November 26, 2003
Strong growth and surging consumer sentiment fail to weaken
bonds or boost the dollar
Concerns over the Balance of Payments still plague the
dollar
The fixed income rally has eroded the 'risk premium'
Disinflation and a patient Fed should keep the risk premium
in check
Softening of the Stability Pact is not a threat to bonds or
the Euro
MXN and local interest rates under pressure after fiscal
reform prospects dwindle
Czech and Poland expected to Leave Rates Unchanged
Heavy economic data calendar today, focus on consumption and
durable goods
1. Overview
Activity in US and Europe continues to exhibit a sharp acceleration, with
the European bond market relatively more vulnerable to a further setback
originating from a pick up in growth, in our opinion. The consensus remains
downbeat on the prospect of Euroland recovery and we remain comfortable
holding underweight positions in Europe (and also in Japan) against an
overweight exposure in the US in our government bond portfolio.
The upwardly revised US Q3 GDP figure to 8.2% and a surge in consumer
sentiment in November did not negatively affect Treasuries while continued
improvement in the German Ifo and French consumer spending are keeping
upward pressure on European yields. It is notable that the 10-year yield in
the US is about 40bp below the high of the year, whereas the 10-year yield
in Euroland remains close to its highest point.
The US Dollar failed to strengthen against the majors following the better
data and the question still remains whether the Dollar can shed the looming
balance of payments problems and benefit from sustained economic expansion
into 2004. If 8.2% GDP growth and significantly better sentiment from the
household sector cannot spark a dollar rally, will anything be able to save
the dollar from depreciating further?
Evidence that the 'commodity currencies' were becoming overstretched heading
into year-end led us to initiate tactical short positions in AUD and NZD
yesterday. We would hold a short NZD/US$ position with a 1-day stop above
0.6440 and a short AUD/US$ position with a 1-day stop above 0.7240, with a
short trading horizon in mind. In the November FX Monthly we raised our
forecasts for the commodity currencies to reflect positive developments in
the external environment and ongoing strength in domestic demand. Our new
twelve forecasts were changed to 1.31, 0.72, and 0.62 in CAD, AUD, and NZD,
which is generally close to current spot rates. At that time we did not
believe a significant appreciation would be possible and highlighted the
risks that an unwinding of long speculative positions could pose in the
short term.
2. Risk Premium - Enough of a Cushion?
In the past few weeks the fixed income market has undergone a swift and
radical adjustment in interest rate expectations. According to the Dec-04
Eurodollar contract, nearly 50bp of tightening has been eliminated through
year-end and the June Federal Funds contract has similarly rallied around
25bp. The reaction appears sensible given the uncertainty surrounding fourth
quarter growth and ongoing questions about the sustainability of the
expansion. It is somewhat surprising, however, in the context of the Fed
being widely believed to be positioning to eliminate the 'considerable
period' language from the December 9 FOMC statement.
The explanation, in our view, is that market participants understand the Fed
is constrained by the current language, and that its removal and a shift to
a more flexible framework will not be a signal of imminent monetary
tightening. The common theme in recent Fed commentary is that policy
officials have circumvented using the 'considerable period' phrase and have
rather chosen other synonyms such as 'patient'. More importantly, FOMC
officials are linking the timeline for tightening to specific economic
events like the output gap, inflation, and the uncertainties posed by robust
productivity gains.
Our own view is sympathetic to the removal of the current language and also
that the Fed has plenty of room to wait before beginning the tightening
cycle. Our forecast remains that the Fed will stay on hold until mid-2005.
This begs the question of whether the front end of the curve has sufficient
protection to guard against possible upward surprises after the recent
rally. The Dec-04 Eurodollar is priced for a Fed funds rate of around 2% to
2.25% by year-end and the June Fed funds contract is fully discounting a
25bp rate hike by mid-year.
The most informative way of viewing the risk premium embedded in interest
rate markets is through the historical spread between the rolling 1st and
5th Eurodollar contract (currently Dec'03 - Dec'04) and the spread between
the 2-year government note and the Federal Funds target rate.
The underlying message is essentially the same in both cases, and indicates
that the 'risk premium' is not too small when compared to the recent past.
The current Eurodollar calendar spread, using the 1st and 5th contract, is
121bp and the spread between the 2-year note and the Fed Funds rate is 84bp.
For Eurodollars, this is not much different than the average since June or
the implied tightening that was discounted in April 2003 and through late
2002. It is much less than the aggressive tightening priced in through early
2002 when the risk premium reach almost 250bp. Similarly, the current 2-year
less Fed Funds rate spread is about on par with the average since June and
is also substantially less than early 2002.
On the surface, a logical comparison between the present situation and the
1994 bond market "bubble" and the subsequent aggressive Fed tightening seems
valid. We do not agree, however, and believe that the fears are unwarranted.
Disinflationary forces will be present until the output gap is fully closed
- this will require four consecutive quarters of 4% GDP growth - and with
the Fed remaining committed to keeping short-rates low to underpin domestic
demand it is premature to expect a significant increase in the risk premium.
However, we have recently been flagging that real rates are too low across
the term structure given the improved growth prospects in the US (see GS
Global Markets Daily - Hoping It's For Real, 25 November for additional
details). Yesterday we initiated short positions in the 2032 3 3/8 TIPS with
a stop on a close below 2.20%.
3. Stability Pact - Not a Threat to the Euro or Interest Rates
As expected, disciplinary procedures against France and Germany for
breaching the 3% deficit ceiling of the Stability Pact were not invoked at
the EcoFin meeting. Yesterday's decision will most likely have limited
influence on monetary policy despite the hawkish comments from the ECB
saying that they remain committed to price stability. The official softening
of the Stability Pact is not particularly bearish for the Euro either as
Europe does not face the 'twin deficit' problem of the US. For our detailed
response, please refer to today's European Daily Comment.
Summarizing, we make the following key points. First, this outcome is not a
surprise and we have long argued that rigid application of the Pact would
make little economic sense. Second, it removes a potential bar to growth in
taking away the threat of unwarranted fiscal tightening Third, the decision
in itself should not be taken as a pointer to higher deficits and higher
long-term interest rates. The key to the path of bond yields over coming
months will be whether Euroland growth continues to pick-up, as we expect.
Fourth, as already noted, this decision will not precipitate a hike in
interest rates, despite the hostile reaction of the ECB yesterday. No doubt,
however, the ECB will be quick to cite fiscal policy as one of the factors
to justify a tightening move when it believes that the underlying conditions
are in place to justify higher interest rates next year.
4. Meltdown in Mexico?
In recent days the Peso and Mexican fixed income products have sold off,
triggered by weekend news indicating that part of the PRI leadership would
not support the tax reform proposal. With no prospect for reforms, markets
are discounting that a weaker Peso is necessary to help the economy recover.
A weaker Peso is generally viewed as a harbinger of higher inflation,
leading to higher interest rates. We have done quite a bit of work on
inflation pass-through from changes in the Peso and find that the
relationship has broken down in recent years.
A more plausible story to rationalize the pressure on long-term rates is
that without reforms growth will be lower, implying potentially lower tax
revenue, a higher fiscal deficit, and higher debt issuance. While the Peso
is likely to remain under pressure, we see long-term rates declining over
the next 12 months. The biggest, short-term risk for long dated yields is
one noted by Paulo Leme, namely, that Congress closes the fiscal gap through
administrative price hikes or ad-hoc excise taxes, instruments that could
permanently raise the price level. We believe that even in those
circumstances, the impact on 10-year TIIE should be temporary and we
continue to recommend 10-year receivers with a 2-day stop on a close above
9.60.
5. Czech and Poland Expected to Leave Rates Unchanged
The monetary policy meeting ends today in Poland and we expect the MPC to
leave rates unchanged. Slightly higher inflation, stronger activity, a weak
Zloty, and an even weaker bond market do not support an additional easing of
monetary conditions, in our view. In the Czech Republic, the next monetary
policy meeting is scheduled for tomorrow and no change in rates is expected.
Jens Nordvig notes that the minutes from the October 30 MPC meeting showed
that two members of the CNB's board voted for a rate cut. Recent data have
given mixed signals as to the momentum in the economy. FRAs are currently
pricing 25bp of hikes on a 6-month horizon, this is fair in our view and we
would look for clearer signs of increased growth momentum before entering
short positions in the money market.
6. FX Equilibrium In Eastern Europe
In a View Point released on Monday (New GS-DEEMER Estimates Show CEE4
Currencies Closer to Equilibrium) we revisit our GS-DEEMER models for
Eastern Europe in the context of revised estimates for total factor
productivity. We find the new data has a sizeable impact on our 'fair value'
estimates for the trade-weighted CZK, SKK, HUF, and PLN.
On average, we find equilibrium real rates to be 10.4% stronger than our
previous estimates. This implies that the overvaluation of CZK and HUF is
now smaller and that the PLN is now undervalued, after falling 14% in
trade-weighted terms over the past two years. These findings support our
existing rate recommendation in Poland to be short 5-year rates and stay
long 12-month rates in Slovakia through FX swaps, and our cautious attitude
towards the HUF and the CZK.
7. Things To Watch
In a holiday-shortened week (the US markets are closed on Thursday in
observance of Thanksgiving), today is the final day for economic data and
the calendar is exceptionally heavy with a couple important releases to keep
an eye on. Following the poor reading in September (-0.3%), the personal
consumption figures for October will be scrutinized to gauge the extent of
the slowdown in consumption growth following the fiscal induced spurt in Q3.
Strong survey readings on manufacturing activity point to additional gains
in orders for durable goods for the month of October and the upward trend in
bookings for nondefense capital goods should continue. The weekly jobless
claims data (to be released today instead of the customary Thursday release)
continues to highlight an ongoing improvement in labor market conditions,
which is beginning to be reflected in the monthly payroll data.
Also released today is the final reading for the November University of
Michigan consumer sentiment survey along with the regional manufacturing
survey for the Chicago region. A slight improvement in manufacturing
sentiment is likely after the strong reading from the Empire and Philly Fed
surveys.
The Federal Reserve will also present the Beige Book today, which compiles
commentary and assessments from the thirteen Federal Reserve districts on
overall economic activity.
Later this morning the September Balance of Payments figures for Euroland
are released. We expect the trend in the current account surplus will likely
have continued to deteriorate. However, given recent data releases on the US
side, there is likely to be a let-up in the significant bond outflows seen
over the Summer, which pushed the BBoP into deficit.
8. Current Trading Views
Below is a list of our outstanding trading recommendations.
In FX, we would:
* Stay long EUR/$ with a 1-day stop on a close below 1.1750.
* Hold short NZD/US$ with a 1-day stop above 0.6440.
* Hold short AUD/US$ with a 1-day stop above 0.7240.
* Hold short EUR/CHF with a 1-day stop above 1.5550.
* Hold short EUR/NOK with a 1-day stop above 8.23.
* Hold a $/CNY ATMF put with expiry in March 04.
In fixed income, we would:
* Stay short the 2032 3 3/8 TIPS for an initial target in the
2.70-2.80% area, with a stop on a close below 2.20%.
* Stay long 5-yr swaps in the UK against 5-yr swaps in Euroland with a
stop on a close above 155bp.
* Stay short 1-yr CHF swap rates, 2-yr forward; target 3%, stop below
2.2%.
* Stay long 10-yr Mexican TIIE rate receivers; target 8.75%, stop on a
2-day close above 9.6%.
* Receive 2-yr GBP swaps vs. paying 5-yr fixed and hold the opposite
positions in SEK swaps with a 1-day stop on a close above 80bp.
Best Regards
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