Review and Preview
April 01, 2008
By Ted Wieseman | New York
Treasuries posted significant losses across the curve over the past week – incredibly, the first across-the-board negative week for the market, from the 4-week bill to the 30-year bond, since October. A huge sell-off on Monday as risk markets surged higher on a big further reduction in investor fears about systemic and counterparty risk was only partly reversed over the rest of the week as credit, equity and other focus markets reversed some or all of Monday’s rally over the rest of the week. Agency MBS also were softer after the big rebound over the prior couple weeks from the earlier period of disastrous performance, in large part as a result of periods of significantly stepped up mortgage origination activity (the refi index in the MBA’s mortgage applications survey spiked 82% in the latest week), and this weighed on Treasuries. Meanwhile, the seemingly low demand and stop-out rate at the Fed’s first Treasury Securities Lending Facility (TSLF) auction helped ease fears about strains in the repo market. The main impact of the auction was to sharply raise previously extremely low Treasury general collateral repo rates towards much more normal levels, which also contributed to a further easing of the squeeze in the bill sector, a move that our financing desk thinks could have a significantly positive psychological impact on their market. The Fed’s Primary Dealer Credit Facility (PDCF) – the introduction of which seems to have marked a key turning point in market sentiment about systemic risk – also appears to be seeing good use. Loans outstanding as of Wednesday rose to US$37 billion from US$29 billion a week earlier, so it has apparently been tapped in significant amounts on top of the initial Bear Stearns-related borrowing reflected in the prior week’s number. And the New York Fed’s open-market desk surprisingly did reverse repos on Friday to drain reserves even though fed funds was trading a good bit above target, suggesting that there might have been significantly more PDCF borrowing going on as quarter end loomed. Economic data released through the week were mostly market-friendly but had limited impact. The expectations gauge in the Conference Board’s consumer confidence survey plunged to almost a record low, the durable goods report was very weak and pointed to a significant drop in 1Q investment spending, core inflation moderated a bit more than expected and consumer spending remained stagnant. The main positive outlier was a bounce in existing home sales. Home sales appear that to be possibly bottoming out, but we still think that even if they are, new construction will need to fall much further to bring inventories under control over the next year. The upcoming week brings the key early round of March data, which we expect to remain recessionary, as well as testimony on the economic outlook by Fed Chairman Bernanke.
For the week, benchmark coupon yields rose 14-19bp, with the 2-year yield up 14bp to 1.67%, 5-year 19bp to 2.53% (with 2-3bp of the increases for these two accounted for by the rolls into the new issues), the 10-year 15bp to 3.47%, and the 30-year 18bp to 4.345%. The Fed’s TSLF auction broke the squeeze at the short end. After averaging below 1%, mostly well below 1% and with trades being done at 0% every day since March 17, the Treasury overnight general collateral repo rate averaged 2.07% on Friday, a much more normal relationship to the 2.25% fed funds target. This move also helped to alleviate the squeeze in bills, with the 4-week bill’s bond equivalent yield up 96bp to 1.29%, 3-month 80bp to 1.39%, and 6-month 32bp to 1.51%. Broadly based renewed upside in commodity prices helped TIPS to partially reverse a couple of weeks of major underperformance, with the 5-year yield up 5bp to 0.16% and the 10-year 12bp to 1.12%. Swap spreads were mixed on the week, but wider in the intermediate and longer ends of the curve, with the benchmark 10-year spread rising 5.5bp to 67.5bp after having narrowed almost 30bp over the prior couple of weeks from multi-year highs hit earlier in the month. Agency MBS slightly underperformed swaps on the week, but this also came after what had been a big (though only partial) recovery from huge prior spread widening. Through the week, Treasuries largely followed inversely the performance of credit and equity markets, which generally had major rallies on Monday and small further gains on Tuesday followed by negative reversals on Wednesday to Friday, resulting in mixed net performance for the week across markets. Credit widened a good bit from Tuesday’s best levels but still ended better on the week. In afternoon trading on Friday, the series 9 investment grade CDX index (the series 10 debuted as the new on-the-run during the week) was 14bp tighter on the week at 146bp. The high yield index was 65bp tighter on the week at 665bp through Thursday’s close, but some of this was being given back Friday, with index trading down 5/8 of a point in late trading. Stocks followed a similar trajectory of a big rally on Monday, smaller further gains on Tuesday, and then a downside reversal the rest of the week, but the early-week gains weren’t as big as in credit, resulting in the S&P 500 ending the week down 1.1%. The leverage loan LCDX index was 44bp tighter on the week through the midday Friday pricing at 421bp. The commercial mortgage CMBX market had a very good week, with a comparatively small reversal off the best levels hit early in the week. The AAA index tightened 40bp on the week to 154bp and the AJ 125bp to 407bp. The subprime ABX market, on the other hand, remained a negative outlier, continuing to show little or no net improvement over the past couple of weeks as other markets have rallied strongly. The current series AAA index fell 0.84 point on the week to 51.93 (and nearly broke 50 mid-week), not far from the low close of 50.67 hit March 17. There was a lot of volatility but little net change in Fed pricing on the week, with the futures market continuing to price a 1.75% funds rate trough, but unsure if we’ll get there in April or June. The May fed funds contract lost 2bp to 1.88%, continuing to price a toss-up between a 25bp and 50bp cut at the April FOMC meeting. The July contract lost 0.5bp to 1.785%, and the low-rate September contract was unchanged at 1.74%. A bit more reversal off the expected trough in rates by the fall was priced in for next year in eurodollar futures, with the Sep 08 to Sep 09 spread rising 13.5bp to 53.5bp and the Dec/Dec spread 9.5bp to 72bp. 3-month LIBOR has now set higher six straight days, from a low of 2.54% on March 18 to 2.70% on Friday, leading to a significant rise in LIBOR/expected fed funds spreads. On the week, the 3-month LIBOR/3-month OIS spread increased by 12bp to 73bp. Economic data released the past week bearing directly on our 1Q GDP forecast netted out, and we continue to forecast a 0.4% annualized decline. The weak durables report pointed to a bigger drop in business investment, but the surprising composition of the unrevised 4Q growth rate of +0.6% – a downward adjustment to inventories offset by an upward revision to consumption – implied a bigger inventory contribution. And real consumer spending remained stagnant in February, but the pattern of revisions to prior months was marginally positive, leading us to slightly raise our consumption estimate, though to a still just barely positive rate. Durable goods orders fell 1.7% in February, as a partial rebound in the volatile aircraft component provided only a small offset to a 2.6% plunge in the key core gauge, non-defense capital goods ex-aircraft. A record 13.3% plunge in machinery bookings was responsible for the weakness in core capital goods orders; computers (+10.0%), telecom equipment (+6.0%) and electrical equipment and appliances (+1.6%) provided a partial offset. Non-defense capital goods shipments were also weak, falling 2.1% in February on top of a 0.4% decline in January, pointing to a significant decline in business investment in equipment and software in 1Q. We now see equipment investment falling at an 8% annual rate and overall investment 7%. A partial growth offset was provided by another elevated gain in inventories (+0.5%), which pushed the I/S ratio to its high since 2001. This positive from inventories was further added to by the composition of the 4Q revision, and we now see inventories adding 0.4pp to 1Q growth. Meanwhile, personal consumption spending ticked up 0.1% in February. With the overall PCE price index up 0.1% (+3.4%Y), real spending was flat and has now shown close to zero growth over the past three months. The pattern of revisions to prior months was slightly favorable, though, and we raised our 1Q consumption estimate marginally to a still very weak +0.7% annualized. Core inflation was also moderate in February, rising 0.1% for a lower-than-expected 2.0%Y gain, unchanged from a lowered January rate and down from +2.2% in December, thanks to small downward revisions to 4Q and January. Year-ago comps are going to be very challenging for the next few months, however – core PCE inflation rose at only a +1.3% annual rate in the four months through June 2007 – so the year-on-year pace will likely drift higher again through mid-year. Other data were mixed, with a shocking deterioration in consumer sentiment, but some positive signs from the home sales results. The Conference Board’s measure of consumer confidence plunged 11.9 points in March to 64.5, a 15-year low (outside of the beginning of the Iraq invasion in 2003). Deterioration in expectations – considered a leading economic indicator – was particularly severe, with the expectations gauge down 10.1 points to 47.9, the second-lowest reading ever (the only lower outcome coming in 1973). Expectations for job growth over the next six months were particularly grim, but expectations for overall growth were also very negative. The current conditions index plunged 14.8 points to 89.2, a four-year low and biggest one-month drop since after September 11. New home sales fell 1.8% in February to a 590,000 unit annual rate, while existing home sales rose 2.9% to 5.03 million. This slowed rate of decline in the former and bounce in the latter combined with stability in the pending home sales index since the August bottom, and slight improvement in the homebuilders survey recently suggest that we may be approaching a bottom for home sales. Still, with inventories remaining extremely elevated, even if sales are nearing a trough, new construction will likely need to fall much further to bring inventories under control over the course of the year. The months supply of unsold new homes was unchanged at 9.8 in February, a high since 1981, while existing home supply moderated a bit, but at 9.6 months remained badly imbalanced. We look for another 25% decline in single-family housing starts over the course of the year to get this inventory situation under control. The upcoming week sees the release of the early round of key March economic data, highlighted by the employment report on Friday, which we expect to show a third straight decline in overall payrolls and fourth straight decline in private sector jobs. Prior to that, the main focus will be on an appearance by Fed Chairman Bernanke on Wednesday morning before the Joint Economic Committee to testify on ‘The Economic Outlook’. The Fed’s official view has been that we are not in a recession, just a period of very sluggish growth, but that outlook is clearly becoming increasingly untenable. Still, Fed policy has certainly acted as if we are in a recession, with the most aggressively pre-emptive easing campaign in history. We think we’re approaching the trough in the fed funds rate, as does the market, so this testimony will be watched for any guidance there. Much of the question and answer session of the hearing will likely be devoted to the Fed’s Bear Stearns intervention, which will also be the specific subject of a second Congressional hearing Chairman Bernanke will be a part of on Thursday. The Fed will conduct its second TSLF auction on Thursday. The size and acceptable collateral will be announced on Wednesday. In addition to the employment report, other data releases due out include the manufacturing ISM, construction spending and motor vehicle sales on Tuesday and factory orders on Wednesday: * We forecast a March manufacturing ISM of 48.0. The regional surveys released to this point have been mixed but taken together relatively steady. So, we look for little change in the ISM index relative to the 48.3 reading seen in February. Meanwhile, we expect to see another uptick in the price gauge, as the recent pullback in quotes for some commodities probably occurred too late in the month to have any impact on the March report. * We look for another sharp 1.1% decline in construction spending in February, with the residential category once again leading the way. The non-res and public components are expected to show little change this month. * Following the disappointing performance seen in January and February, motor vehicle sales appear likely to come in only modestly higher in March at 15.6 million units annualized. The industry is pointing to a number of possible explanations for the recent sales slide, including tighter credit conditions, falling consumer confidence and a postponement of big-ticket purchases until tax rebate checks are received. Also, while automakers have been tinkering with incentive offers, they don’t seem to be getting too carried away at this point. * The 1.7% drop in the durables component should be only partly offset by price-supported upside in non-durables, leading to a further 0.6% drop in overall factory orders in February, on top of the sharp decline in January. The I/S ratio should rise two-tenths to 1.26, which would be the highest level in a year. * We forecast a 50,000 decline in March non-farm payrolls. Another round of significant job cuts in the construction and manufacturing sectors should help to lead to a third-consecutive monthly decline in overall payrolls. A portion of the anticipated fall-off in factory jobs is related to the spillover effect of a strike at an auto parts supplier. A number of large plants have been shut down due to the lack of parts, and we believe that this development will shave about 20,000 jobs from the March employment tally. If the strike continues, the impact on next month’s report could be significantly larger. Another complicating factor this month is the impact of the early Easter. The last time the Easter holiday fell this early on the calendar was in 1913. Indeed, in the past 20 years, there have only been a couple of occasions when the Easter holiday came nearly as early as this year. In both cases, there were some unusually large swings in retail employment during the March/April period – but in different directions. So, while we look for retail jobs to be unchanged in March, it is certainly possible that seasonal distortions will lead to a noticeably higher or lower outcome. Finally, a decline in the civilian labor force helped to push the unemployment rate lower in February. This was likely a reflection of statistical noise – as opposed to any sort of fundamental factor – and we look for a rebound in the jobless rate to 5.0% in the March report.
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Revising GDP Growth Estimates Down
April 01, 2008
By Chetan Ahya | Singapore & Tanvee Gupta | India
Summary Over the last two months, the growth environment in India has further deteriorated. First, credit market developments in the US and Europe have dried up risk capital allocation to emerging markets debt as well as equity capital (see India Economics: Credit Market Developments: It’s Not Just Their Problem, March 10, 2008). Second, high commodity prices have increased the headline inflation rate by 1.56 percentage points over the last two weeks to 6.7% during the week ended March 15, 2008. This has increased the risk that policymakers will initiate fresh measures, which will further compress the growth trend. Moreover, this has taken away the hope of a meaningful decline in bank lending rates in the near term, which we believe is critical to prevent deceleration in domestic demand. Building in the recent adverse macro environment, we are revising our GDP growth estimates to 7.1% from 7.4% for F2009 and to 7.6% from 7.8% for F2010. Two Out of Three Growth Engines Already Slowing The monetary policy tightening has certainly reduced the overheating and financial instability risks. However, we believe that the relatively high level of lending rates has already resulted in a sharp reduction in consumption growth. Leveraged spending by households has already declined sharply, as reflected in two-wheeler sales, consumer durables production and mortgage lending growth. Consumer goods production growth has decelerated sharply to 4.3% during the three months ended January 2008 from the peak of 18.5% in June 2005. Two-wheeler sales have been declining year on year for the past 11 months. Growth in fresh mortgage disbursements has remained low at single-digit levels for the last few quarters. In addition to the sharp deceleration in consumption growth, the export sector has suffered a slowdown because of weakening demand in the developed world and appreciation in the rupee. Export growth in rupee terms has weakened to an average of 7.9% over the past six months compared with 23.3% during the 12 months ended March 2007. A leading indicator (US ISM New Orders Index) for India’s exports predicts a further slowdown over the next six months. Hence, two out of the three engines of growth (consumption, exports and capex) are already faltering. The combined effect of weaker consumption and export growth trends is reflected in a sharp deceleration in revenue gains for a broad basket of 1,524 companies (excluding oil and gas and finance companies) to 13.4%Y during the quarter ended December 2007, from the recent peak of 28.9%Y during the quarter ended September 2006. Industrial production also decelerated to 5.3% in January 2008 from an average of 8.3% in the quarter ended December 2007, and the peak of 15.8% in November 2006. Private corporate capex has been the bright spot so far. Although some amount of slowdown in consumption was critical to reduce the overheating risks, the extended duration of this weaker growth phase could cause serious damage to overall growth momentum. We believe that this sharp slowdown in demand for final goods has started weighing on the corporate sector’s confidence for business investment. Indeed, an aggressive pick-up in corporate investment two years back is now beginning to show up in the form of operative capacity available for production. In our view, weaker sales growth when the capital charge for new capacity is increasing will hurt corporate profitability and sentiment. Risk Aversion in Domestic and Global Financial Markets Adding to Downside Risks India’s growth acceleration has benefited more from the globalization of capital markets than from the globalization of trade. The inflection point for the current growth cycle was April 2003, which signaled the start of the synchronous rise in emerging market equities. We believe that a favourable sustained global risk appetite trend has been at the heart of India’s current growth acceleration cycle: average GDP growth accelerated to 9.5% during F2006 and F2007 from an average of 6.2% in F2003 and F2004. The risk-appetite growth linkage is as follows: rise in risk appetite – rise in non-FDI capital inflows – lower real rates and strong credit-driven growth. In this context, we believe that the key concern for India’s growth outlook will be continued turbulence in the US financial markets and its impact on capital inflows into India. Quick Response from Monetary Policy Unlikely Headline inflation accelerated to 6.7% during the week ended March 15, 2008, from 5.1% during the week ended March 1, 2008 and 3.1% during the week ended November 24, 2007. The key components – food, fuel and metals – have contributed to this acceleration. We believe that the Indian political system has lower tolerance for supply-side inflationary pressures from oil, food and global commodities, even if the second-round effects are manageable. The rise in inflation means that the Reserve Bank of India (RBI) is unlikely to cut rates at its April monetary policy meeting. Loose Fiscal Policy Will Offer Some Help The government has already announced policy measures that will widen the fiscal deficit in F2009. Two of the key measures are: (1) a Rs600 billion farm loan write-off and (2) a Rs300 billion increase in salaries and pension payments to central government and railways employees, which should provide some support to consumption growth. We believe that these expansionary measures will soften the adverse impact on leveraged household consumption on account of the high level of interest rates and increased risk aversion in the banking system. Cutting Our Growth Forecasts Official industrial production has consistently been below our estimates for the last three months. In our view, the recent macro developments – particularly increased risk aversion in the global financial markets and delay in the much-needed policy rate cuts due to the rise in inflation – will affect India’s growth outlook. We believe that, in addition to weak consumption and export growth, business investment will now start slowing over the next six months. Incorporating these macro developments, we are cutting our GDP growth forecasts to 7.1% from 7.4% for F2009 and to 7.6% from 7.8% for F2010. Upside Risks to Our Estimates The outcome of the current cycle will depend on the trend in global commodity prices and global risk appetite. India needs a fall in commodity prices to reduce inflation pressure. A decline in commodity prices could reduce the supply shock concerns, allowing the RBI to cut policy rates, thus reviving domestic private consumption. However, at the same time, India needs the global risk-appetite trend to be constructive so that the capital-inflow trend does not reverse. Continued capital inflows would also ensure that liquidity conditions remain favorable for private corporate capex. They would also ensure that the government gets more time to respond with accelerating infrastructure investment and overall effective capacity growth.
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Higher Oil Prices but Repeat of 2005 ‘Mini-Crisis’ Unlikely
April 01, 2008
By Deyi Tan & Chetan Ahya | Singapore
A Stress-Test of the Domestic Demand Story? Indonesia has been one of the strongest domestic demand growth stories in the ASEAN region – a theme we have been highlighting over the past two years. One of the key drivers for this improvement in domestic demand has been a steady decline in the cost of capital. This, in turn, has been supported by major changes in the macro balance sheet such as a sharp decline in public and external debt, improvement in the current account surplus and a steady rise in the foreign exchange reserves balance. However, we believe that elevated oil prices, coupled with acceleration in food inflation and emergence of financial market volatility, could pose risks to the domestic demand story in Indonesia (see Emerging Risks to Domestic Demand Story, January 29, 2008). Recall that in October 2005, oil prices crossing US$65/bbl led to a ‘mini-crisis’ in the currency, which depreciated sharply by 11% in August 2005, in line with a deteriorating oil trade balance. The government had to raise fuel prices by 126% in October 2005 and hiked policy rates by 425bp in 2H05. With headline inflation already at 7.4% and oil prices staying above US$100/bbl, the risk of a setback to the domestic demand growth story is rising. However, we believe that the stronger macro balance should ensure that the headwinds for the domestic demand story, if any, would likely be small and temporary. Moreover, part of the reason for the 2005 ‘mini-crisis’ was a lack of coordination between Pertamina and Bank Indonesia in buying US dollars to pay for oil imports. This weakened the rupiah. As oil prices rose, importers had to sell more rupiah to pay for oil, which became more expensive in local currency terms. This led to further currency volatility, exacerbating the inflation problem. In this regard, we believe that the impact of higher oil prices this time is not as negative for Indonesia as the 2005 ‘mini-crisis’ seems to suggest. Oil Sensitivity Analysis In this context, we are also reviewing the sensitivity of the macro indicators to oil prices. An oil price rise tends to affect the economy in three broad areas: (1) inflation and consumer purchasing power; (2) subsidy burden and fiscal balance; and (3) the current account and balance of payments, which in turns weighs on the exchange rate outlook and monetary policy. 1) Inflation and purchasing power: Indonesia runs a two-tiered pricing system for fuel. Fuel prices for households are subsidised at rates of 31-72% for premium fuel, gas oil and kerosene. Based on the CPI weights, a 10% hike in fuel prices would lead to a 0.3 percentage point (pp) increase in headline inflation from the first-round impact and 0.4pp from the second-round effects such as higher transport prices, assuming full pass-through. Similarly, a 10% hike in fuel prices would affect consumer discretionary spending power by 0.6% of GDP. However, the government has indicated that it may not raise fuel prices before 2009 when elections are to be held. Indeed, inflationary pressures are a concern as headline inflation has already risen to 7.4%, which is above the central bank’s inflation target of 5-7%. 2) Fiscal balance: With the government opting not to raise fuel prices, stress from higher oil prices is transferred from the household balance sheet to the government’s balance sheet. Oil prices affect the government’s revenues as well as expenditure. Higher oil prices have a direct positive impact on the central government’s revenue in the form of oil and gas income tax and non-tax revenue. However, it also increases expenditure outflows as the central government shares 15% of the revenue from oil mining with regional governments. In addition, higher oil prices mean higher fuel and electricity subsidies. Variations in the structure of the oil and gas PSCs (production sharing contracts) complicate the sensitivity analysis on the revenue side. However, assuming a common simplistic PSC framework, we estimate that each US$10/bbl increase in oil prices raises oil and gas revenue by 0.6% of GDP. On the expenditure side, if retail fuel prices are unchanged, the oil and electricity burden will increase by 0.67% of GDP for each US$10/bbl rise in price and revenue sharing will increase by 0.09% of GDP. Hence, with each US$10/bbl increase in the oil price, the fiscal deficit is likely to deteriorate by about 0.15% of GDP, putting little pressure on public debt levels. For 2008, the government has revised the fuel and electricity subsidy and fiscal deficit estimates to 4.1% and 2.1% of GDP, respectively, assuming an oil price of US$95/bbl. If the oil price average is US$110/bbl, we believe that the total fuel and electricity subsidy burden would increase to 6% of GDP (US$29 billion) in 2008 and the fiscal deficit would be 2.3% of GDP. 3) Current account balance: The impact on the current account balance can be broken down into two parts: (a) crude oil balance and (b) refined oil balance. Overall, a rise in oil prices is negative for the current account due to its adverse impact on the refined oil balance. (a) Impact on crude oil balance: Indonesia’s crude oil trade balance has been close to zero in the past few quarters, and was at -0.1% of GDP (3M trailing sum annualised, % of GDP) in January 2008. Given that net crude imports/exports are negligible, there is no significant impact from oil price movements on the current account balance. (b) Impact on refined oil balance: A rise in the oil price is negative as Indonesia imports about 15% of its refined oil demand. Its refined oil trade balance was running at -2.8% of GDP (3M trailing sum, annualised) in January 2008. Ceteris paribus, a US$10/bbl rise in prices would worsen the refined oil trade deficit and, therefore, the current account balance by about 0.15% of GDP. Additionally, the refined oil balance can deteriorate not only because of higher prices but also on account of increased leakage arising from the disparity between subsidised rates at home and relatively higher retail prices among ASEAN neighbours. The difference in retail oil prices between Indonesia and its neighbours has exceeded the 2005 peak of US$0.85/litre to US$0.98/litre. While the refined oil trade deficit has been relatively contained so far, continued elevated prices present the risk that the refined oil balance could widen further on the price effect, with arbitrage further compounding the deterioration. Temporary Risks to Domestic Demand Story but Not a Repeat of 2005 Mini-Crisis While we like Indonesia’s structural growth story, we believe that rising oil prices combined with higher food prices and increased global financial turbulence have increased the risk of a temporary pushback in the domestic demand story. However, in our view, the adverse impact of higher oil prices will be lower than that suffered in 2005. The fuel price hike, if necessary, is likely to be smaller this time around. In addition, the current account balance is now more comfortable at 2.5% of GDP in December 2007 than in 2H05. The adverse impact of higher refined oil product imports on the current account should be absorbed more easily. This reduces the risk of extreme volatility in the exchange rate if capital inflows remain weak.
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