The Case for Higher Real Rates

December 17, 2009 By Richard Berner & David Greenlaw | New York We think 10-year Treasury yields will jump to 5.5% by the end of 2010, driven primarily by a rise in real rates to 3% or more. That call is clearly inconsistent with the consensus view of modest growth and declining inflation, and it is light years away from the current level of real TIPS yields at 1.3%. Even those who agree with our somewhat upbeat view of sustainable growth and moderate inflation think that our rate call just does not jibe. We reiterate our rate forecast. Although we have outlined the factors behind our call over the past six months, investors are demanding and deserve more explanation. The purpose of this note is to elaborate on the framework and factors driving our call. In a nutshell, we think real rates are well below long-term norms. Over the next 12 months, unprecedented net saving shortfalls, a revival in investment, a less accommodative Fed, uncertainty about inflation and concerns about the sustainability of US fiscal policy will likely boost real rates significantly above those norms. Here we focus on the role of saving and investment. Long-term real risk-free rates tend to fluctuate around 3%. The framework for determining real rates varies with the time horizon, as different horizons change the emphasis on the factors involved. In the long run, and on average through the cycle, real rates should reflect returns on capital and potential real growth. Those who believe that returns on investment, productivity and potential growth have declined in recent years would argue that there should be a corresponding decline in real rates. We do not buy that story; productivity and potential growth are certainly lower than they were in the 1960s and in the late 1990s, but at about 2% and 2.5%, respectively, they are in line with the average of the last 60 years. Returns on capital declined as corporate overinvestment in the technology boom boosted capital-output ratios, and returns have declined cyclically in the recession. But to maintain profitability, Corporate America has slashed capital spending and boosted productivity; witness the 3.8% increase in labor productivity over the year ended in 3Q. Meanwhile, investors need compensation for taking on duration risk (e.g., the risk of holding a ten-year security as opposed to rolling over ten one-year instruments). Our colleague Jim Caron thinks that this ‘term premium' for risk in normal times should be at least half a percentage point or 50bp. Adding that to the 2.5% potential growth rate yields a 3% norm for real, risk-free yields. Thus, we think real, risk-free, long-term rates may fluctuate around that 3% norm, well above today's levels. But supply and demand can prevail in the short term. In the short-to-medium term, other factors can persistently drive real rates away from those long-term norms. In our view, the spectrum of real yields over a medium-term timeframe is determined by supplies of saving and demands for investment, or their financial counterparts, the supply and demand for credit. Of course, saving always equals investment ex post; the ex ante question is always at what price - what interest rate - will the market clear? Explaining today's rate levels is simple as pie. We find it easy to explain why real rates are exceptionally low despite record-low net national saving. First, the deepest recession since the Great Depression has clobbered investment across the board - in housing, corporate capital and inventories - and it is the excess of saving over investment that has driven rates down. In the corporate arena, the non-financial corporate financing gap (the difference between internally generated cash flows and corporate fixed and inventory investment) fell to a record low of -2.8% of non-financial corporate GDP in 3Q. Correspondingly, the demand for credit has plummeted to record lows. Second, on the supply side, the Fed designed its Large-Scale Asset Purchase programs (LSAPs) to take massive amounts of duration and convexity risk out of the fixed income markets. The LSAPs thus keep rates lower than they would otherwise be, inducing investors through portfolio balance effects to take on more risk. In our view, when investment rebounds, even modestly, the supply/demand balance driving real interest rates will change dramatically. Moreover, as the Fed ends the LSAPs early in 2010, duration and convexity will return to the fixed income markets, and portfolio balance effects will begin working in reverse to tighten the supply of credit. In the very short run, technical factors may be the primary catalyst for higher yields. For example, our colleague Jim Caron believes that sellers of high-strike interest rate insurance may have to sell bonds as rates go up - in a move akin to convexity hedging by mortgage investors and servicers (see 2010 Global Interest Rate Outlook: The World Is Uneven, November 30, 2009; and Asymmetric Risks Point To Higher Yields, Steeper Curve, December 10, 2009). Jim and team believe that those technical factors could push 10-year yields up quickly to 4.5%. In what follows, we present a review of the coming changes in saving-investment (im)balances that point to higher real yields. The end of quantitative easing and rising term premiums will further add to the pressure on yields. Slight rise in saving would still leave it close to record lows. Net national saving in relation to the size of the economy is a critical building block in our analysis. Fueled by rising wealth and easy credit, national saving has trended lower over the past 35 years - with the exception of the mid-1990s. Over the past year, while personal saving has risen significantly in response to the plunge in household net worth, ultra-aggressive fiscal stimulus and declines in national income relative to output took net national saving to a record-low -2.6% of GDP by 3Q09. Our analysis of the four sources of saving - personal, corporate, government and saving from abroad - indicates that net national saving will increase somewhat over the next year, but will only get back into positive territory in 2011. For the consumer, we believe that caution and modest wealth gains will push personal saving gradually higher. In our view, that will not result in consumer retrenchment; on the contrary, we think income will be growing rapidly enough to provide wherewithal for spending growth of roughly 2% in real terms, and to boost the saving rate by about a percentage point over the next year from 4.5% to 5.5% (representing about a US$120 billion increment to saving). That is consistent with employment gains of about 1%, a half-hour increase in the workweek, a rebound in property income (such as dividends), and further significant growth in unemployment insurance benefits, Cobra assistance and the second installment of the Making Work Pay tax credit. Corporate America will also contribute modestly to private saving, as stronger revenue gains will boost the top line and higher profit margins will boost the bottom line. In turn, companies are able to expand margins and exploit the operating leverage in their businesses because they have slashed capacity. For example, recent gains in production have lifted operating rates by some 250bp from their lows. We expect that much of the profit gain henceforth will be paid out in dividends rather than retained; dividends have plunged by a record 21% over the past two years. As a result, undistributed profits (the net corporate contribution to national saving) likely will decline as a share of GDP in 2010. Government dissaving is likely to decline somewhat through 2010, and inflows of saving from abroad probably will increase as the current account deficit widens. With regard to the US budget deficit, however, we would stress two points that represent a one-two punch for interest rates: First, Federal red ink will remain well above all past records for at least five years, and neither the Administration nor Congressional leaders have so far put forth any credible plan to reduce future deficits. Second, as discussed below, Treasury debt managers are making dramatic changes to the maturity of debt issuance, which will change the balance between supply and demand out the curve. We expect the Federal budget deficit to be about US$1.3 trillion in F2010 - a shade below the US$1.4 trillion gap seen in F2009. The slippage reflects a modest pick-up in tax revenue as the economy begins to grow and a pullback in outlays aimed at supporting the financial sector, which should more than offset an acceleration in stimulus spending tied to the American Recovery and Reinvestment Act that was enacted last February and other new measures (such as the expanded homebuyer tax credit and bonus depreciation changes). As a result, total government dissaving may decline slightly in the year ahead. But the real story in Treasury issuance is that the composition is shifting dramatically towards coupon securities as debt managers attempt to gradually boost the average maturity of the Treasury debt outstanding from its current level of about 4 years up to a range of 6-7 years. Gross coupon issuance - the best gauge of the supply burden confronting the market - likely will top US$2.5 trillion in the current fiscal year, up 40% from F2009. In fact, the increase in coupon issuance during the year ahead should be about equal to the amount of total issuance in a ‘normal' year (such as F2008). That step-up in supply, coming as the Fed concludes its Treasury buying program and as the Fed tapers its purchases of RMBS, constitutes a key source of uncertainty in our analysis. The overall data on government dissaving are not sufficient for us to gauge the impact on rates of large budget deficits and the Treasury issuance required to fund them. Inflows from global investors to increase again. Despite strong export gains, rising oil and other import prices likely will combine with rising imports and shrinking US surpluses on services and investment income to widen the nominal current account deficit. As represented by the GDP accounts, we estimate that the corresponding inflows from global investors will rise by about 0.6% of GDP to 4.2% over the four quarters of 2010, or by about US$110 billion. Yet that inflow won't likely come easily in today's context. Concerns about sovereign credit risk and fiscal sustainability imply that global investors will demand a concession to buy US debt. Although the US won't default on its debt, investors are always handicapping the risks of owning even the benchmarks for global sovereign credit. Ex ante, investment is poised to increase more than saving; higher rates required to clear market. At first blush, the increased saving that we expect may sound bullish for interest rates. What many fail to appreciate, however, is the extent to which investment outlays will rise over the course of the next year in spite of the rise in rates. Housing, of course, is credit-sensitive, but credit availability and collateral requirements are as important as interest rates. The fact that traditionally measured housing affordability has skyrocketed and yet housing is staging only a modest recovery from a record plunge speaks to the importance of credit availability. Our hunch is that improved availability in the coming year means that housing demand will improve even as rates rise. For Corporate America, there is a parallel story. Capital spending plunged in the recession to an unprecedented degree, and new investment is needed to rebuild capital stocks. The ‘accelerator' of rising output on a sustained basis and improved corporate cash flow will also drive capex higher. Moreover, empirical work suggests that corporate capital spending is relatively insensitive to changes in interest rates. Finally, we believe that companies will shift from a record 10 quarters of liquidation to accumulating inventories by year-end. Combined, this shift to sustainable growth in housing, business investment and inventories will result in a significant increase in private credit demand. The upshot is that the necessary balance between rising saving and rising net investment is unlikely to occur at today's interest rates. Finally, two other factors are expected to lift real interest rates. First is a repricing of the likely path for short-term interest rates. Currently, fed funds and eurodollar futures are pricing in a 90bp move up in rates by year-end 2010, and a cumulative move by year-end 2011 of about 200bp - less than what we expect through year-end 2010. As a result, we think the market has more repricing of the yield curve to do. Second, uncertainty over fiscal credibility and inflation will lift term premiums and likely add to the looming pressure on real yields.

Global Forecast Update: 2010 Outlook: From Exit to Exit

--Monetary policy exit --BBB reocvery in G10 (creditless and jobless recovery) --tale of two worlds: high growth in emerginng markets vs tepid reocvery in developed marktes --differentiation within G3 --sovereign and inflation risk (in developed countires, it is transformed into inflaiton risk) December 11, 2009 By Joachim Fels, Manoj Pradhan & Spyros Andreopoulos London This year was all about the exit from the Great Recession - and, as we had expected at the start of the year, it worked courtesy of massive global policy stimulus. Next year will be all about the exit from super-expansionary monetary policy - we expect the major central banks to start exiting around mid-2010. Yes, they will likely be cautious, gradual and transparent. However, the prospect and process of withdrawal may have unintended consequences: we think government bond markets will be the first victim. While we believe that the exit will be the dominant macro theme next year, we identify five important economic themes in our global economic outlook that, in our view, will be highly relevant for investors in 2010. A tale of two worlds: We forecast 4% global GDP growth in 2010, up only marginally from three months ago (see the previous Global Forecast Snapshots: ‘Up' Without ‘Swing', September 10, 2009). True, if this turns out to be about right, it would be a fairly decent outcome, especially compared to the widespread doom and gloom earlier this year. However, it falls short of the close to 5% growth rate in the five years prior to the Great Recession, and it will be the product of unprecedented monetary and fiscal stimulus, which poses substantial longer-term risks on various fronts. Moreover, our 4% global GDP growth forecast masks two very different stories. One is a still fairly tepid recovery for the advanced economies - the ‘triple B' recovery we discuss below. The other is a much more positive outlook for emerging markets, where we forecast output to grow by 6.5% in 2010 (China 10%, India 8%, Russia 5.3%, Brazil 4.8%), up from 1.6% this year. A rebalancing towards domestic demand-led growth in EM is well underway. Moreover, as our China economist Qing Wang has been pointing out for a while now, the official statistics are likely to vastly underestimate the level and growth rate of consumer spending in China. In short, we think that the theme of EM growth outperformance has staying power and has even been bolstered by the crisis. A ‘triple-B' recovery in G10: In contrast to our upbeat EM story, we forecast barely 2% average GDP growth in the advanced G10 economies in 2010 - a triple B recovery where the three Bs stand for bumpy, below-par and boring. On our estimates, GDP growth has averaged around 2% in the G10 in the second half of this year and won't accelerate much from that pace next year - hence our ‘up' without ‘swing' characterisation from three months ago remains valid. The two reasons why we think the recovery in advanced economies will be of the ‘triple B' type are that it is likely to be creditless and jobless. Creditless recoveries - defined as a situation where banks are reluctant to lend and the non-bank private sector is unwilling to borrow - are the norm following a combination of a credit boom in the preceding cycle and a banking crisis; and creditless recoveries typically display sub-par economic growth as credit intermediation is hampered. Moreover, we expect a jobless G10 recovery, with unemployment in the US declining only marginally next year and rising further in Europe and Japan. Unemployment may well stay structurally higher over the next several years in the advanced economies as many of the unemployed either have the wrong skills or are in the wrong place in an environment where the sectoral and regional drivers of growth are shifting. More growth differentiation within the G3: Beneath the surface of what we call a lacklustre ‘triple B' recovery in the advanced economies lies a differentiated story for the three largest economies within this block - the US, the euro area and Japan. We expect significant growth differentials between these countries in 2010, which may well become a topic for currency, interest rate and equity markets again. We see the US as the growth leader among this group next year, with output expanding by 2.8% in the annual average of 2010. The euro area economy looks set to grow by less than half that rate (1.2%), while Japan should hardly grow at all (0.4%) next year and is forecast to actually fall back into a technical recession in 1H10. One reason for relative US outperformance is that the creditless nature of the recovery affects the US private sector by less because banks (as opposed to capital markets) play a smaller role in financing the economy than in Europe or Japan. Another reason is that US companies have been much more aggressive in shedding labour this year than their European or Japanese counterparts, so the US labour markets looks set to recover (albeit slowly) next year, while we expect unemployment to rise further in both Europe and Japan. Further, European and Japanese exporters should feel the pain from this year's currency appreciation, whereas US exporters should benefit from this year's dollar weakness. Crawling towards the exit, but triple A liquidity cycle remains intact: As stated above, we expect the beginning of the exit from super-expansionary monetary policies and its implications to be the dominant global macro theme in 2010. We will discuss details of the likely monetary exit strategies across countries in next week's year-end Global Monetary Analyst. Here, it suffices to say that we expect the Fed, the ECB and the PBoC to move roughly in tandem and raise interest rates from 3Q10, with the Bank of England following in 4Q. Some, like the central banks of India, Korea and Canada, are likely to move earlier, while others, such as Japan, will lag behind. Generally, given the remaining fragility in the financial sector, central banks are likely to approach the exit in a cautious, gradual and transparent manner, so any hikes will likely be telegraphed well in advance, partly through appropriate twists in the crafted language, and partly through some cautious draining of excess bank reserves. Importantly, while the end of easing and the beginning of the exit can be expected to cause wobbles in financial markets, and this is one reason why we see bonds selling off sharply next year, we point out that official rates are likely to stay well below their neutral levels (even factoring in that these themselves are likely to be lower now than they have been in the past) throughout 2010 and, probably, also in 2011. Hence, monetary policy is only expected to transition from super-expansionary to still-pretty-expansionary. This would leave what we have dubbed the ‘triple A' liquidity cycle (ample, abundant and augmenting), which we have identified as the main driver behind this year's asset price bonanza and economic recovery, fairly intact next year. The metrics we follow to validate or refute this view is our global excess liquidity measure depicted in the chart below, which is defined as transaction money (cash and overnight deposits) held by non-banks per unit of nominal GDP. This measure exploded this year and we would expect it to rise further, though at a much lower pace, through 2010. Sovereign and inflation risks on the rise: Fifth, but not least, we think that sovereign risk and inflation risk will be a major theme for markets in 2010. The current issues surrounding Greece's fiscal problems are only a taste of things to come in many other advanced (note: not emerging) economies, in our view. We note that fiscal policy looks set to remain expansionary in all major economies next year, as it arguably should be, given the ‘triple B' recovery which still requires support. However, markets are likely to increasingly worry about longer-term fiscal sustainability, and rightly so. Importantly, the issue is not really about potential sovereign defaults in advanced economies. These are extremely unlikely, for a simple reason: most of the government debt outstanding in advanced economies is in domestic currency, and in the (unlikely) case that governments cannot fund debt service payments through new debt issuance, tax increases or asset sales, they can instruct their central bank to print whatever is needed (call it quantitative easing). Thus, in the last analysis, sovereign risk translates into inflation risk rather than outright default risk. We expect markets to increasingly focus on these risks in the year ahead, pushing inflation premia and thus bond yields significantly higher. Put differently, the next crisis is likely to be a crisis of confidence in governments' and central banks' ability to shoulder the rising public sector debt burden without creating inflation.

Assessing Housing Risks

December 02, 2009 By Richard Berner New York Despite recent improvements in housing demand, construction and home prices, housing risks are turning negative immediately ahead. A ‘payback' from the end of the first-time homebuyer tax credit likely will be the main catalyst, and additional negatives involve the interplay among less-favorable demographics, looming foreclosures and rising joblessness. Yet we strongly believe that renewed housing recovery is coming, courtesy of improved affordability, some easing in credit availability, a renewed tax credit and a return to positive employment gains. The upshot: Weakness in demand, activity and prices is likely through year-end, but we still expect modest improvement in 2010 and beyond: A 10% rise in demand and housing activity is still the most likely outcome next year. Improvement in many housing metrics. There is no mistaking the improvement in many housing metrics from their trough, at least through October. Sales of new and existing one-family homes jumped by 24.6% and 27.8%, respectively, in the six months ended in October, reflecting some of the positive factors mentioned above. Although one-family housing starts tumbled in October compared with September, they have risen 33% from their February lows. Inventories of new and existing homes have plunged dramatically, promoting a better balance between supply and demand. New home inventories stand at 239,000, the lowest since 1971 in absolute terms. Inventories of existing homes, at 3 million, are well below their peak of 3.8 million in late 2007, although still near the previous peak last seen in 1985. And home prices are either flat or up, depending on the measure used: Over the past six months, the FHFA purchase-only home price index has been flat, while the Case-Shiller S&P home price index is up 2.5%. That compares with declines of 11% and 32% over the previous two and three years, respectively. Payback coming, plus barriers to activity. Yet those improvements must be set in perspective for two reasons: First, the first-time homebuyer tax credit boosted new and existing sales through October, and a payback is coming. Second, three hurdles still linger for housing: The overhang of inventories of existing homes on the market and a ‘shadow inventory' of yet-to-be foreclosed homes likely will continue to depress new home sales and housing activity for some time to come; demographics are still unfavorable; and rising joblessness is a barrier to qualifying for a mortgage. Gauging the payback. To gauge the coming payback in sales of existing and new homes, we must calibrate the impact of the first-time homebuyer tax credit on demand. That is difficult, because the US$8,000 maximum tax credit incentive represented only about 5% of the price of homes typically purchased by first-time homebuyers and because there is scant basis for comparison - there is only one example of a similar credit (in 1975, and that was for new homes only). This time around, lawmakers enacted two credits for first-time homebuyers. A US$7,500 credit launched in July 2008 was really an interest-free loan. Then, in February 2009, Congress replaced it with a true credit running up to US$8,000 for low-income buyers who had not owned a residence in the last three years, expiring on December 1, for both new and existing properties. The just-expiring credit stimulated demand, but it is unclear by how much. According to the National Association of Realtors (NAR), about 350,000 of the 1.8-2.0 million buyers who will claim the credit this year would not have purchased a home without it. But it is uncertain how much of that was genuine additional demand and how much was simply brought forward. Traditional measures of affordability have soared, courtesy of the plunge in home prices and in mortgage rates. But with lenders demanding bigger down payments, and with the credit not available until the deal is closed, down payments and credit availability remain hurdles for many buyers, especially first-time ones. The 1975 homebuyer credit represents the sole historical parallel and may shed light on the potential payback this time. That earlier incentive, which was aimed only at new homes, initially boosted sales and then triggered a second surge as the expiration date neared. Fueled by lower mortgage rates, pent-up demand and the credit, new home sales jumped by 63% over 1975, but declined by 16% over several months in 1976 after the credit expired. That moderate ‘payback' may foreshadow today's experience, and we assume both home sales and single-family housing starts will soften a bit in the next few months (into early next year) and rise moderately thereafter. Indeed, the sharp decline in mortgage applications underway since early October already hints that the payback is coming. Yet, as discussed in more detail below, a new credit that extends through April 30, 2010 likely will limit the weakness. Three hurdles for housing. No catalogue of housing risks would be complete without acknowledging three other headwinds. The recession has slowed household formation, looming foreclosures will dump more inventory on the market, and rising joblessness will deter lenders and buyers. Moreover, homebuilders are struggling to compete with distressed property sales, and financing to start construction is still hard to come by. Less favorable short-run demographics. Demographic trends are critical for assessing long-term housing demand, but short-term changes in demographic fundamentals that are influenced by the business cycle also matter. In the current downturn, both slowing household formation and declining interstate labor mobility have been housing headwinds. The latest Census Bureau report showed that new households grew by only 398,000 between March 2008 and March 2009, compared with increases of 772,000 and 1.6 million in the two previous years. Data are incomplete for March 2009, but it appears that the growth in prime-age households (25-54) slowed even more significantly. That's a time-honored cyclical pattern; many couples postpone marriage and having children in recession, and this time is no different. What is different is the depth of the contraction in payrolls that has affected a broader swath of the population. Thus, the annual demographic increment to housing demand has slowed to perhaps 250,000, even assuming a pick-up in household formation and a 65% home ownership rate. In a related development, the percentage of grown children moving back in with their parents has also escalated according to data from the Pew Research Center. The authors note that, "Overall, the proportion of adults ages 18 to 29 who live alone declined from 7.9% in 2007 to 7.3% in 2009. Similar drops in the proportion of young people who live by themselves occurred during or immediately after the recessions of 1982 and 2001." In addition, the interplay between housing woes and labor mobility has created frictions in the labor markets: Without a new job, workers wanting to move are unable to do so, depressing housing turnover; conversely, the inability to sell one's home has limited labor mobility and thus the capacity of workers to move to take a new job in another venue. The ‘shadow inventory': How big? Fully 4.47% of all loans were in the foreclosure process and 9.64% were delinquent at the end of 3Q09, up 150bp and 265bp, respectively, from a year ago according to the Mortgage Bankers' Association; both are records. With about 55 million mortgages outstanding, some analysts estimate that the ‘shadow inventory' of yet-to-be foreclosed homes will rise to more than 13% of that total, or 7 million mortgages. A key trigger for foreclosure is when home owners are in a negative equity position; that is, when the amount they owe exceeds the value of the home. According to First American CoreLogic, 23% of all mortgagees are underwater. Such a surge in foreclosures, even if spread out over a couple of years (as seems likely in any case), would reverse the improved supply-demand balance seen over the past year, put renewed downward pressure on home prices, further discourage housing lenders from offering attractive loans, and pressure household wealth. Several related factors could reduce the coming rise in foreclosures. First, lenders may be increasingly willing to modify outstanding mortgages by writing down the outstanding mortgage amounts to eliminate negative equity; previous efforts to modify the terms of mortgages by lowering rates or forbearing did not help many lenders or borrowers, because redefault rates ran between 50-60%. Second, lenders may also be more willing to accept short sales (in which they eliminate the sellers' negative equity to allow a sale to occur). Third, the Administration is promising to increase resources to enable eligible borrowers who have undergone trial modifications under the Home Affordable Modification Program (HAMP) to convert to permanent modifications. If successful, these developments could limit price declines by holding otherwise foreclosed homes off the market or taking them out of the supply chain completely. So far, however, delays over documentation and other snafus have held up the modification process, so progress may be slow in coming. Are there upside risks for housing? In our view, improved affordability, a better balance between supply and demand, some easing in credit availability, a renewed tax credit, and a pick-up in job and income growth are all likely to offset these housing headwinds and promote a modest recovery. The improvement in affordability lately has been the result of lower interest rates, but subdued home prices have also helped. Current coupon MBS yields have recently plunged to the lows seen in the spring, or 3.9%. With 30-year conventional mortgage rates already at a record-low 4.78%, and further declines likely, housing affordability is soaring. The 2.5% recovery in home prices over the past six months only represents a tiny offset to that improvement. Further, although supply still exceeds demand, the balance is improving. The rebound in new home sales and the plunge to record lows in September housing completions has rapidly normalized inventories of newly constructed homes. As mentioned, new home inventories fell by 4% in October to 239,000 units, a 38-year low. At current sales rates, supply fell to 6.7 months' supply, close to the six months generally thought to represent balance. We may see a bit of renewed upside in months' supply if there is a temporary pullback in sales, but it now seems likely that inventories of newly constructed homes (although not the total, which includes the ‘shadow inventory') will be back to balanced levels by early next year. Credit availability is also easing somewhat. The proportion of banks reporting that they tightened mortgage lending standards in the Fed's October Senior Loan Officer Survey dropped to 26%, down from 77% a year ago. While lending standards are still tight, it is the change in standards that matters for growth (see Calibrating the Credit Crunch, November 20, 2009). Extending the credit. In addition, the payback from the expiration of the first-time homebuyer tax credit may be short-lived because new relief is on the way. Earlier this month, Congress passed new legislation that extends the credit for first-time buyers and expands it to cover current home owners purchasing a new or existing home (up to a maximum credit of US$6,500) between November 7, 2009 and April 30, 2010 (the purchaser will have until July 1, 2010 to close). Current home owners must have used the home being sold or vacated as a principal residence for five consecutive years within the last eight. Married couples with incomes up to US$225,000 are eligible for the maximum credit, higher than the US$175,000 under the credit expiring this week. Finally, improving job and income growth are critical for any lasting improvement in housing demand. On that score, there is already some good news. High-frequency labor market indicators, such as initial and continued claims for unemployment insurance, point to some improvement in the immediate future. And the just-reported US$82 billion (1.3%) upward revision to 2Q wage and salary income likely foreshadows more cyclical improvement for both pay and payrolls. The upshot is that despite significant headwinds and near-term payback from the expiration of the first-time homebuyer tax credit, we think powerful offsetting factors will help housing mount a modest recovery into 2010 and beyond.

Beyond a Dual Downgrade - Mexico

November 18, 2009 By Gray Newman, Luis Arcentales & Daniel Volberg New York After a tumultuous turn in recent weeks, Mexico's congress is putting the final touches to the federal government's 2010 budget. This year, however, the budget is likely to receive greater scrutiny than in most years for one reason: the potential threat that at least one of Mexico's three principal rating agencies will downgrade the country's sovereign credit rating. Investors have been parsing the public comments from the rating agencies, particularly from the two that have Mexico on negative outlook. We find the focus on Mexico's rating a bit surprising. After all, it was only a year ago that the rating agencies were (rightly or wrongly) under considerable attack from many in the investor community. Imagine you had taken a part of the year off from looking at markets: you'd likely be very surprised to see just how important the verdict of the rating agencies now appears to be, at least in Mexico. Faced with the uncertainty surrounding the next decision by the rating agencies, as well as the precise timing of any move, our advice is two-fold. First, we think Mexico watchers should start with the assumption that both of the two rating agencies that have Mexico on negative outlook will downgrade the sovereign's foreign debt rating from BBB+ (three notches above the cutoff for investment grade) to BBB. We usually shy away from making calls on what a rating agency will do. But after exploring the rationale by both of the agencies in question, as well as reviewing the evolution of the liquidity and solvency ratios of Mexico relative to its peers, we think that a dual downgrade (that is, a downgrade by two agencies) is the most likely scenario. Second, we would encourage investors to look beyond today's ratings debate. Whatever the outcome in the coming months - and our sense is that changes, whether in the form of a downgrade or a move back to stable outlook, are likely to take place in the near term - investors should not lose sight of the long-term challenge facing Mexico, which is to boost potential GDP growth. Behind the commendable management of Mexico's public debt, behind the torturous political negotiations to approve some form of tax measure this past month to help patch up a growing public sector deficit, and behind the public sector's overdependence on pro-cyclical oil revenues, is one overarching challenge: Mexico needs to do much more to boost its sustainable growth path. Boosting potential growth is no easy task. It is very easy for armchair analysts in New York or London to dole out policy advice from the comfort of their posts. But in reviewing Mexico's growth record, we cannot help but believe that the economy would be returning to a stronger and more sustainable growth path if more was done in three areas: address shortfalls in human capital through a thorough rethinking of education policy; strengthen the laudable recent steps in funding infrastructure; and finally, ensure that a regulatory environment is in place to promote competition and foster a thriving entrepreneurial base throughout all sectors of the economy. Why a Downgrade? Our reading of the rating agencies suggests that they remain concerned that Mexico policymakers have not done enough to address three concerns: an excessive budgetary dependence on oil revenue (the flipside to a low non-oil tax base), limited fiscal savings (virtually wiped out by 2010), and insufficient progress in boosting long-term growth. While the authorities have made progress in the 2010 budget negotiations to boost non-oil tax revenues, it is not clear that the actions taken to date have been sufficient to trigger a move by the two rating agencies back to a stable outlook from the current negative outlook. In the case of one of the rating agencies, the negative outlook was first announced in November 2008 amid enormous financial market uncertainty. Since then, the global economy has improved and the turmoil in financial markets has subsided. Neither Mexico's external accounts nor the financial stress experienced by some Mexican corporations at the time - both raised as concerns a year ago - have proved to be significant issues. But, the bar is much higher in the case of the rating agency that announced in May 2009 that it was putting Mexico on negative outlook. By May of this year, financial markets had stabilized, the US and Mexican economies were no longer showing signs of a worrisome downward spiral and yet Mexico's outlook was moved from stable to negative, largely on concerns that Mexico would not adequately reform its fiscal policy. Whatever the benefits derived from Mexico's recent budget process for fiscal year 2010, it is not hard to imagine that the rating agencies will decide that not enough has been done to address Mexico's "underlying structural fiscal vulnerabilities" - excessive reliance on oil revenues, lack of significant fiscal savings and a low non-oil tax base. The rating agencies can also make an additional element: the move is not solely about Mexico. Since the global turmoil accelerated just over a year ago, most of Mexico's peers (those in the broader BBB class including BBB+, BBB and BBB-) have either experienced a downgrade in rating or a deterioration in outlook. For Mexico to maintain its current rating, it would need to show that it had outperformed its peer group (even if that meant its deterioration was more modest than others). Yet, work by Daniel Volberg, using the most common solvency and liquidity ratios, suggests that Mexico has remained in a similar position of disadvantage relative to it peers during the past year - a position of disadvantage relative to a group that has seen its average rating downgraded. (For the purposes of Daniel's work, he has used the ratings of the group of broad BBB credits as rated by Standard & Poor's in 3Q08 and then compares them with the latest available data in mid-2009.) The Timing of the Downgrade We suspect that the first downgrade could come later this month or next following a review of the fiscal measures approved in their finality by Mexico's congress on November 15. However, a downgrade by a second agency seems more likely set for late in the year or early next year. What seems clear to us is that both rating agencies feel certain pressure to move away from the ambiguity of a negative outlook. The real choice is either a move to a stable outlook or a downgrade by one notch to BBB. The actions taken by the authorities in recent months (the budget, the lifting on the caps for the oil stabilization funds, as well as the move to takeover the power company, Luz y Fuerza del Centro) are set to be judged against a bar that looks at Mexico's longer-term challenges of fiscal flexibility and growth. What it Means for Markets We suspect that the pace of recovery of the Mexican economy will be much more important for equity markets and investors watching local rates in the coming year than a rating change from investment grade BBB+ to investment grade BBB status. While our Mexico economist, Luis Arcentales, expects a modest recovery in 2010 and consensus estimates for next year's GDP growth are near 3%, Gray Newman has a bias that the recovery could be stronger. Gray argues that the significant decline in 1H09 should make for a very easy base and hence boost Mexico's GDP reports at the beginning of 2010. And Mexico's peso weakness, which stands in sharp contrast with the rapidly appreciating currencies of many of Mexico's emerging market peers, should also benefit Mexico's manufacturing base and feed through to the Mexican consumer. So far, the data seem to be going in Luis's favor: the recovery in 2H09 has been modest despite the benefits that a weaker currency might provide, and concerns abound over the strength of the recovery in the industrial plant in the US, Mexico's dominant trading partner. The greatest impact from a downgrade would appear to come in debt markets or perhaps in the currency market, but even there many market participants argue that a downgrade by at least one rating agency is already priced in. Mexico's credit default swaps, while rallying of late, remain wide to credits such as Brazil (BBB-), which has a current rating two notches below that of Mexico (BBB+). Some participants argue that debt and currency markets have not fully priced in a downgrade to BBB by two of the three rating agencies. We'll leave that discussion for our strategy team, but would add one observation. Although it is difficult to argue that a dual downgrade (that is, a downgrade by two agencies) is positive for the pricing of Mexican assets, we would suspect that the downgrades would be accompanied by a return to a stable outlook. The current position in which two rating agencies have Mexico's outlook set at negative (since November 2008 in the case of Fitch Ratings and since May 2009 in the case of Standard & Poor's), may have raised the bar, making it more difficult for investors to build a case to buy Mexican debt instruments, given the concern over the timing of a single- or dual-downgrade. Once the downgrades take place and the outlook has changed to stable, investors should be able to focus on the relative strength of Mexico's credit fundamentals with less concern about the timing of a possible rating change. We feel strongly that if a downgrade takes place, Mexico's outlook will be moved to stable. In our review of the metrics being used by the rating agencies, we could find little evidence to support Mexico being reclassified as a BBB- credit, the lowest investment grade rating. Indeed, public comments by an official at one of the rating agencies suggested that a ‘two-notch' downgrade from BBB+ to BBB- is not being contemplated. A move to BBB with a negative outlook would, from our perspective, be viewed too close to a move to BBB-, and this does not appear to be the signal that the rating agencies wish to send. The Debate in 2010 The real debate in 2010 is likely to depend on the strength of growth in the Mexican economy. If economic activity surprises on the upside (which is Gray's initial bias), then we suspect that investors will begin to shift their attention away from our long-term concerns that revolve around Mexico's limited progress in boosting potential GDP and the public sector's oil addiction, which tempers Mexico's ability to engage in counter-cyclical fiscal policy. But whether Gray's biases play out or Luis's view of a modest recovery in 2010 turns out to be a more accurate forecast, we agree that the challenges for Mexico's long-term growth prospects remain much the same as they were before the turmoil that engulfed the globe last year. Growth in 2010 could surprise to the upside, but we would caution against confusing a statistical rebound after the significant fall seen in 2009 with a stronger, long-term growth path. And without stronger growth, as Luis Arcentales and Daniel Volberg have argued repeatedly this year, Mexico is likely to find it challenging to improve its fiscal house (see "Mexico: Zipping Up the Fiscal Straightjacket", EM Economist, October 30, 2009). Despite all of the focus on Mexico's oil dependence, Luis and Daniel forcefully argue that GDP growth assumptions matter even more. Luis and Daniel find that, assuming trend GDP growth of 3% and expenditures rising at roughly half the pace of recent years in real terms (about 3.6%), in the absence of tax reform Mexico was headed for a fiscal deficit of 3.6% of GDP in 2015. In contrast, the authorities' original proposal would have been of significant help - Luis and Daniel estimate that if it had been adopted, the fiscal deficit would have largely stabilized, heading towards 2.6% of GDP. Instead, the final bill was watered down when Congress removed the 2% ‘anti-poverty' consumption tax (that would have included food and medicine) and instead raised the VAT tax (excluding food and medicine) by 1%. Luis and Daniel find that the revised tax reform means that, under the same 3% GDP growth and 3.6% real expenditure conditions, the fiscal deficit may be heading towards 3.2% of GDP. And the risks are much higher if growth disappoints. For example, if you work with growth at half their initial assumption (only 1.5%), then the fiscal deficit would approach or even go beyond 5% of GDP under all scenarios. Of course, in those circumstances we would expect the authorities to cut expenditures - but the exercise is designed to show just how sensitive Mexico's current fiscal situation is to growth. Bottom Line Be ready for renewed focus on Mexico's rating, especially if - as we suspect - both rating agencies currently with a negative outlook move to downgrade. That move could create a near-term jolt to investor sentiment. But we suspect that much of the handwringing will subside if growth returns stronger in 2010. In a way, we think that would be a mistake: our concern is that even with stronger growth in 2010, Mexico has not made much progress in tackling what needs to be done to strengthen its long-term growth profile. Mexico's fiscal dilemma is largely just another symptom of the underlying shortfall on the potential GDP growth front. Out of crises often taboos are broken and reforms are born; that does not appear to be the case in Mexico in the aftermath of the severe downturn of late 2008 and 2009. Instead, we fear that another opportunity has been largely lost.

Fedspeak: Roadmap for the Exit

October 28, 2009 By Richard Berner New York & David Greenlaw San Paulo The FOMC next meets on November 3-4. In anticipation, market attention is riveted on every nuance of Fed language and actions. That's hardly surprising, as the case for today's ‘sweet spot' in risky assets rests on short rates staying anchored, liquidity remaining abundant and prospects improving for growth, however modest. Fed officials won't change policy any time soon. But they know that effective communication is more critical than ever as they craft the exit strategy from an ultra-accommodative stance. Market participants want the Fed to clarify its views about the outlook and about the circumstances in which the Fed will unwind its stance. That will help to reduce uncertainty about the implications of the exit process for financial markets. By reducing uncertainty, Fed officials can actually improve the effectiveness of monetary policy. Three areas are critical: First, officials can update the baseline outlook and risks to it, and how they will react to changes. Second, they can map out their exit game plan, continuing to identify the tools they will use and the sequence for deploying them. Third, they can say what they do and do not know about the exit process, given that the Fed and market participants are in uncharted waters. Outlook risks. As noted in the minutes from the September FOMC meeting, the Fed's baseline outlook has probably improved since late June, when the central tendency for growth over the four quarters of 2010 was a range of 2.1-3.3%, and the Fed projected core inflation to run about 1.5%. The revisions will probably reflect generally improving incoming data and a further easing in financial conditions. Despite our conviction that the recovery will be sufficiently strong as well as sustainable, we'd be the first to admit that both are uncertain. Underlying vehicle and housing demand remains unclear following the expiration of ‘cash-for-clunkers' and the first-time homebuyer tax credit. With payrolls still declining and income growth weak, consumer spending strength is in doubt. And contributions to growth from capex, net exports and the government are uncertain. There is even more dispersion around the inflation outlook: Economic slack is unprecedented, while monetary stimulus, rising commodity prices and a weaker dollar might boost inflation expectations and inflation. Even the extent to which inflation has fallen is unclear: The Fed's preferred inflation gauge - the core PCE price index - rose only 1.3% in the year ended in August, but removing a sharp decline in the so-called non=market component of PCE prices yields a rate of 1.7%. Clarifying the reaction function. Given that uncertainty, clarity on how officials will react to changes in the outlook will help market participants understand the roadmap for policy. Many will expect the Fed to tighten sooner if it boosts its growth outlook. However, even if its revised outlook for growth improves to match ours, with ‘core' inflation low and declining, we think that officials will keep policy accommodative through mid-2010. An ongoing improvement in financial conditions may promote a gradual unwinding of the quantitative/credit easing that the Fed implemented to offset the credit crunch. Nonetheless, the current circumstances suggest that the existing guidance on interest rates - "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period" - is probably due for a change. A softening of the language at either the November or December FOMC meetings would be entirely consistent with our expectation that the first phase of the exit strategy (whether you call it reining in excess reserves, shrinking the balance sheet, or unwinding QE) will commence in 1H10 and that rate hikes will follow in 2H. Unlike in 2004, this language is highly conditional on economic conditions. By spelling out how much economic conditions have changed and what will be the response, the officials can help market participants understand the Fed's preferences and reactions. The "exceptionally low" language describes the stance of policy rather than its direction, so it is conceivable that it could still be applied to a 1% or even 2% funds rate target - especially with some small tweaks to the wording. Tools to use. While there appears to be some disagreement regarding the timing and the triggers for exit, all Fed officials seem to agree that the exit strategy has two basic components: 1) shrinking the volume of excess reserves and 2) raising the policy rate. Reverse repurchase agreements (RRPs) will be used to address the former. But there are several unanswered questions: How and when will the Fed use reverse RPs to drain excess reserves, given the massive size of the job? Will it need other tools such as accepting term deposits or selling assets? Will paying interest on reserves give it control over the funds rate? Here is some background. Thanks to aggressive expansion by the Fed, excess reserves - the surplus held by banks at the Fed over required reserves - currently total US$987 billion. We estimate that the excess will grow to about US$1.2 trillion by early 2010. The expected increase reflects three factors: 1) the ongoing impact of the large-scale asset purchases (LSAPs); 2) a looming slowdown in the pace of unwinding other Fed liquidity support facilities (the unwinding has provided significant offset to the LSAPs to this point but simply does not have much more room to go); and 3) the winding down of the Treasury's Supplementary Financing Program (SFP). Thus, far from exiting any time soon, the Fed will actually be adding more quantitative easing unless it takes offsetting action. This means that an important near-term issue is whether the Fed passively accepts more QE or attempts to offset the growth that should soon appear in the balance sheet and bank reserve data reports. The hawks on the FOMC would appear to have a powerful argument if they want to push the issue: "OK, we understand the rest of you don't want to exit yet, but if the recession is over, why are we doing the opposite of exiting?" The counter argument from the doves will be that draining operations might send a confusing signal to financial markets, and as long as the reserves are merely being stockpiled in cash accounts at the banks, what does it matter if more are added? Indeed, this seemed to be the prevailing sentiment at the September FOMC meeting, according to the recently released minutes. Thus, while it will be interesting to watch this debate play out in coming weeks as excess reserve balances soar to new highs, we don't sense that the Fed is about to start draining reserves. At this point, our best guess is that draining operations won't commence until early 2010. Whenever it does decide to start draining, the Fed will quickly enter uncharted territory. Although officials point out that reverse RPs are a standard component of the Fed's toolkit, the largest previous operations ever conducted with primary dealers were on the order of US$25 billion - and that was only for a relatively brief interval last autumn when the Fed was still attempting to sterilize the impact of all the new liquidity support facilities. Communications are critical here too: For example, the Fed has been conducting test reverse RPs, and to insure that investors understand the difference between policy and operational testing, the New York Fed issued a clarifying press release. Fed officials have actually outlined three approaches to draining reserves: reverse RPs, term deposit accounts and asset sales. We doubt that the Fed intends to sell assets any time soon, since such action would probably be quite disruptive to markets - this is more of a long-run option. Moreover, while offering term deposits would appear to be a useful means of draining significant volumes of reserves, this is an untested innovation that carries some legal and technical complexities. The Fed seems to be moving forward most aggressively with the reverse RP option. Initially, there was some concern that dealer capacity for large tri-party reverse RPs was quite limited due to balance sheet constraints, so the Fed signaled that it might have to conduct operations directly with large investors, such as money market funds. However, it now appears that dealers may be able to absorb a much larger volume of operations than previously believed, which would avoid the need for the Fed to deal with a new set of counterparties. Since this matter is expected to be a topic of discussion at the upcoming FOMC meeting, we are likely to get additional clarity on the technical aspects of how reverse RP operations fit into the overall exit strategy following that session. Finally, looking further ahead, the Fed has another tool - interest on excess reserves (IOER) - that, if effective, would enable officials to raise the policy rate without significant reserve draining. If the Fed hikes that rate, it raises the cost of borrowing; when banks can hold excess reserves on deposit with the Fed, they won't lend at rates below the IOER. Yet there are some institutions (in particular, the GSEs) that are not authorized to receive IOER, so there are leakages in the system. And at very low rates, IOER may not function properly. Therefore, the open market desk at the NY Fed may have to use the other tools noted above to execute the tightening as instructed by the FOMC. Uncertain impact of exit on markets. Beyond when exit will start and how it will work, there are several questions about the impact of such policies on financial markets. Will banks deploy their cash assets into securities or loans, reducing market rates and expanding credit supply? Will the interest rate on excess reserves become the policy rate, at least for a while? What will be the impact on market funding rates of conducting large reverse RP operations? The September FOMC minutes note that the Fed staff has examined the impact of very high reserve balances for bank balance sheet management and the economy. In tandem with the substantial volume of excess reserves, large banks that report weekly hold nearly US$1.2 trillion in cash assets on their balance sheets, or more than double the year-ago level. The staff believes that as banks grow more comfortable with the economic outlook, those now holding these balances for liquidity-management purposes could redeploy them into securities or loans. That shift in the asset mix would narrow spreads or increase credit availability; instead of boosting bank liabilities and the ‘money' multiplier, this would increase monetary stimulus through the asset side of banks' balance sheets. Finally, we suspect that large reverse RP operations could put upward pressure on financing rates - with general collateral RP rates possibly trading well above fed funds. We will be exploring this issue in greater detail over the course of coming days because it opens the door to the possibility that the fed funds rate might lose its status as the main barometer of monetary policy. Political constraints? Effective Fed communications will also help the FOMC navigate the current political environment. There is a deeply held concern that the Fed will be unable to execute an exit strategy due to political constraints. That's not surprising, given that criticism of the Fed is at its highest level in 70 years, according to some historians. And there will always be some politicians who criticize the Fed when it embarks on a tightening campaign. Nonetheless, we believe that such concerns are overblown. Since the days of Arthur Burns, the Fed has largely managed to run policy independently, and there is a new and very powerful argument in favor of independence. Since many place the blame for the financial and economic crisis of recent years squarely on an overly lax monetary policy coming out of the last recession, it's going to be especially difficult to criticize the Fed for exiting this time around. In addition, Chairman Bernanke's campaign to communicate directly with the public at large has strengthened the Fed's hand and probably contributed to President Obama's decision to nominate him for a second term. In the end, it's certainly conceivable that the Fed could delay exit longer than it should (just as it is possible that it moves too soon). But we are convinced that if the Fed was to wait too long, it would be because it misread the economy, not because of political influences.

Recovery on Track, but Not Overheating (3Q 09)

China October 23, 2009 By Denise Yam, Qing Wang & Katherine Tai Hong Kong & Steven Zhang Shanghai GDP Economic growth remains robust in 3Q09: The Chinese economy grew 8.9%Y in real terms in 3Q09, recovering further from 7.9% in 2Q. On a seasonally adjusted basis, sequential quarter-on-quarter growth slowed, as expected, to 2.3% (+9.6% annualized), from the very strong 4.5% in 2Q. On the other hand, nominal GDP growth (at 6.4%Y in 3Q, implying a 2.3%Y decline in the GDP deflator) remained undermined by deflation, offsetting the gains in the terms of trade. Though a tad below our forecast (+9.5%Y, +2.9%Q), the pace is undoubtedly robust, in our view, characterizing the economic recovery as on track, but not yet overheating, calming fears of an imminent shift in policy stance towards tightening. Should we mark-to-market our full-year growth forecast to reflect the latest result, it would imply a figure that is moderately below our current projection of 9%, and we will likely revisit this in the coming weeks. Industrial Production Pick-up attributable to export recovery... Industrial value-added grew 13.9%Y (+1.3%M SA) in September (+12.3% in 3Q versus +9.1% in 2Q, +8.7% YTD), ahead of our (+13.5%) and market (+13.2%) forecasts. We believe that this is attributable to the narrowing decline in exports (-15.2%Y in September versus -23.4% in August), as delivery for exports recorded a single-digit (-9.9%Y) decline for the first time this year. ...though domestic demand is still the key growth driver: Needless to say, the manufacturing sector remains dependent on domestic demand for growth as external demand still takes time to recuperate. This is evidenced in the continued outperformance of local enterprises (shareholding companies +16.6%Y in September, collectives +13.5%, SOEs +11.8%) over foreign-invested producers (+8.9%). Trade A pleasant surprise in September... After disappointing results for several months, sticking out like a sore thumb in China's sound recovery story, trade data finally provided an upside surprise in September, adding to the good news from Korea and Taiwan in the same month. Even though we had forecast a narrowing in the year-on-year declines in shipments compared to results reported for August, the improvements were much larger than expected. In September, the year-on-year drop in exports narrowed to 15.2% (-23.4% in August), while imports slipped only 3.5%Y (-17% in August). On a seasonally adjusted month-on-month basis, exports and imports grew 6.3% and 8.3%, respectively, the strongest pace since April, picking up from 3.4% and 1%, respectively, in August. ...with manufactured imports reclaiming positive growth ahead of expectation: The strong recovery in domestic demand lifted imports of manufactures by 1.8%Y, returning to positive growth for the first time in 11 months. Overall imports of primary products are still declining year on year (-14.7% in September versus -29.1% in August), primarily due to lower international prices, but copper (+49% in value in September) and aluminum (+51%) intakes have already returned to positive growth, while ferrous metals demand is also recovering steadily (iron ore -4%, steel products -10%). We remain convinced that the worst is over for the trade sector. As year-on-year declines in shipments are likely to narrow significantly in the coming months, we believe that we remain on track to reach our full-year forecasts for exports (-16%) and imports (-13%). Retail Sales Further pick-up, in line with expectations: Retail sales growth picked up further to 15.5%Y (+1.4%M SA, +15.4% in August, +15.1% year to date), in line with forecasts, although the acceleration was partly driven by easing deflation, suggesting that sales growth in real terms likely remained broadly stable. Autos (+44.5%Y in September), furniture (+34%) and construction and decoration materials (+30.2%) remain the leaders in terms of growth in sales, consistent with the domestic investment demand-driven nature of the current economic upcycle. Fixed Asset Investment Strong, and still a key growth driver... Although external demand is showing signs of recovery, while domestic consumption has surged ahead with robust growth, fixed investment, having kick-started the rebound from the recent recession, remains a key growth driver for the economy as a whole. Nationwide FAI grew 33.2%Y in 3Q (+33.4% year to date), while urban FAI grew 35.1% in September (+32.9% in 3Q, +33.3% year to date). ...and increasingly driven by private sector initiatives: Although policy-driven investment projects, such as those in infrastructure (e.g., railways +87.5% year to date), continue to record the strongest growth, the recovery in private sector investment, especially real estate development (+37.1%Y in September, +17.7% year to date), is helping to relieve the reliance on government initiatives to power growth. Monetary Data Expansion sustained at fast pace in September, supportive of economic recovery: September turned out to be another strong month for money and loan growth, defying fears in recent months that the authorities are adopting a noticeably tighter monetary stance upon realizing a cyclical rebound in the economy since 2Q09. New loan creation picked up for the second straight month, to Rmb517 billion (+38%Y). Nevertheless, this is still consistent with our belief that monetary growth is normalizing after the strong pace in 1H09. Year to date, new loans totalled Rmb8.67 trillion, up 149%Y. Meanwhile, broad money M2 growth reached 29.3%Y in September, the highest level since the high-inflation periods of the mid-1990s. Nevertheless, we expect normalization in monetary expansion towards a more sustainable level, so the slowdown in loan creation should not constrain real economic expansion, or be interpreted as policy tightening, in our view. Foreign reserves data suggest continued mild inflows of ‘hot money' in 3Q09: China's foreign reserves reached a new record-high of US$2.27 trillion in September. The US$141 billion increase over three months ago again exceeded the trade surplus (US$39.3 billion in 3Q) and FDI (US$12.9 billion in July-August) by a wide margin. Nevertheless, part of the reserves ‘accumulation' was again attributable to the increase in valuation of investments in USD terms, due to the appreciation of the euro (+4.4% in 3Q) and yen (+7.3%). Our proxy for ‘hot money' inflows, which is the incremental change in reserves, net of the trade balance and FDI and adjusted for exchange rate movements and interest income, shows positive inflows in all three months in 3Q09, totaling US$25.6 billion, albeit less than 2Q09's US$63.9 billion. Inflation Upstream deflation easing faster than expected: Producer and raw materials purchasing price indices showed an uptick in September, narrowing year-on-year deflation more substantially than forecast. PPI fell 7%Y (-7.9% in August), while RMPPI fell 10.1% (-11.4% in August). On a month-on-month seasonally adjusted basis, both indices sustained sequential gains for the fourth straight month, by 0.8% (+0.8% in August) and 0.7% (+1% in August), respectively. The uptick was driven primarily by smaller declines in energy prices. Although the faster-than-expected ease in upstream deflation and the ongoing rapid monetary expansion are fuelling fears for high inflation next year, we are not too concerned at the current juncture, as we argue that broad money growth is currently biased upwards by a shift in household financial asset allocation, while the output gap from weak exports should help to contain inflation pressure in the next 12 months (see China Economics: Worried About Inflation? Get Money Right First, October 20, 2009). ...while deflation at the consumer level is narrowing on the lowering base effect from food: Food inflation returned to positive territory in August (+0.5%Y) and accelerated further in September to 1.5%, in line with expectations, on the back of the lowering base effect. This helped to narrow overall consumer deflation to 0.8%Y in September (-1.2% in August), the mildest level since China dipped into deflation in early 2009. On a sequential basis (non-seasonally adjusted), consumer prices bottomed in June and July, and have since then risen by 0.5% in August and 0.4% in September. Conclusion Outlook and policy implications: Although slightly below our forecast, the pace of economic growth in 3Q09 is robust, in our view, characterizing the economic recovery as being on track, but not yet overheating, and calming fears of an imminent shift in policy stance towards tightening. We continue to believe that the authorities are committed to policy stability so as to uphold private sector confidence, and expect the growth-supportive policy stance to be maintained until mid-2010. Specifically, although the State Council gave a cautiously optimistic assessment of the current economic situation and struck a less dovish policy tone at a meeting held on October 21, the policy message remains broadly unchanged, namely to carry on "proactive fiscal policy and appropriately loose monetary policy" with a view to maintaining policy continuity and stability. The notable change in language at the press statement compared to previous ones was the new reference to "managing inflation expectations" as a policy objective during the remainder of the year. In our view, the authorities are unlikely to resort to a rate hike, RRR hike or renminbi appreciation to "manage inflation expectations" as it stands, given that current inflation remains low and the economic recovery has just started to gain momentum. Rather, we suspect that the authorities may more likely resort to verbal intervention to ease the public concern about potential inflation, aided by less frequent adjustment to the prices that are still regulated by the government. In any case, the authorities are clearly preparing the market for an inevitable slowdown in new bank lending growth in the coming months and next year. These changes in policy tone are broadly in line with our expectations. Therefore, our policy call remains unchanged: the current policy stance should remain broadly unchanged toward year-end and turn neutral at the beginning of 2010 as the pace of new bank lending creation normalizes from about Rmb10 trillion in 2009 to Rmb7-8 trillion in 2010. We believe that policy tightening in the form of a base interest rate hike, RRR hike or renminbi appreciation is unlikely until 2H10.

The Virtues of ‘Over-Savings': A Post-Crisis Reflection on the Chinese Economy

October 12, 2009 By Qing Wang Hong Kong Mapping the future course of policy action. The developments in the Chinese economy since late 2007 have been truly remarkable. The economy completed a six-month journey from the end of ‘overheating' in 1Q08 to the beginning of a ‘hard landing' in 4Q08, as the global financial turmoil broke out. China managed to become the first of the major economies to recover from the ‘great recession' as a result of powerful policy responses without precedent. With a strong recovery now underway, attention is increasingly being paid to the potential consequences of the super-loose monetary and fiscal policies and the attendant exit strategies. It is an issue of asset allocation, given China's high level of national savings. China's national savings rate is about 55% of GDP - 19% is contributed by households, 11% by the government and 25% by corporate sector. There are only three forms in which national savings can be deployed: 1) onshore physical assets; 2) offshore physical assets; and 3) offshore financial assets. Onshore physical assets are formed through domestic fixed-asset investment. Offshore physical assets are formed either through overseas direct investment or by obtaining ownership of existing offshore physical assets through M&A by Chinese residents. Offshore financial assets are formed either by the central bank's official FX reserve accumulation or private portfolio investment under free cross-border mobility (i.e., no capital account controls). A recurring macro theme: high investment, high growth and low inflation. High savings provide sufficient funds to finance high growth of domestic investment, which, in turn, delivers high economic growth. This high growth, backed up by high domestic savings, tends to, ceteris paribus, generate deflationary instead of inflationary pressures. Specifically, when investment is initially carried out, it is part of aggregate demand (i.e., moving the demand curve to the right) and thus tends to put upward pressure on prices. However, investment will eventually add to production capacity and thus substantially boost supply (i.e., moving the supply curve to the right). The net impact is that, despite high economic growth, inflationary pressures will likely remain subdued. In a high-saving environment, any inflationary pressure is unlikely to last long, as the supply response through investment will likely be fast, given that abundant funding due to high saving is readily available. Offshore financial assets are primarily in the form of FX reserves. China's offshore financial assets are primarily in the form of central bank's FX reserves, which account for 70% of China's total offshore assets. This has largely reflected capital account controls, such that domestic residents are not allowed to freely invest offshore. However, offshore financial assets in the form of official FX reserves do not imply genuine deployment of domestic private savings offshore, as domestic liquidity - which corresponds to the part of savings that would have been invested in offshore physical or financial assets by the private sector had there not been capital account controls - is created when the central bank accumulates FX reserves, but stays inside China. Persistent asset price inflation pressures. On the one hand, abundant domestic liquidity is created as a result of FX reserve accumulation, and the demand for financial portfolio investment is strong; on the other hand, domestic capital markets are under-developed, and there is insufficient supply of securitized investment products. In China, 85% of financial intermediation is through the banking system, while the stock market accounts for only about 10%, and the bond market is virtually non-existent. The unbalanced demand-supply in capital markets is a key reason for the rich valuation in China's stock market. As a discounting mechanism, the still-small stock market in China is ‘over-burdened' to price in the long-term ‘bright future' of the entire economy, such that it can easily get into a bubble situation in a short period of time, especially when investor sentiment turns buoyant. China's high savings is a generational phenomenon. China's high national savings is a generational phenomenon. The high savings ratio is primarily a function of such secular forces as China's demographics, largely shaped by China's ‘one-child' policy and slow adjustment in households' spending habits against the backdrop of rapid economic growth. The ‘one-child' policy artificially lowers the dependence ratio sharply in a much shorter period of time in China than in other countries, where aging is a natural process. The low dependence ratio substantially raises the savings ratio. While households' incomes increase rapidly in line with overall economic growth, personal consumption habits may take years and even decades to change. This results in a high savings ratio, which is often attributed to ‘cultural factors'. While other structural factors, such as lack of social security and corporate governance at SOEs, may also contribute to the high savings ratio in China, their impact is either marginal or an indirect reflection of the abovementioned secular forces. The whole picture: persistent asset price inflationary pressures to be a norm. Reflecting the ‘virtues of over-saving', the Chinese economy has experienced, and will likely continue to experience, high growth and relatively low inflation, with a cushion against external real or financial shocks, as long as the high savings ratio persists, in our view. In this context, persistent asset price inflation pressures will likely become the norm instead of the exception in the Chinese economy, constituting the most important and a constant macroeconomic challenge to policymakers for years to come, in our view. Top policy priority: contain leverage with a view to minimizing systematic risks. In an ‘over-savings' economy like China, managing persistent asset price inflation pressures will likely become a more important policy objective than controlling conventional CPI inflation or promoting economic growth for years to come. However, since the conventional monetary policy tools are not best suited for managing asset price inflation, the pressing task is instead to minimize the attendant systematic risk in the event of a bursting asset price bubble. The damage from a bursting asset price bubble with limited leverage is more manageable. To this end, ‘containing leverage' in the economic system will likely become a key policy objective. This will entail strict mortgage rules for homebuyers, strict restrictions on margin trading in the stock market, and strict capital adequacy requirements for banks. Also, in this context, preventing one-way bets on the renminbi exchange rate becomes important, as strong expectations of renminbi appreciation will induce hot money inflows, which is yet another form of leverage employed by foreign speculators. In a similar vein, there is a need to push ahead with asymmetric liberalization of capital account controls to induce capital outflows and discourage capital inflows. Outbound capital account liberalization under initiatives such as the qualified domestic institutional investor (QDII) and qualified domestic retail investor (QDRI) programs should help to satisfy domestic savers' need to own offshore financial assets directly, thereby slowing the pace of FX reserve accumulation by the central bank and domestic liquidity creation. Controls over inbound capital flows - especially short-term portfolio investment - should, however, be either maintained or removed only gradually. Otherwise, these inflows contribute to exacerbating asset price inflationary pressures stemming from domestic savings and further complicate the policy challenges. Structural reform agenda: price deregulation and development of capital markets. With macroeconomic and systematic risks under control, prominence should also be given to structural reform measures that help to improve the quality of investment. While ‘over-savings' helps to deliver good headline figures, such as high growth and low inflation, the capital generated by ‘over-savings' should be allocated efficiently. To this end, liberalization of administrative controls over interest rates and the price of energy and other key natural resource commodities should be implemented without delay, in our view. Domestic capital markets - including both equity and fixed income markets - should be strengthened to address the asset price inflationary pressures by increasing supply of securitized products to meet the rising demand for investment opportunities. Structural reform agenda: what about consumption-promoting measures? Boosting domestic consumption by lowering the savings ratio has been made a key policy priority, especially since the global financial turmoil broke out. However, if China's high national savings is a generational phenomenon, there is not really much policy room to help lower the ratio meaningfully, in our view. In particular, strengthening the social security system and corporate governance at SOEs may lower the household savings ratio, but it may not be able to effectively lower the national savings ratio. Any consumption-boosting structural reform would likely be modest and have a marginal impact. Aggressive policy measures to lower the savings ratio irrespective of its generational nature would be counter-productive, in our view, by making a welfare system too generous to be affordable by a still low-income country like China. In fact, many of the relevant policy proposals being discussed in this regard should be viewed as measures to address income disparity instead of aiming at increasing consumption at the aggregate level, in our view. Near-term policy implications. We expect the current policy stance to remain broadly unchanged towards year-end and to turn neutral at the beginning of 2010 as the pace of new bank lending creation normalizes from about Rmb9.5-10 trillion in 2009 to Rmb7-8 trillion in 2010. Policy tightening in the form of an RRR hike, base interest rate hike or renminbi appreciation is unlikely until the middle of next year, in our view.

US Economic and Interest Rate Forecast: Don't Fear the Double Dip

October 09, 2009 By Richard Berner & David Greenlaw New York Double-dip fears are returning as the ‘second-derivative' in the economy has turned negative, with incoming data calling into question both the strength and sustainability of the recovery. That's consistent with our view that a hearty 3Q revival would give way to a wobbly 4Q. But in our view this bumpy start to recovery neither presages a double dip nor serves as a harbinger of a ‘new normal' 2% growth path for the US economy. Rather, we continue to think that a moderate, sustainable expansion will emerge, one that eventually stabilizes inflation, revives private credit demands, and lifts real bond yields. Consequently, we're still comfortable with our view that the Fed will begin to renormalize interest rates in mid-2010. US: Forecasts at a Glance %Y change 2009E 2010E 2011E Real GDP -2.5 2.7 2.8 Inflation (CPI) -0.4 2.1 2.5 Core inflation (CPI) 1.6 1.4 2.0 Unit labor costs -1.0 -0.7 1.1 After-tax ‘economic' profits -11.9 12.2 8.8 After-tax ‘book' profits -11.1 12.4 8.2 Source: Morgan Stanley Research estimates The slowdown in incoming data is not surprising; indeed, we have been expecting a significant ‘payback' in 4Q output and demand growth as the summer surge in motor vehicle output slows, the ‘cash-for-clunkers' vehicle incentive expired, and the effects of the first-time homebuyer tax credit wind down (see Recovery Arrives - but Not a ‘V', September 8, 2009). Moreover, it is common for production snapbacks in the early stages of recovery to promote temporary surges in output followed by temporary relapses. Disappointing data. Despite our 4Q caution, incoming data have been disappointing relative to our expectations. Existing home sales fell and new home sales flattened in August, while one-family housing starts retreated. We expected weakness in non-residential construction and capital goods outlays, yet they have been weaker still. Likewise, light vehicle sales have fallen slightly more than expected in September. It appears that imports satisfied more demand than expected in the summer quarter, and we wouldn't be surprised to see some retracement in recently strong exports. Payrolls and thus wage income were weaker than expected, limiting spending wherewithal for consumers. September's decline of 263,000 jobs and a six-minute decline in the private work week pushed private pay down by 0.5% on the month. As a result, we have marked down our 2H annualized growth estimates from 3% to 2.75%, with 3Q now estimated to be 3.5% and 4Q running at just 2%. Weak labor markets underscore the near-term downside risks. Four ingredients for sustainable growth. But this slowdown does not change our view of 2010. On the contrary, we believe that four ingredients for sustainable growth are even more evident than a month ago. In brief, monetary policy won't exit prematurely, fostering market healing; fiscal thrust is poised to translate into fiscal impact; global demand continues to improve; and economic and financial excesses are abating. On the last point, housing and inventory imbalances are diminishing, companies have slashed capacity, and employment is now running below sustainable levels. Exit talk is just that. Despite the discussion of exit strategies by Fed Vice-Chairman Kohn and Governor Warsh, officials are not about to change their extremely accommodative policy stance soon. This gives us comfort that financial markets will have more time to heal before policy support dwindles, increasing the chances for sustainable recovery. The Fed has made its intentions abundantly clear in post-FOMC meeting statements, in the minutes of FOMC meetings and in speeches by Fed officials. At the September FOMC meeting it affirmed that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period". With inflation likely to stay below the Fed's preferred level for some time, and the growth outlook uncertain, the costs of moving too soon are probably higher than those of being somewhat late, so Fed officials would thus rather err on the side of accommodation. In fact, continued asset purchases and the recently announced wind-down of the Treasury's Supplemental Financing Program (SFP) could significantly expand the Fed's balance sheet and excess reserves in coming months unless offsetting action is taken. However, the Fed also does not want to foster new asset bubbles or overstay its welcome and risk escalating inflation expectations. So it is winding down liquidity facilities; some automatically become less attractive for participants to employ as markets heal, and the Fed is reining others in. The Fed is ‘tapering' its large-scale asset purchase programs to avoid ‘cliff effects' while assuring their termination. And it is emphasizing the eventual need for a pre-emptive exit from its current stance, noting that it has or will have all the tools it needs to do the job, while at the same time stressing that it is too early to execute such a strategy. The risk in such a balanced message is that the Fed confuses market participants. In our view, that risk is small, provided that the Fed provides a continued flow of information about how it sees the outlook, and how it will test its operational capacity to drain reserves. Such a test is coming this week as the open-market desk at the New York Fed is gearing up to conduct some ‘test' reverse RP operations. Lasting fiscal impact. A second support for sustainable recovery comes from fiscal policy. We have emphasized that there are significant lags between fiscal thrust and fiscal impact, with the latter providing ongoing support for growth, so worries that the effects of fiscal stimulus will soon peter out are overblown. Measured by the change in the cyclically adjusted federal deficit in relation to potential GDP, fiscal thrust should fall to about zero by the middle of 2010, and if the Bush tax cuts sunset as scheduled on December 31, thrust could turn into significant fiscal drag. But because we suspect that there are lags of anywhere from 3-9 months between thrust and impact, we believe that fiscal impact will remain positive well into 2011. This is especially the case for infrastructure outlays, which at the state and local government level have yet to show any improvement in monthly data through August, although there is anecdotal evidence of a pick-up. Meanwhile, we are slightly more concerned about the impact of another part of the fiscal drag story than last month. Spending cuts and tax increases at the state and local level are offsetting federal stimulus. Especially concerning is the loss of 160,000 state and local government jobs over the past four months - about one in eight jobs lost over that period - which is eroding confidence and spending wherewithal. As we noted a month ago, however, such cutbacks always occur late in recessions as budget pressures trigger a pro-cyclical response. Indeed, such job cuts were far more severe in the 1981-82 downturn, amounting to 400,000 jobs over an 18-month period at a time when those government payrolls were one-third smaller. Exiting excess. Progress on reducing four areas of excess also increases the odds for sustainable recovery (see Exit from Excess: Setting the Stage for Sustainable Growth, September 14, 2009). First, housing imbalances are shrinking. Single-family homeowner vacancy rates declined from their peaks of 2.9% to 2.5% in 2Q, and further declines likely occurred last quarter; the inventory of unsold new homes dropped to 7.3 months' supply. We do worry that rising foreclosures could increase housing imbalances and the pressure on home prices, given the ‘shadow inventory' of yet-to-be foreclosed homes, reckoned by some to be 5-7 million. But the bust in housing starts has slowed the growth in the housing stock to less than 1% and, with demand improving, fundamental imbalances are dwindling. Second, inventory liquidation likely peaked in 2Q, and a slower pace will add to growth. Third, companies are reducing excess capacity at record rates: Capacity in manufacturing excluding high-tech and motor vehicles and parts industries has shrunk by 0.9% over the past year - a pace comparable to the post-tech bubble bust. And capacity in another industrial subaggregate - including primary metals, electrical equipment and appliances, paper, textiles, leather, printing, rubber and plastics, and beverages and tobacco - has contracted by a whopping 2.2% over the past year. As a result, operating rates are rising again, helping to arrest the decline in inflation and laying the groundwork for renewed capital spending gains. Jobless recovery less likely. Finally, we've argued that aggressive payroll cuts make a ‘jobless recovery' less likely. Clearly, limited or no job gains would stifle recovery in spendable income and consumer outlays, further suppressing what we see as a moderate recovery. But past job cuts have virtually eliminated what were minimal hiring excesses and are likely now creating some pent-up demand. A month ago, we measured the extent of hiring excess or shortfall by cumulating the errors made by a relatively standard relationship used to forecast labor hours worked (and, with a projection for the average workweek, employment). If positive, the cumulative differences between actual hours and those predicted by the relationship suggest that there is an overhang of labor to work off. Through 2Q09, the errors cumulate to zero, suggesting that the aggressive job cuts seen in this recession have eliminated any excess. Declines over the past three months - of 638,000 private payrolls - likely pushed those cumulative errors sharply negative, especially if we are correct that output rose at a 3.5% annual rate. Moreover, early estimates indicate that non-farm payrolls were 824,000 lower in the year ended in March 2009 than currently estimated. This implies, if those revisions were all in private payrolls, that the current private job tally is lower than at the trough in the last recession in July 2003. As we see it, far from suggesting an ongoing pace of job loss, this implies some underlying pent-up demand for labor that should materialize at some point down the road. Declining inflation should stabilize, critical for our Fed call. Bond bulls argue that inflation is going to zero, reflecting massive slack in the economy. We disagree. Courtesy of that slack, measured by an output gap of roughly 7% of GDP, US inflation is now falling and will likely head towards 1%. But operating rates are starting to rise, and housing imbalances are narrowing (which will stabilize rents). It's worth noting that all of the deceleration in core CPI inflation that has occurred over the past few years has been attributable to a rapid moderation in the shelter category. Specifically, since the start of 2007, the core CPI has slowed from +2.7% to +1.4% while the shelter category (which has a weight of 43%) has slowed from +4.3% to +0.9%. Shelter costs will no doubt stay soft for a while longer, but further downside from here is probably limited. This reinforces the notion that there is limited deflation risk and that core inflation could begin to drift up a bit in coming years - despite a still-sizeable output gap. Moreover, thanks to a sliding dollar, we believe that import prices will also soon turn higher, stabilizing and eventually lifting inflation. With a sustainable recovery well underway by mid-2010, we believe that the Fed will want to begin to normalize policy rates around that time. The case for higher real rates. Bond bulls argue that real yields can go lower because credit demand is weak and will stay that way. Admittedly, private credit demand is still falling, so the supply of alternative assets for investors to buy is low. Correspondingly, however, we believe that real yields will rise when private credit demand revives. This will occur when businesses' external financing needs - at a record-low minus 2.5% of GDP in 2Q - turn positive and when household deleveraging gives way to new mortgage and other borrowing, if only at a moderate pace. When companies switch from inventory liquidation to accumulation, and when capital spending revives, corporate spending will outstrip cash flow again. Then the combination of reviving credit demand and still-high Treasury supply will push up real rates. Who will buy Treasuries? However, many believe that rising household saving and bank buying will provide a significant boost to demand for Treasuries. We disagree. Recent flow of funds data hint at the likelihood of a supply/demand imbalance in the Treasury market over the course of coming quarters that will push up real rates. In the four quarters ended 2Q09, net issuance by the Treasury amounted to about US$1.9 trillion. Roughly 70% of these securities were purchased by foreigners and ‘households' (note: in the flow of funds accounts, the household category is a catch-all that includes all sectors for which the Fed does not have data - i.e., hedge funds, endowments, foundations, etc.). We suspect that much of this buying in the ‘household' sector reflected a one-time asset reallocation to risk-free investments by endowments and foundations during the height of the financial crisis. Also, there have no doubt been a lot of short-term trading bets in the Treasury market on the part of leveraged investors. It's worth noting that the household sector has been a net seller of Treasuries over the longer run. Thus, we suspect that household demand - which already showed signs of a dramatic pullback in 2Q - will slow quite a bit more in coming quarters. Indeed, even if the personal saving rate were to rise dramatically - as some (but not us) believe likely - households are not going to be big buyers of Treasuries. That is simply not a favored investment for either the typical household investor or for the other non-profit organizations that are lumped into the category. Looking at the other investor categories, Fed buying reflects purchases under the large-scale asset purchase program (LSAP) that will expire in October. Commercial banks are not typically big buyers of Treasuries, but loan demand has softened and some banks have boosted their securities holdings. We suspect that loan demand will remain weak for a while longer and that banks will continue to load up on securities. So, we have factored in a further jump in their Treasury purchases over the next few quarters. However, we strongly disagree with the notion that the share of Treasuries on bank balance sheets will return to the levels seen in the 1980s and early 1990s. Meanwhile, money market mutual funds bought a lot of T-bills when issuance of these securities skyrocketed in 2H09. But we expect the Treasury to pay down a lot of bills going forward. Moreover, money market conditions are healing and the MMMFs will be moving back into traditional assets such as commercial paper. According to the flow of funds data, the only other big net buyer over the last year is the broker/dealer category. However, we believe that this is largely a TSLF story (dealers took in Treasuries and gave the Fed mortgage collateral). Dealers are not typically big net buyers of Treasuries and in our view won't be going forward because TSLF is winding down. Making reasonable assumptions for the other miscellaneous classifications and assuming that foreign investors purchase the same amount of Treasuries over the next four quarters as the past four - an aggressive assumption, given the indications that foreign central banks are planning to diversify out of both dollars and Treasuries - this would still leave about a US$600 billion hole on the demand side. Moreover, because the Treasury is shifting so much issuance out of bills and into longer-dated coupons, the duration of the Treasury supply will be rising rapidly in coming quarters. All of this highlights the looming supply/demand imbalance that we believe will eventually contribute to a significant rise in real yields.