Monday, June 27, 2011

Another big week ahead for Greece

It will be another big week in the unfolding Greek debt crisis as the authorities continue to adopt a “muddle through” strategy.

The next step is for the Greek parliament to legislate the implementation of its €28billion austerity programme. That debate begins today and is due to be voted on by June 29th.

The pressure is mounting on the Greek opposition leader to endorse the program – he has said he will vote against it. In the statement from the EU Summit at the weekend, the EU council made it clear they are looking for broad political backing for the austerity program:

“The European Council calls on all political parties in Greece to support the programme’s main objectives and key policy measures to ensure a rigorous and expeditious implementation. Given the length, magnitude and nature of required reforms in Greece, national unity is a prerequisite for success.”

Having survived last week’s confidence vote, it’s likely the programme will be passed, although where politicians are involved, anything can happen. This is a critical step in accessing the next tranche (€12b) of the first bailout loan. Greece will need to be able to access these funds by mid-July if it is avoid default.

Assuming the program is passed this week, Eurozone finance ministers and the IMF will endorse the bailout tranche in early July. It will also allow discussions to start on a second bailout. From the weekend EU statement:

“Following the request by the Greek government announced by the Greek Prime Minister, (passing the austerity programme) will provide the basis for setting up the main parameters of a new programme jointly supported by its euro area partners and the IMF, in line with current practices, and at the same time for allowing disbursement in time to meet Greece’s financing needs in July.”

If the programme is not passed, Greece is heading for disorderly default and a likely more painful adjustment process. That choice is now in the hands of the Greek parliament.

Thursday, June 23, 2011

No surprises from the Fed

There were no surprises in the press release from the US Federal Reserve this morning. All comments were consistent with recent press releases and Chairman Ben Bernanke’s speech two weeks ago.

The Federal Open Market Committee (FOMC) acknowledged the slower than expected pace of the economic recovery and weaker than expected labour market indicators. They also acknowledge the likely temporary nature of some of the factors (higher commodity prices and supply disruptions following the Japan earthquake) that have contributed to the recent weakness.

They expect the pace of activity to recover later this year, as we do, but they have lowered their GDP forecast for 2011 to a range of 2.7-2.9%. This is down from the April forecast of 3.1-3.3%, but still higher than our 2.5% expectation. Unemployment is expected to finish the year in the range 8.6-8.9%, up from 8.4-8.7%.

At the same time they forecast inflation to be slightly higher in 2011 with the annual increase in the core personal consumption expenditure (PCE) deflator expected to be in the range 1.5 - 1.8%. (Hmm…how long before we start worrying about stagflation?). That revised inflation forecast is up from a range of 1.3-1.6%. It is this turnaround in the core inflation indicators that is the deal breaker for any further quantitative easing. See the post below on why we don’t expect to see QE3 anytime soon.

Most importantly today there were no changes to key monetary policy messages. The FOMC continues to expect economic conditions to “warrant exceptionally low levels for the federal funds rate for an extended period”. QE2 will be completed this month and the Fed will continue to reinvest principal repayments from its security holdings, maintaining its balance sheet position.

Stopping reinvesting principal will be the first step towards tightening and will most likely happen about the time the Committee drops its “extended period” comment. In our view, that’s still a 2012 story.

Tuesday, June 21, 2011

Is the New Zealand Dollar Over-Valued?

Commentary by Jason Wong, Head of Investment Strategy

The NZ dollar recently reached $US0.83, a level not seen since 1981, when Robert Muldoon was still Prime Minister, the All Whites had just qualified for their first World Cup, and Hudson and Halls were deemed to be the best television entertainers. When measured in real terms and on a basket of currencies (the same weights as the MSCI index), NZ’s real exchange rate reached a record high. So where to from here?




It is tempting to argue that the NZ dollar is “over-valued” and therefore must fall. We recall hearing the expression “the NZ dollar is over-valued” back in 2004 when the currency first breached the $US0.70 mark after a period of weakness following the bursting of the tech bubble. Economists, politicians, central bankers and media have been, and still are, running the same line. So is the NZ dollar over-valued?

It all depends on one’s perspective. Relative to historical norms, the NZ dollar DOES seem over-valued. In real terms the currency has never been as high and the average level in nominal terms since NZ’s low inflation era began in 1992 is $US0.61.

But are these normal times? It’s not hard to conclude that economic conditions are fairly abnormal. Firstly, NZ’s terms of trade are at an elevated level, the highest since 1974. NZ’s terms of trade are largely driven by commodity prices, since commodities make up the bulk of NZ’s exports. Commodity prices are a key driver of the NZ dollar so it is not surprising that NZ has a very strong exchange rate in an environment of very strong commodity prices.

Secondly, we are in a post GFC world with significant debt concerns for the US, Continental Europe, UK and Japan. Interest rates in those countries are abnormally low and monetary policy settings, including quantitative easing, are far from normal. This has depressed those currencies relative to the value of the NZ dollar.

Such abnormal market conditions suggest that it is dangerous just to look at the value of the NZ dollar relative to history and make some sort of judgement on valuation.

We recently did some extensive modelling work on the NZ dollar and concluded that a taking backward-looking view is not a very profitable strategy. These models looked at mean reversion from historical averages and momentum type indicators. The value-add from using such models to take asset allocation tilts on various cross rates was inconsistent across periods and across different cross-rates.

A profitable strategy is likely to be one where a correct forecast is made about the future path of commodity prices, interest rate differentials between NZ and other countries, and relative growth prospects between NZ and the world. The problem is that these “inputs” are difficult to forecast and therein lies the difficulty in projecting future currency gyrations.

Looking a year ahead, we see scope for commodity prices to retreat after a strong run over the last decade. We also see more chance of upward pressure on NZ interest rates compared to current market pricing and we expect NZ’s economy to grow faster than others, following a period of underperformance. The first driver would be negative for the NZ dollar, but the latter two would be positive for the NZ dollar.

Whether the NZ dollar rises or falls will depend on which key driver for the NZ dollar predominates. There are, of course, many other factors which could influence the NZ dollar. Investor risk appetite, for example, is another key driver but one which is difficult to pin down.
Overall, we would put more weight on global factors dominating during the course of the next year. This could mean that the NZ dollar struggles to gain further traction, after the recent strong rally.

If we thought that the world was returning to more normal economic conditions, then a mean reversion model would call for a massive short position on the NZ dollar. Our central view is that these abnormal conditions are likely to linger for some time yet, which will probably mean that the NZ dollar continues to trade well in excess of historical norms. From current levels we see more downside risk than upside risk, but only have a mild short position on the NZ dollar given the wide bounds of uncertainty at the moment.

Thursday, June 16, 2011

Is Japan Bouncing Back?

We are optimistic about the ability of the Japanese economy to bounce back from the devastating March earthquake and Tsunami in the short-term, but we need to keep an eye on longer-term challenges.

First quarter 2011 Japan GDP came in at -0.9% q/q, with the earthquake and tsunami derailing what had otherwise been a promising start to the economic year. In particular, inventories moved sharply lower as production was disrupted. Consumption growth slowed to a standstill.

More recent partial activity data tells us the turn-around began in April. After slumping 15% in March, industrial production rose slightly in April. We expect a sharper recovery to follow given the sharp improvement to over 50 (indicating expansion) of the manufacturing PMI in May.


As you would expect the recovery is strongest in the sectors that were hardest hit by the earthquake. The replenishing of inventories will be sufficient to generate strong production in the months ahead, as conditions allow.

However, a critical factor in that initial recovery will be the prospect of power shortages over the coming summer, the peak period for power consumption. This has the potential to constrain the recovery to some extent. If so, it will have a broader impact across Japan than just the earthquake damaged areas.

As with most natural disasters (which we are becoming far too experienced at having to think about!), while the initial economic impact is negative, the longer term impact is likely to be positive as reconstruction starts and then gathers momentum.

The Japanese Government has already announced its first recovery program, estimated at around +0.9% of GDP. This will be financed by a reprioritisation of existing expenditure programs. This has been made necessary by the rating agencies making it clear to Japan that a debt-funded recovery program would not be looked on favourably.

A larger second program is being worked on now and is expected to be announced within the next few months. This is likely to be a bigger program (some Japan analysts are estimating 3% of GDP) and will be financed via “reconstruction bonds”. An interesting feature of this program is that the repayment of the bonds is likely to come from a dedicated tax, which is likely to constrain activity further out.

It’s the scale and nature of this second program that will help determine the economic outlook for Japan over the next few years. The concern at this point is that current political issues, including the possibility of an early election, could delay the finalisation of the program.

Wednesday, June 15, 2011

What are the Chances of QE3?

The recent run of poor US economic data has raised the inevitable question of the prospects of seeing a third round of quantitative easing, or QE3. That question is being given extra currency given the imminent conclusion of QE2 this month.

QE2 was introduced because the Federal Reserve was concerned about its lack of progress towards meeting its dual mandate of full employment and price stability. At the end of last year, when QE2 was being considered, the unemployment rate was over 9% and there was little in the way of discernible signs that the labour market was improving.

On the inflation front, the annual rate of increase in the core Personal Consumption Expenditure (PCE) deflator, the Feds preferred inflation gauge, had fallen to what was to be its low point of 0.7%.

Seven months further on and the economy appears to be weakening again. In his most recent speech last week, Federal Reserve Chairman Ben Bernanke admitted the recovery had suffered a “loss of momentum” and was proving to be “frustratingly slow”. Much of the responsibility for the slowdown over the last few weeks was given to the weather, high commodity prices and global supply chain disruptions following the Japan earthquake and Tsunami, all factors that Bernanke believed would prove to be transitory. We agree.

In the meantime the unemployment rate, following a brief period below 9%, is back to 9.1%. After a series of three months of solid but unspectacular gains in employment, the most recent data for May was disappointingly soft. That’s in line with the general weakness in the activity data.

On the positive side, there is a persistent trend now of increases in private sector employment. The principal drag on jobs growth is the government sector which is cutting employment as predominantly State and local governments get budgets back to a more sustainable footing. That will only gather momentum as Federal government cuts start to impact.

It is, however, the inflation picture that has changed most dramatically over the last few months. When the Fed was first considering implementing QE2, the annual rate of increase in the core PCE deflator was around 1%. However, using a more near term measure, the 3-month annualised rate of increase was only around 0.3%. The Fed would have taken that as a sign that the annual rate of increase was going to decline further, indeed it bottomed out at 0.7% in the year to December 2010.






That annual rate has now moved back up to 1.0%. That doesn’t sound like much of an increase, but consider this: the 3 month annualised rate of increase has now risen to 1.9% for the three months to April. The Fed will now be taking that as a sign that core inflation is headed higher. Let’s be bold: Deflation is dead.

We think the turnaround in inflation is sufficient cause to discount the possibility of QE3. Sure the labour market hasn’t made the gains we would have liked to see and the rate of overall economic growth is slow, even allowing for the recent disruptions. But Bernanke made another telling comment in last week’s speech: “monetary policy is not a panacea”. In other words: economy - heal thyself.

We believe QE3 is unlikely at this point. It is possible to construct a case for QE3, but later. You will recall our view that fiscal consolidation will do a considerable amount of the “de-stimulus” work needed, when the time is right. That takes the pressure off the work that monetary policy will have to do. There is a possibility that fiscal consolidation becomes too big a strain for what could still be a fragile economy. Then, it seems to me, the time may be right for QE3. But that’s probably a 2013 story.

Thursday, June 9, 2011

RBNZ June Monetary Policy Statement

Our Head of Investment Strategy, Jason Wong, drew the short straw this morning and consequently spent a fruitful morning at the RBNZ lock-up for the June Monetary Policy Statement. These are his comments on the Statement:

The RBNZ left the official cash rate at 2.5% as widely expected. Those who just read the press release could be forgiven for thinking it was a pretty uneventful statement, with the policy message of “the pace and timing of increases will be guided by the speed of recovery, but for now the OCR remains on hold”. However, those who read the whole statement got a much clearer picture of the likely tightening in monetary policy over coming quarters.

The Bank’s 90 day bank bill track showed rates rising from 2.6% currently to 3.0% by December , then onto 4.6% by December 2012, and even higher towards 4.9% by the end of the period. This is more aggressive than previously projected. Just to spell it out, the Bank basically thinks it’ll have to raise the OCR by circa 200bps by the end of next year. This is about double what the market had priced in before the Statement.

The Bank thinks that the outlook for the NZ economy has improved since the March Statement, hence the higher projected interest rate track. In addition, the NZ dollar has been stronger than expected, and with only a mild depreciation factored in from this higher level, the currency will be doing more work in reducing growth and inflation pressures compared to previously expected.

The bottom line is that the projections outline a pretty firm track for monetary policy in the period ahead – in excess of that previously projected by the Bank and firmer than the market has priced in. While some might be surprised by this stance our projections have, for some time, factored in a significant tightening, with the OCR at 4.5% by the end of September 2012. We believed that the emergency rate cut back in March was unnecessary and that inflation pressures were already building in the economy to warrant a tighter policy stance.

It is somewhat interesting that the Bank isn’t tightening policy already. It highlights in the Statement that its estimate of core CPI inflation has been above 2% over the last two quarters and that underlying inflation is expected to rise as GDP growth picks up. Isn’t the Bank meant to be aiming for 2% inflation, the mid point of the target range, not the top of the range? When asked why the Bank wasn’t tightening now, the answer was that it wanted to see further evidence that a sustainable recovery was underway and commented that it tightened prematurely back in the middle of last year.

In our view the RBNZ might already be “behind the curve” and waiting another six months raises the risk of the Bank struggling to reduce inflation down further down the track. Recall that 2-year inflation expectations recently reached its highest level since the low inflation era began. The Bank is assuming that the recent increase in inflation expectations is temporary. We hope the Bank is right otherwise NZ could be in for another monetary policy cycle where rates need to go a lot higher compared to taking a more pre-emptive policy stance.

The possibility of the Bank raising interest rates more than the market currently projects suggests upside risk to NZ bond yields and further upward pressure on the NZ dollar over the balance of this year. For a weaker NZ dollar to ensue we really need to rely on global factors, such as weaker global growth momentum continuing and weaker commodity prices.

Wednesday, June 8, 2011

Bernanke, the US economy and monetary policy

Federal Reserve Chairman Ben Bernanke today came as close as is possible in a formal speech by a Fed Chairman to venting frustration. He admitted the economy had recently suffered a “loss of momentum” and was proving to be “uneven” and “frustratingly slow”.

He sees the recent bout of weakness as being largely due to the recent high level of commodity prices that has constrained household budgets and the supply disruptions caused by the Japanese earthquake. He expects both factors to wane and growth to strengthen in the second part of the year. We concur.

The Chairman does not seem overly concerned about the rise in commodity prices and the impact on consumer inflation. He anticipates that over the medium-term they will have a “relatively modest impact”, at least while there is considerable slack in the economy and inflation expectations remain relatively stable.

Understandably he put considerable emphasise on the labour market, noting that “developments in the labour market will be of particular importance in setting the course for household spending”. Yep – can’t disagree with that. He went on to say that “until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established”.

Despite being somewhat frustrated with the pace of the recovery, Bernanke offered no signal that QE3 was in the offing. On the contrary the most telling comment for me in the whole speech was that “monetary policy cannot be a panacea”. Perhaps it’s time for the economy to stand on its own two feet?

We know from the minutes of the April FOMC meeting that the Committee would have to see a significant deterioration in the economic outlook before we saw another round of quantitative easing. Recent weakness in activity indicators, especially if they are largely due to transitory factors, does not meet that test.

However, Bernanke also acknowledges today that the US will soon face “an increasing fiscal drag on the economy” as fiscal policy tightens. That will have significant implications for monetary policy settings as it unfolds.

Tuesday, June 7, 2011

US hits another soft patch

A slew of weak activity data out of the US recently points to the economy having hit another soft patch:

1) Real incomes went nowhere in the first part of 2011 (see post below).

2) The Conference Board consumer confidence index fell from 66.0 in April to 60.8 in May. No doubt the fact the US housing market is still struggling to find a base and bad weather were more than sufficient to offset early modest declines in petrol prices.

3) The ISM manufacturing index fell from 60.4 in April to 53.5 in May. New orders fell from 61.7 to 51.0 while production fell from 63.8 to 54.0. Motor vehicle production was a factor in the weakness and reflects the automotive parts shortage following the Japan earthquake. This decline matches the fall in the non-manufacturing index in the prior month.

4) Non-farm payrolls rose a disappointing 54k in May, well down on the 232k in April. Of most concern to the Fed will be the nudging up of the unemployment rate to 9.1%, up from 9.0% in April and 8.8% in March. While weather and the Japan earthquake were a factor, the weakness was broader based.



This is not the first soft patch for the US recovery; remember the double-dip concerns from the middle of last year? The explanation now is much the same as it was then: the US recovery will be hard work and it has been, and will continue to be, non-linear in fashion. That means it will hit some rough patches along the way.

At this stage it looks like Q2 GDP will struggle to do better than the 1.8% seasonally adjusted annual rate (saar) posted in the first quarter. The positive spin is that as concerns about growth mount, commodity prices should continue to fall which would provide some welcome relief to household budgets and consumption as the year progresses. In the meantime, expectations of a tightening in monetary conditions will contine to get pushed out further into 2012. That is entirely appropriate.