is excessively quantity-driven, because local government officials are promoted on GDP performance. The central government is shifting its criteria for promoting local government officials to reflect balance and efficiency in addition to growth. As long as the government sticks with this policy, China’s usage of commodities for units of GDP should also decline.

In my view, a compressive commodity strategy is necessary to safeguard China’s development. The right time for implementation is during the next global downturn. It is never too early to put together such a strategy.

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Japan
Liquidity Collapse?
Jun 02, 2006

Takehiro Sato (Tokyo)

What’s new

Concern about depletion of excess liquidity is weighing down global capital markets. However, this is an overreaction, in our view, and economic fundamentals are not worsening. Liquidity risk takes getting used to, and we doubt that investors will continue to turn their backs on a market that is returning to normal.

Conclusions

Concern about liquidity drying up is en vogue in the early stages of monetary tightening (it happened two years ago in the US as well). However, fashions are always changing, so it is important not to be sidetracked by this one.

Policy implications

Excess reserves should decline significantly as a policy rate hike results in higher opportunity costs. This is not to say that the BoJ will reduce its current account balance in order to hike rates. Rather, the current account balance should decline naturally as a result of a rate hike. This should have nothing to do with global excess liquidity drying up, however.

Risks

Capital markets will likely be susceptible to even minor bad news until market participants get used to liquidity risk. However, a dip towards the summer would present good buying opportunities, in our view.

Details

Market functions continuing to recover

Money market volatility increased at the end of last month as the BoJ cut its current account balance to about ¥12 trillion. As a result, the overnight unsecured call rate rose temporarily above the Lombard rate (0.1%), the theoretical maximum. This was a widely expected product of the end of quantitative easing, but the return of liquidity risk is also a symbol that market functions are improving. As such, the rise in short-term interest rates tells us a couple of things:

1) The money market changed significantly during the five years of quantitative easing due to major reforms like capping deposit guarantees and the introduction of the RTGS (real-time gross settlement) system. In particular, tight supply-demand of funds was common even under the zero interest rate policy, when the excess reserves are drained.

2) Markets do not change continuously, but often in a discontinuous manner.

Also, we have long said that the BoJ’s current account balance and the timing of policy rate changes are unrelated. The current situation appears to confirm this.

Below, we discuss what we see as the future for asset markets in light of money market changes and the message sent by the BoJ’s reserve balance.

Market re-acknowledges yen availability risk

To begin, the quality of the money market has shifted remarkably during the period of quantitative easing. We see three main reasons. First, one by-product of capping deposit guarantees is that savings are now concentrated in megabanks, which have relatively stable finances. As a result, deposits now outweigh loans at megabanks. Second, tightening BIS regulations have increased awareness of risks related to lending by one domestic financial institution to another. Third, the introduction of RTGS has made daily fluctuation of capital supply-demand more volatile. Financial institutions became indifferent to liquidity risk during the five years of quantitative easing, and this resulted in such negative developments as a shrinking of credit line networks, a shrinking of front and back-office operations and the postponing of responses to major changes like the introduction of the RTGS system. This decline in market functions likely caused the current overreaction by market participants.

Prior to the capping of deposit guarantees, funds flowed constantly from regional banks, credit unions and trust banks to city banks. However, after the cap was applied, the money market became more limited, serving only foreign banks (that are constantly short of yen) or financial institutions needing an emergency input of yen funds. As a result, the overnight call rate, which was previously thought to be risk-free, now includes a premium, although this could be temporary.

What does the future hold? At the end of last month, the BoJ pumped a record amount of capital into the money market, and indicated that it wanted to keep the overnight unsecured call rate from rising. As a result, the overnight call rate returned to a weighted average of about 0.03%. However, market participants who are once again concerned with liquidity risk will likely procure more capital than usual, and they will procure as much as possible at longer-term rates instead of at the more unstable overnight call rate. Thus, short-term rates other than the overnight rate will likely remain high, even if concerns that interest rates will rise are somewhat eased by a strengthening yen and a falling stock market.

It appears that this risk premium will not drop remarkably until either market participants regain their sensitivity to liquidity risk and get used to day-to-day funding operations, or the policy rate is actually raised, meaning that no more bad news would be likely in the short term. Until one of these things happens, speculation that excess liquidity will shrink is likely to create instability, with the market highly susceptible to even minor bad news.

High liquidity risk could increase other risks

Next, the decline in the current account balance held at the BoJ seems to be sending a negative message to global investors. Let’s review the latest developments:

The current account balance totaled ¥14 trillion as of June 2, while the amount of legally required reserves is about ¥6 trillion. However, it is impossible for the BoJ to lower its reserve balance to the legally required level because of tight supply-demand on the call market. Indeed, the BoJ’s aggressive moves to pump funds into the money market at the end of May actually increased the current account balance from ¥12 trillion to ¥14 trillion. We think that the BoJ will look to lower its current account balance going forward, but lowering it too much could cause interest rates to rise. In other words, there is a limit to how much it can be lowered.

Given this, it would seem that lowering the current account balance is no longer necessary or sufficient for hiking rates. In fact, we think that excess reserves will decline significantly as a policy interest rate hike results in higher opportunity costs. That is, we do not expect the BoJ to reduce its current account balance in order to hike rates. Rather, the current account balance will decline naturally as a result of a rate hike. This should have nothing to do with global excess liquidity drying up, however.

So what are the implications for capital markets? We cannot deny that overseas investors are assuming the absorption of excess reserves to be one of the causes for global liquidity drying up. If investors thinking this way end up as the majority, then the market will essentially be a beauty contest regarding whether they are correct or not. In fact, it does not look as though the asset markets are reacting favorably to the BoJ’s action.

However, there is an ongoing argument as to how ‘excess liquidity’ should be defined. Quantitative indices like the monetary base or M2+CD are not much help. We would like to universally define excess liquidity as a situation of loose credit, or one where sensitivity to risk has declined. Based on this, it appears that one of the reasons for the minor panic in global capital markets since mid-May is that the BoJ reducing excess reserves (or speculation that it will do so ahead) resulted in a higher risk premium. In other words, it appears that market participants not only newly acknowledged liquidity risk, but also became more aware of risks that go along with it like credit risk and market risk. The rapid rise in the money market rate stemming from changes we discussed earlier also helped increase concern.

Dealing with liquidity risk takes getting used to

So what does the future hold? The key factor in determining the future is whether market participants continue to be concerned about yen liquidity. If liquidity risk rises, credit risk rises as well; on the other hand, when market participants get used to dealing with liquidity risk, their other concerns recede. However, it is important to note that this will not go on forever. Market participants just need to get used to liquidity risk, and when they do the risk premium should naturally decline. Accordingly, one should not be too concerned about the softer asset markets currently. Also, the reason that the short-term money market is once again acknowledging liquidity risk is that the market is normalizing. Investors are unlikely to ignore fundamentals and continue to turn their backs on a Japanese market that is normalizing.

Conclusion

We do not agree with the negative things being said about the BoJ’s recent operations. Even if we admit that the BoJ’s absorption of excess reserves having an adverse impact on global capital markets, we believe that the impact will stem from an overreaction to liquidity risk, not from declining economic fundamentals. Concern about liquidity drying up is en vogue in the early stages of monetary tightening (it happened two years ago in the US as well). However, fashions are always changing, so it is important not to be sidetracked by this one.

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Euroland
A BullFight in Madrid
Jun 02, 2006

Elga Bartsch (London)

Bullfights, la corrida, are still regarded by many as a key element of Spanish cultural heritage. This coming week, the ECB Governing Council heads to Madrid to debate the appropriate course of monetary policy action at this week’s Council meeting at the Banco di Espana. While it seems certain that euro area interest rates will be increased at this meeting, it is less obvious by how much. In my view, there is a distinct possibility that the ECB could surprise the market and us by raising interest rates by more than 25 basis points at that meeting and make up for lost time by hiking 50 basis points. Although an outright fight seems unlikely, there will likely be a lively discussion between those who believe that the Bank needs to act more decisively to contain rising risks to price stability and those who are in favour of a continuation of the ECB’s gradual tightening campaign. Any indication of rising inflation risks in the euro area might act as the proverbial red flag to the bulls.

In my view, the incoming data warrants a slight acceleration in the ECB’s tightening campaign ahead of the August summer recess. Only this week, we saw headline HIPC inflation unexpectedly rising to 2.5%Y in May, PPI climbing back to 5.4%Y, M3 money supply growth soaring to 8.8%Y and loan growth surging to 12.3%Y in April. All of these indicators would suggest that cyclical inflation risks, although still limited, are on the rise. More worryingly for the medium-term inflation outlook, inflation expectations measured by various surveys have risen markedly since the May Council meeting. Consumers’ inflation expectations, for example, have jumped to a reading of 22, the highest level since the spring 2002, thus marking a more than six point gain. On our estimates, a net balance of 22% of households who expect inflation to rise in the coming twelve months corresponds to an HICP inflation rate of around 2.5%Y, up from a previous estimate of 1.9%Y in April. Similarly, manufacturers’ selling price expectations have risen further above their long-term average in May. Finally, inflation expectations embedded in the euro-area bond market have remained elevated at 2.24%.  

Together with very robust activity indicators, rising risks to price stability argue in favour of hiking interest rates pre-emptively by 50 basis points before the August summer recess to ensure that inflation expectations remain anchored, I think. One should bear in mind that, contrary to that of the Federal Reserve, the ECB monetary policy stance is still a rather expansionary one, with current policy rates about 100 basis points below the neutral level. Unfortunately, the ECB had already ruled out a move in May back in April (see EuroTower Insights: Too Much Communication, May 19, 2006). Therefore, it might now find itself in a bit of a tough spot where it will have to choose between being perceived as falling behind the curve or being perceived as astounding already jittery financial markets. The recent rise in the euro and a fall in equity markets might, however, prevent the ECB from stepping up its tightening campaign at this stage. Despite continuous efforts on the part of all ECB Council members to leave the door open for a 50 basis point move, the market is assigning only a small probability to such a large rate hike this coming week. Personally, I see the, as ever, subjective probability of a 50 basis point hike being as high as one-third.

If the ECB indeed hikes interest rates by 50 basis points this coming week, the knee-jerk reaction in financial markets would likely be negative from both government bonds and equity investors. It doesn’t take an advanced degree in bond mathematics to see that the front-end of the euro area bond market will likely take the hardest hit. As a result, we would likely get a bearish flattening of the yield curve, especially if the subsequent press conference comes across as hawkish, which it might well do given that Mess. Trichet, Papademos and Caruana would have to justify the Council’s bold decision. In my opinion, the ensuing sell-off in the bond market following a potential 50 basis point rate hike would likely present a buying opportunity for bond investors. This is because such a bold, pre-emptive move, together with a potential further rise in the euro that it will probably trigger, should fuel market concerns about the euro-zone growth outlook for next year. Contrary to money market futures, which price ECB interest rates rising gradually to 3.75% in the course of next year, we look for an early peak at 3.25% at the end of this year and even see scope for ECB interest rate cuts in late 2007. This view might become more mainstream after a 50 basis point move in Madrid. And at that point, we might see ten-year Bund yields starting to fall on a more sustained basis than the recent flight-to-quality bid. Beforehand, ten-year Bund yields might first have to rise though.

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Malaysia
April Trade Lower than Expectations
Jun 02, 2006

Deyi Tan (Mumbai) and Denise Yam, CFA (Mumbai)

April trade disappoints. April trade numbers surprised on the downside. Exports growth came in at 6.3% YoY (vs +9.5% in March). Imports came in 11.4% YoY. This is below our expectations of 12.5% and 16.4%, respectively.

Where’s the shortfall? In electronic and some primary commodities ... Momentum in electrical and electronic goods, which comprise key exports such as semiconductors and computer and electronic parts, was more subdued at 4.2% YoY (vs+ 7.7% YoY in March). Primary commodities such as crude oil, which have surged in double-digit territory, registered a surprising contraction (-1.4% YoY) despite the price effect. Liquified natural gas was flat (+0.5%), though palm oil and petroleum product exports accelerated to 8.7% YoY and 60.1% YoY, respectively.

Capital imports moderates ... Meanwhile, by end-use classification, capital imports showed a marked decline in momentum (+8.9%YoY) after a quarter of 29.2% growth. This is because 1Q05 capital import growth was bolstered by lumpy imports, and also due to base effects. Intermediate imports sustained at 8.2%. Consumption imports decelerated to 14.0% YoY.

What does this imply for the trade outlook? We are not too worried about the April data, though the sporadic weakness likely indicates a momentum that is not only capped by a loss of competitiveness but also underpinned by patchy demand from export markets. Nonetheless, we think the trade growth cycle, which was on an uptrend before this, likely has a few more months to go before softening. From the trade perspective, the persistence of high oil prices will also help to support what we see as a relatively shallow recovery.

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India
Portfolio Flows - The Critical Macro Link
Jun 02, 2006

Chetan Ahya (Mumbai) and Mihir Sheth, (Mumbai)

What’s new: The recent sell-off in emerging market equities and outflow of portfolio flows have again brought to the fore the macro challenge presented by India’s over-dependence on portfolio flows. Portfolio flows have accounted for about one-third of the total capital flows into India over the last three years, and have been a key factor behind the low real interest rates during this period.

Implications: Rising US short-term rates and India’s current account balance swinging into deficit have already pushed real interest rates higher. Given portfolio equity outflows of US$2.6 billion over the last 15 trading days, there is now a risk of this low-real-rate-dependent, credit-driven growth cycle breaking.

Conclusion: We think the reversal of portfolio flows, which has been the anchor of India’s growth acceleration trend in the last three years, highlights the need to initiate bold reforms in the area of privatization, FDI and infrastructure (PFI reforms) to sustain the 8%-plus growth rates.

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