Economic Commentary - Dave's Top Ten
Merrill Lynch
22 July 2005
This research product summarizes the 10 major macro themes of the past week as a
prelude to our weekly publication the Market Economist.
1. Forecasting the Fed seemed a lot more straightforward in 2002 and 2003. We had
expected Mr. Greenspan to be less hawkish in Wednesday's semi-annual address to
the House Finance Committee than he was at the last testimony in February.
However, such was not the case and we must face the reality that more rate hikes
are coming—there was precious little in the Chairman's sermon even remotely
hinting that the Fed is close to being done in its current tightening program. The
fact that he so strongly suggested that further policy tightenings are coming-
"realizing this outcome [editorial note: that is, the Fed's base case scenario of
"sustained economic growth and contained inflation pressures"] will require the
Federal Reserve to continue to remove monetary accommodation" was all market
participants needed to hear. As a consequence, we now believe that the Fed will
take the funds rate to 4.0% by the end of the year, with an outside chance that we
could get to 4.25% before all is said and done. Greenspan also went out of his way
to warn homeowners about the potential pitfalls of leaving themselves exposed to
higher rates, cautioning “households may have trouble meeting monthly payments
as interest rates rise” and “it is important that lenders fully appreciate the risk that
some households may have trouble meeting monthly payments as interest rates and
the macroeconomic climate change." We can only surmise that the 'change' he is
referring to is up in interest rates and down in the macroeconomic climate.
2. No doubt we will see more upward pressure at the front-end of the Treasury curve;
however, our bullish view on long-term bonds has not changed one iota. Given that
the Fed will likely raise rates at least three more times the risks of an inverted yield
curve and a "growth recession" (a real GDP trend of 2%) next year have risen
materially. Based on the Fed's behavior, and confirmed by Wednesday's words,
soft-patches are deemed as temporary. So it will take a lot-and he highlighted
energy costs and terrorism as two such risks-more than we had initially thought to
get the Fed to go to the sidelines. Ordinarily, a 3%+ growth economy and low and
stable core inflation were the ingredients for a stand-pat Fed, but that apparently is
not the case. An intent made even more puzzling since the Chairman noted that
there is still “slack labor and product markets.” Tightening into such an
environment, in fact, could end up pulling long-term interest rates down even harder
and faster than our current 3.5% twelve-month target on the 10-year note.
3. We still hold to the view that the Fed will be easing in 2006—the gift that
Mr. Greenspan will leave his successor will be the ability to cut rates (as
opposed to his first action in 1987, which was to raise rates aggressively
and precipitate the stock market collapse in October of that year). The
usual lag between the last tightening and the first easing is around six
months, so the expected rate cuts next year may now be a second half
instead of a first half event as we had expected earlier. But between now
and then, all we can say for sure is that barring some unforeseen
calamity, the Fed is taking short-term rates higher. Our sense in terms of
timing is that the tightening cycle will have run its course by the time Mr.
Greenspan's tenure at the Fed is up at the end of January. What we do
know with certainty is that Alan Greenspan has had a rough experience
with asset prices corrections before—he likely does not want another one
with the core inflation rate so low. If home prices corrected sharply, the
saving rate would have a big rise, recession risks would rise substantially
and deflation would likely ensue—hardly the combination that he wants
to leave the next Fed Chairman in 2006. As for the Fed's modest slowing
in growth towards 3.25%-3.5% in 2006 from 3.7% y/y right now—well
that would really go against the historical record. Going back to the
mid-1950s, there were 11 times when the Fed raised rates by 300 bps or
more. Out of those 11, only 2 times did GDP fail to slow after the Fed
raised rates 300 bps or more (or almost 90% of the time, GDP slows
when the Fed raised rates by 300 bps or more). On average, GDP goes
from 4.7% four quarters prior to the 300 bps rate hike to 2.4% fourquarters
after the fact, so the greater risk if the funds rate goes to 4% is
that growth ends up getting sliced in half. (Note that in the past 25 years,
the economy slowed down 100% of the time and by a similar amount).
4. The highlights of yesterday’s FOMC minutes: Some members agreed
additional hikes probably needed while some members differed on the
degree of needed future tightenings. The Committee noted that “recent
data suggested that the solid pace of spending growth had slowed
somewhat, partly in response to earlier increases in energy prices, but
that labor market conditions apparently continued to improve
gradually”. After listening to Greenspan this week, we believe that they
will get to 4.0% (outside chance of 4.25%) and that should be it.
Additionally, while the minutes noted that participants will not respond
directly to asset price moves (they have to say that since the Fed is not
supposed to be influenced by asset prices), we have become increasingly
convinced that housing prices are absolutely an influence on policy at this
point. As noted in the minutes, “the rise in house prices had been
accompanied by a modest shift toward potentially riskier types of
mortgages, including adjustable-rate and interest-only loans, which
could pose challenges to both lenders and borrowers”. On the inflation
front, the participant’s views were mixed, but the relatively benign
inflation data we’ve had recently was acknowledged. “While agreeing
that inflation had to be watched carefully, other meeting participants
emphasized that recent core inflation data had been relatively
restrained…”. The minutes also showed that "additional tightening
would probably be necessary, but views differed on the amount of
tightening that would likely be required to keep inflation contained and
bring output in line with potential." So everyone on the FOMC agrees
that rates must move up, the only question is by how much. The internal
debate at the Fed will likely become more energetic as we move closer
and closer to 4%—meaning the minutes will likely become ever more
important in the months ahead.
5. We do not know why so many believe that the Fed is so accommodative:
Yes, credit spreads are tight but we're not convinced that is saying
anything about the state of monetary policy. The real funds rate is now in
positive terrain based on any inflation measure you want to use at a time
when there is still an output gap—which we estimate at 1.5%—does not
represent a loose monetary stance. That the economy is cruising along
near potential and core inflation trends are low and showing signs of
rolling over. The dollar has firmed this year, notwithstanding yesterday's
FX move by China. Raw industrial commodity prices are well off their
highs. And the money supply numbers, which fell sharply on the July
11th week, are extremely well contained—y/y growth in M1 now at
0.6%; 3.5% for M2; 1.1% for MZM and 4.9% for M3. These are not the
conditions for higher inflation and not the conditions, in our view, for a
sustained selloff in the bond market. We reiterate—we have seen
FIFTEEN such bond selloffs in the past five years and cumulatively the
10-year note yield rose 1000 basis points. Each time, the highlyleveraged
economy slows shortly thereafter and these spasms reverse
course. Of note, the most bullish comment we can make now is that the
Johnny-come-lately bond bulls who turned constructive on the Treasury
market at the yield lows of 3.8% two months ago have now turned
bearish (see Bloomberg article on TOP<GO>). Now all we have to do is
wait for the COT data to see if the hedge funds have unwound their
40,000+ contact net long position in the 10-year note.
6. Time to get worried on housing? We have a situation now where a mere
16% of California households can afford a median-priced home.
Speculative activity has reached such a crescendo that housing starts have
reached 2 mln units at an annual rate even though net household
formation is running closer to 1.5 million units. Real home prices are up
9.5% year-on-year whereas prior peaks never got above 8%.
Historically, real home prices averaged nearly 1% per year—that's why
real estate was always seen as a "hedge" against inflation. This was the
average from 1975 to 1995. Then from 1995 to 2000, real home prices
averaged 2% growth per year, and from 2000 to 2005 they averaged over
5% growth annually. And now that trend has accelerated to over 9% y/y
growth (12.5% nominal). With so much spending already having taken
place premised on crystallizing those rapid home price increases, imagine
what happens to consumer spending and GDP growth if home prices stop
going up. Look at the U.K. as an example—retail sales decline, the
economy sputters and interest rates go down. At the peak of BOE
expectations a year ago, the market was bracing for another 50 bps+ of
U.K. rate hikes—which never came to fruition. Now investors are
bracing for U.K. rate cuts—and don't think that we can't see that
developing in the USA as the futures market discounts a 4% funds rate by
year-end. This housing mania may last, but not indefinitely. As the chart
illustrates, home prices in real terms are 36% higher than they were at the
two major highs posted over the past 25 years.
7. Chinese revaluation thoughts: While the initial move was 2.1%, we
believe this is only the beginning. Washington can now declare
victory—think of the bright side: tariff retaliation and trade war risks
have gone down materially as a result. The bond market had its typical
early negative reaction, which we believe is overdone. First, even if
China reduces the pace it buys Treasuries, we were never convinced it
was 10-year notes that were the vehicle of choice, and more to the point,
we could merely see a shift towards accelerated BoJ buying if the yen
appreciates, which is likely the case. (Since no one knows what the new
basket of currencies is going to be and seeing that the +/- 0.3% daily band
is against the dollar, who can really say how much this will really affect
the Treasury market?) Second, we believe U.S. market interest rates are
driven far more by domestic inflation fundamentals than by cross-border
flows, and there is not a shred of evidence that this revaluation or even
further moves will prove to be inflationary. It could well be that in
China's "socialist market economic structure" (as so described in the
PBOC website), exporters will be instructed to cut their prices to
maintain market share even as the currency is revalued. Don't think it
could happen? Look at the Japan experience—not necessarily a fixedexchange
rate but for years certainly resembling a managed float—dollaryen
went from Y150 in 1990 to Y110 today and the import price index
from Japan has gone from 75.2 to 75.8—over that 15-year interval of yen
strength, Japanese producers never raised their prices in the U.S. market.
And by doing so, their share for example of the US auto sales pie has
gone from 26% to 32%. Who would have thought? As an aside, Japan
must come out of this a big competitive winner—add on the 2.1% reval
and so far this year, the yen has dropped 7% against the yuan YTD.
8. Back in May, we published a report on the impact of a (10%) Chinese
revaluation. In our view, first-round impacts are small—keep in mind
that China accounts for 10% of U.S. trade and therefore 1% of GDP. So,
by our calculations, a 10% revaluation within a year adds 0.1% to GDP
growth, adds 0.1% to the inflation rate, and trims the current account
deficit/GDP ratio by a grand total of 0.1%. In other words, even a 10%
revaluation would have marginal first-round macro impacts. We did say
back in May that the day of the reval would trigger a knee-jerk negative
reaction in the bond market, but it shouldn't last. It is unclear what
impact this will all have on China's Treasury securities buying—after all,
Japan de facto revalued by 50% over the past 15 years and its holdings of
Treasuries have soared over that time from $100 billion to around $700
bln today. Even after the yen strengthened, Japan bought more
Treasuries to prevent an even greater strengthening (and what if
speculative inflows come into China in anticipation of further currency
appreciation—isn’t it possible that the PBOC then buys MORE
Treasuries to quell the undesired yuan appreciation?). China does indeed
own $250 billion of Treasury securities but let's keep in mind that the
U.S. Treasury market is deep—there are over $4 trillion of U.S. federal
marketable securities outstanding. Moreover, the share of longer-term
(10 yrs+) notes in global central bank Treasury portfolios is barely more
than 10%. As for sectors that are most affected by the Chinese currency
move—at the margin—would be the items we import most from China:
electronics, toys, clothing/textiles, and appliances/furniture. As an aside,
a June survey conducted by Baruch College and Financial Executives
International found that 39% of U.S. businesses said a revaluation would
have no effect on their activity and a further 50% said any impact would
be "small". That leaves the grand total of 11%. So this was more of a
political event than an economic or even a market event as far as the U.S.
landscape is concerned.
9. When we talk about globalization we are talking not just about the
breakdown in barriers to tradable goods and services but also the reality
that for the first time in our professional lives, we have global arbitrage in
cheap labor. Full stop. Until we got the June employment report, private
payrolls almost five years into the expansion were still below the prerecession
peak—unprecedented. As it is, this still goes down as the most
sluggish U.S. employment cycle ever recorded. But jobs are being
created—in low-cost locales like China (finished goods manufacturing)
and India (software, biotech, engineering) where we estimate that
employment is rising 18 million annually or about the equivalent of 6
years worth of nonfarm payrolls in the USA. Not only that, but these are
Economic Commentary – 22 July 2005
Refer to important disclosures on page 6. 5
the areas—emerging markets—which are also seeing the most rapid
capacity and investment growth. Capex growth in emerging countries
has outpaced that in the industrialized world in each of the past four years
and by 4 percentage points per annum. But this expansion is not going to
fill domestic consumption—India has a personal savings rate of around
30% and it's more like 40% in China. And in the past decade, emerging
countries in general have swung their aggregate balance of payment from
a $90 bln current account deficit to a $340 bln surplus—funds that are in
turn plowed back into the U.S. Treasury market. And the penetration of
low-cost emerging markets into the U.S. market is astounding. They
replaced industrialized countries as the principal shipper of goods to the
USA in 1996—and emerging markets today represent 60% of the U.S.
import pie, up 15% over the past 15 years and this has acted as a very
strong deflationary antidote to the oil price pressures over the past two
years. In fact, the disinflation theme does not belong to the U.S. alone—
it is a global phenomenon, highlighted by our estimates which show the
global output gap now sitting at 0.8% and we are now passed the peak in
terms of demand growth. Guess where core inflation is heading?
10. Back to Importing Deflation from Asia? We said earlier that 80% of the
inflation blip this cycle reflected the dollar and commodities—and now
the impact is heading in the other direction and this is plainly evident in
the latest import cost data. Ex-petroleum import prices fell 0.4% in June
after a 0.2% decline in May which marked the first back-to-back falloff
since April-May 2003 when the Fed was pre-occupied with de-flation,
not in-flation. The y/y trend at 2.1% is down from 2.6% in May, 3.0%
peak in April and the peak of 3.7% in December/04. The three-month
trend has been pared to MINUS-0.8% SAAR—the first negative print
since Oct/03. Imported prices of capital goods were flat in June after
declining in three of the prior four months (flat y/y and -0.4% SAAR
over the past three months). Import prices of consumer goods fell 0.1%
m/m in June, taking the y/y pace to +1.4% from +1.5% (three-month
trend is 0.0%). Autos were flat and have been for 5 of the past six
months. Import prices of industrial goods fell more than 1% for the
second month in a row. Regionally, all we were told in the past 12-18
months by the experts was to look out for waves of Asian-led inflation to
hit our shores. Bad call. Import prices from the Pac Rim are down 0.4%
y/y and the three-month trend is running at -1.2% SAAR. Imports prices
of goods made in China were down 0.1% m/m in June and -0.9% y/y.
Import prices from Japan are flat or down in each of the last four months
(-0.4% SAAR on a three-month basis). The y/y trend in import prices
from ASEAN is -0.8% (flat on a three month basis). |
