For the week, benchmark Treasury yields dipped 1-3bp, a fifth straight weekly rally and a 13-40bp rebound from the March 20 peak of the hawkish Fed pricing shift after the market's overreaction to the March 13 FOMC statement. The 2-year yield fell 1bp to 0.27%, 3-year 1bp to 0.40%, 5-year 1bp to 0.85%, 7-year 2bp to 1.37%, 10-year 3bp to 1.97% and 30-year 2bp to 3.13%. Along with and underpinning the Treasury market gains since March lows, the July 2014 fed funds futures contract has rallied 40.5bp (3.5bp of which was in the past week) to 0.425% and the January 2015 contract 51.5bp (4bp in the latest week) to 0.675%. Backing out some term premium, these levels are still pointing to an earlier start to rate hiking than FOMC guidance, but not much earlier, and this is the most dovish pricing since the first couple of days of February a week after the January 24-25 FOMC meeting. Supply pressures at the $16 billion 5-year auction Thursday and a bit of softening in oil and gasoline futures prices as concerns about a geopolitical disruption to supplies appeared to ease, slightly hurting TIPS relative performance a bit. The 10-year TIPS yield rose 1bp to -0.27%, lowering the benchmark 10-year inflation breakeven 3bp to 2.24%, and the 30-year yield dipped 1bp to 0.75%. The new 5-year issue ended the week at -1.12%, rallying back Friday after being auctioned Thursday at a cheaper-than-expected -1.08%. Mortgages performed well, with Fannie 3.5s outpacing the small Treasury market gains by about 3 ticks, adding to a solid run since the March 20 lows that has seen current coupon yields fall from near 3.25% to 2.85%, returning average 30-year mortgage rates to record lows near 3 7/8%. There's a small amount of premium for potentially stepped up Fed buying probably still embedded in MBS valuations, but these expectations are low at this point and don't seem to have been an important contributor to recent better performance. Instead, in an environment of very low implied and realized rates volatility - a trading environment our volatility desk has described as "slightly depressing" - the fundamental underpinnings for continued carry and yield pick-up-focused buying by banks and money managers have remained quite solid. The main near-term challenge to this may come from increasing supply if origination activity accelerates with rates having moved back down to record lows.
In addition to the continued Fed repricing, to which they contributed, the two key drivers for the past week's continued positive tone in US rates markets were Europe and soft economic data. Over in Europe, pressure on sovereign CDS and government bond yield spreads continued even after seemingly solid auction results in Spain and France. Spain has been the main focus of market concern in recent months, and while in level terms it ended in a very challenging position, relative deterioration for the week was bigger in Italy, France and even Germany. Spain's 5-year CDS spread ended Friday at 505bp, only about 3bp wider on the week but just below the all-time worst close of 510bp hit Monday. Other countries are still trading significantly better than their 2011 wides, but their deterioration in the past week was more pronounced - Italy's 5-year CDS spread widened 31bp to 465bp, France 14bp to 200.5bp, and even Germany 12.5bp to 86bp. Meanwhile, domestically, economic data released in the past week were soft overall. Industrial production (0.0%, manufacturing -0.2%), housing starts (-5.85) and existing home sales (-2.6%) were weak in March, and while overall and ex auto retail sales (+0.8%) were better than expected, underlying details were more muted and left our forecast for 1Q consumption at +2.1% and GDP at +2.7%.
Looking ahead to the key initial run of April data at the start of 2Q that will be released in a couple of weeks, initial indications were sluggish. After two straight much worse-than-expected reports, the 4-week average of initial jobless claims rose to 374,750 in the survey week for the April employment report, up 6,250 from the survey week for the March employment report, which was flat relative to the February survey period after a major decline from mid-September to mid-February. It's become increasingly clear that the acceleration in job growth over the winter was partly just an artifact of the extremely mild winter weather, one of the warmest and least snowy in recorded US history. As we move into the spring now, seasonal factors expect a surge in hiring - about 900,000 jobs will need to be added in April for a flat seasonally adjusted payroll number after a 691,000 seasonal hurdle in March - but the pick-up in hiring has been reduced by the lower-than-normal seasonal layoffs over the winter because of the supportive weather. Our preliminary forecast is for a 140,000 gain in April non-farm payrolls. That would leave job growth averaging 130,000 a month in March and April after gains averaging 246,000 from December to February. Meanwhile, early indications for the upcoming ISM report were mixed, pointing to not much change. On an ISM-comparable weighted average basis, the Empire State (53.8 versus 54.6) and Philly Fed (52.8 versus 50.7) surveys were mixed. Meanwhile, our MSBCI survey (see US Economics: Business Conditions: Recent Data Boost Headline, Leave Composite Flat by Dane Vrabac, April 17, 2012) showed a decent gain in the headline index but little change in the composite. So, we look for the ISM to hold steady at a moderately positive 53.4, well within the fairly narrow range that has been evident over the past six months. Finally, initial industry reports pointed to a further pullback in motor vehicle sales in April, with the surge in gas prices proving a near-term headwind. Our preliminary initial forecast is for a decline to a 14.0 million unit annual rate from 14.3 million in March and the four-year high of 15.0 million in February. The underlying sustainable trend is probably better than that - our forecast for the full-year sales pace is 14.8 million, same as our equity research autos team - but we may be faced with yet another round of supply chain disruptions hitting sales in the near term after an explosion at a chemical plant in Germany reportedly has knocked off line, potentially for months, half of global supplies of a resin that is a critical input to the global auto parts supply chain.
Main market focus in the coming week will be on the FOMC meeting, with the statement released at 12:15pm Wednesday, the updated FOMC summary of economic projections released at 2:00pm, and Fed Chairman Bernanke's press conference starting at 2:15pm. The key items we expect are a reiterated late 2014 policy guidance, but with a slight shifting out of the average expected start to rate hikes, though accompanied by slightly better forecasts for growth and the unemployment rate this year - which may create a bit of a communications challenge for the Chairman. We continue see the prospects for continued Fed asset purchases after June as highly data-dependent, particularly on the April and May employment reports, and we don't expect Chairman Bernanke to suggest any more than that, with policy focus instead likely on reiterating and supporting the late 2014 rate guidance. After the market initially misinterpreted the March 13 FOMC statement and moved to price a much earlier start to Fed tightening, Chairman Bernanke, New York Fed President Dudley and Vice Chairman Yellen have pushed back against this challenge to Fed credibility in a concerted way over the past month, and with help from the employment report and other softer data and the weakness in Europe, they succeeded in driving a major dovish repricing ahead of this meeting.
After the expected reiteration of the FOMC statement's guidance of no rate hikes until "at least last 2014", we expect Chairman Bernanke's press conference to continue this message that no rate hikes are likely for quite some time, and we also think that the graphs summarizing FOMC members' assumptions for the fed funds path in coming years may see a slight net shift further into the future. There could be a bit of a seeming inconsistency in this shift with adjustments to the central tendency economic forecasts, which will probably be effectively marked to market to show a slightly lower unemployment rate at the end of this year and perhaps slightly higher GDP growth. Beyond marking to market of recent developments, however, we still think that the Fed's central tendency GDP forecasts for 2013 (2.8% to 3.2%) and 2014 (3.3% to 4.0%) look too optimistic, given the sizeable potential fiscal policy drag. The ‘fiscal cliff' could be more of a focus in Chairman Bernanke's press conference, but we don't see clear catalysts for any changes to the FOMC's high-looking 2013 and 2014 growth forecasts at this meeting.
Aside from the Fed, investors will certainly continue to focus intensively on developments in Europe in the coming week, and the Treasury market will be occupied with supply, a $35 billion 2-year Tuesday, $35 billion 5-year Wednesday and $29 billion 7-year Thursday, with the 5-year made trickier by being held shortly before the release of the FOMC statements. There are also a number of important economic data releases out, including new home sales and consumer confidence Tuesday, durable goods Wednesday and GDP and ECI Friday:
* We look for new home sales to jump more than 5% in March to a 330,000 unit annual rate, consistent with the sharp run-up in homebuilder sentiment over the past few months. Also, unusually mild winter weather appears to have helped to boost floor traffic in the Midwest and Northeast, though these regions account for a relatively small share of new residential construction.
* Various gauges suggest that confidence has been holding reasonably steady in recent weeks, so we look for the Conference Board's consumer confidence index to hold steady at 70.0 in April. This likely reflects a wide array of crosscurrents. For example, gasoline prices have leveled off, but equity markets have cooled off, and the labor market headlines in early April were somewhat less upbeat than in prior months.
* We forecast a 1.6% decline in March durable goods orders. Company reports show that - after surging in January and February - aircraft orders slipped back to a more normal volume in March. However, since the durable goods report did not appear to capture all of the prior elevation seen in the company data, we are assuming only a moderate slippage in the volatile aircraft sector. Otherwise, we expect to see a modest 0.5% rise in the key core orders barometer - non-defense capital goods excluding aircraft. Such an outcome would be consistent with the recent performance of the ISM orders index. Finally, we also expect capital goods shipments to show a modest gain (+0.5%) as the recent tax-related volatility of late 2011/early 2012 should fade.
* We forecast a 2.7% increase in 1Q GDP. Two weeks ago, we saw growth tracking at +1.8%. But, a series of positive reports - particularly those related to foreign trade and inventories - pushed our estimate up by nearly a full percentage point. We see consumption rising by 2.1%, the same as the 4Q pace. Also, business fixed investment should show a modest gain (+3.5%). We expect the inventory contribution to GDP growth to be neutral, while foreign trade adds 0.4pp, and government adds 0.2pp (mostly from a rebound in volatile defense outlays). Finally, we expect the GDP price deflator to rebound (+1.8%), following an unusually subdued reading of +0.9% in 4Q.
* We forecast a 0.5% rise in the employment cost index in 1Q, close to the pace seen in recent quarters, with the key private wage category also rising a modest 0.5% - right in line with the recent trend. The wildcard for this report is the benefits component. The annual resetting of healthcare contracts and other benefit arrangements has historically tended to generate some upside in 1Q. However, many companies (and public sector entities) continue to shift some of these cost burdens to employees. So, we don't expect to see too much elevation in benefits this time round. On a year-on-year basis, we expect the ECI to hold near +2.0% - well below the +3.3% pace seen as recently as early 2008.
Gray: Daniel, you've had your hands full with the latest developments out of Argentina. Just hours after you had published a note warning that the greatest risk was now one of policy radicalization, Argentina's president announced that she would be sending a bill to Congress to nationalise the controlling stake in the country's largest oil company (see "Argentina: Reversing Direction", This Week in Latin America, April 16, 2012). Indeed, she didn't even wait for the bill to reach Congress; when I turned on the news last Monday I saw the planning minister arrive at the oil company's offices in the Puerto Madero neighborhood of Buenos Aires and heard that they had ordered the security to be changed.
Daniel: It has been a busy week. Actually, the action started a few weeks ago when the authorities began to reverse track on the fiscal front. Reducing subsidies had been an important step forward in trying to regain control over the fiscal accounts and produce the kind of macro adjustment that Argentina needed to regain control over inflation. When that ended a few weeks ago, it was a clear signal that policy was taking a U-turn and in a direction of heterodoxy.
Regarding what you saw and heard last week, there were actually two decisions.
First, there was a bill classifying energy independence as a "public utility", creating a new regulatory body - the National Hydrocarbons Council - that will have a role to play in setting national energy policy at both federal and provincial levels and in nationalising 51% of Argentina's largest energy company. This bill is now being express approved by Congress - the Senate is scheduled to vote this Wednesday.
Second, there was a presidential decree that placed operational control of the company for 30 days in the hands of the government, represented by the planning minister and the vice-minister of Economy. The 30-day decree was to give the authorities time while the expropriation bill made its way through Congress. We have no reason to believe that another decree will be necessary: we should have congressional approval very shortly.
Gray: Wait a minute, you started off by arguing that the worrisome signs began to be seen a few weeks ago. What does the decision of the authorities to pull the plug on subsidy reduction have to do with the move to expropriate a controlling stake in Argentina's largest oil company?
Daniel: Sure, let me explain. As I see it, Argentina's biggest problem isn't its energy sector. Instead, it is its macro model based on keeping its exchange rate weak to boost import substitution and local employment. That model was hugely successful during most of the last decade, but starting around 2007 inflation began to emerge and threatened to erode the currency's competitiveness. As you can see in a chart I often use, Argentina's peso in real (inflation-adjusted) terms has strengthened sharply in recent years if you measure inflation as we do. Indeed, the peso in real effective terms (inflation-adjusted and trade-weighted) is now back to levels we last saw in the 1990s during convertibility. The peso isn't at the strongest levels seen in that decade, but has moved back to the average seen in that decade.
Gray: And the link between that, the fiscal subsidies and last week's expropriation?
Daniel: I'm getting there Gray. The greatest threat to the Argentine weak currency model is inflation. And that is why I was so encouraged late last year when the new administration began to actively tackle inflation. The reduction in fiscal subsidies amounted to a saving of nearly 0.6% of GDP in a matter of months. This is over a third of the difference between Argentina running a fiscal deficit and having a balanced budget. Moreover, we were seeing signs that the authorities were also moving to rein in wage settlements. Ending the fiscal imbalance would have eliminated the need for the central bank to print more money; the control over wage settlements would have been equally positive.
Regain control over inflation and you limit the currency's real appreciation: you begin to tackle what was driving the deterioration in Argentina's trade and current accounts.
At the same time, however, the authorities were not content to deal only with the driver of the current account deterioration (namely inflation). While the macro measures were designed to regain control over inflation and hence slow the pace of currency overvaluation which was showing up in the balance of payments, a whole host of import controls were designed to attack the symptoms. And therein lay the risk: which set of measures would win out: the macro adjustment or the interventionist approach?
Gray: I think I remember which side you came out on. But to be fair to you, most investors had completely written off that anything positive would come of this and appeared to have been underestimating the struggle going on in Argentine policy-making circles. However, it now appears that most Argentine watchers were right.
Daniel: Yes, it certainly appears so. So, to go back to your earlier question, I am afraid that the latest move in the energy sector has less to do with energy and more to do with the authorities' need to try to shore up deterioration on the balance of payments front. Last year, the energy trade balance in Argentina has produced a shortfall of -$3.0 billion versus a surplus of $2.0 billion as recently as 2010. That attracted the attention of the authorities, but again the issue isn't just energy but how to limit any balance of payments deterioration.
Gray: So that means this is not simply a spat with the energy sector or one particular company? Other earners of hard currency could also be at risk?
Daniel: Yes, the risks have risen sharply. There are at least two elements to this issue.
First, the export revenue-generating sectors may be at risk. For example, it's possible that in a few months we could be discussing again the idea of a national grains exchange - an idea that was floated a couple of years back, but never was given the policy green light. The national grains exchange would force all Argentine soft commodity production to be sold at a single entity, giving the authorities effective control over what has been a very independent and decentralised sector that is responsible for the bulk of foreign currency revenue in Argentina. But I don't mean to isolate agriculture - other export sectors - from mining to industry - may be at risk as well. This situation is very fluid.
Second, the ability to repatriate earnings as dividends may also be at risk. If you look at the income account section of the current account data you will see that repatriated earnings last year accounted for an outflow of US$7.3 billion - a record high since the data began to be published in 1994. Indeed, since 2009 repatriated earnings have been larger than inward foreign direct investment. In my view, hampering the ability of companies to repatriate earnings may force many of them to shrink the size of their Argentine operations. This, in turn, could give the authorities additional ammunition to argue that they are seeing "insufficient investment commitments".
Gray: Hmm. You've certainly got your work cut out for you. I understand that given just how fluid the situation is that you aren't anxious to revise your forecasts yet. But can you talk me through where you see the risks or the signposts that you are most carefully watching.
Daniel: There are three things that worry me the most right now, Gray.
First, there is a rising risk of a devaluation some time during the next two years. The main variable to watch on this front in the near term is going to be capital outflows. We have already seen the parallel exchange rate weaken 3% to Ar$5.6 per dollar from Ar$5.4 per dollar in just the past week - a move that tends to be associated with a pick-up in capital outflows. We are also going to be watching international reserves and bank deposits for signs of a deeper crisis of confidence and capital flight. On a longer-term basis, we are watching the real exchange rate to gauge the degree of overvaluation of the peso.
Second, I am concerned about the upside to inflation. Median one-year ahead inflation expectations have moved decisively higher - to 30% in the past two months - after being anchored at 25% for just over a year. This may be partly related to February's tightening of import controls that created scarcity and drove up the price of goods. This may also be related to continued high demands for wage hikes upwards of 30% by organised labour amid rising tension, including strikes. And we cannot discount the expectations for further loosening of monetary policy in the aftermath of change in the central bank charter, especially in light of the fact that M2 is already growing at a 39% annualised pace in the three months through March (and 50% pace in March alone).
Third, I am worried that we will see a negative shock to output - at least initially. One question is whether it will worsen over time or if there will be a rebound. In part this will likely depend on confidence which, in turn, may depend in part on the degree of current account and fiscal deterioration but also on the ability of the authorities to convince the business community that private property in Argentina is not at risk of expropriation.
Gray: That is a tall order Daniel. And given the events of the past month, if I was charged with analysing Argentina, I think I would be ready to pull out the Tipping Points. Remind me to tell you all about them sometime.
But to play devil's advocate here for a second. Couldn't there be a silver lining here? I mean, aren't the authorities likely to be in relatively good shape in terms of their financing requirements. And if GDP growth is lower - you've been arguing all along for GDP growth at 3.1% - doesn't that mean the authorities are likely to save money from not having to pay out on the GDP warrants?
Daniel: Finding a silver lining on the financing requirements front is a bit tricky. A great deal depends on what happens to growth, the fiscal accounts, inflation and the impact of all of that on Argentina's balance of payments.
I'm comfortable adjusting the fiscal accounts to post a larger imbalance, given the failure to reduce subsidies, but it makes little sense to make that first adjustment when a new growth and inflation outlook will likely have an additional impact. But even with all of the uncertainty, I think we can say two things.
First, the financing outlook for 2012 is very comfortable. If we include the GDP warrant payments this year of roughly US$5 billion (based on last year's GDP growth of 8.9%), there is US$20 billion of debt coming due this year. Of these, we would expect US$7 billion to be rolled over by multilaterals and the Social Security fund (ANSeS) - recall that ANSeS holds 55% of all performing Argentine debt. And to pay the remaining US$13 billion, Argentina can rely on short-term central bank lending of up to US$27 billion and international reserves of US$47 billion. There is an additional element - the primary fiscal balance - that must be taken into account. Currently we are forecasting a primary surplus of US$12.6 billion for this year. However, given that the authorities have abandoned fiscal tightening, we could see a significant deterioration relative to our forecast - the primary surplus could fall to just US$0.5 billion or even move to a slight deficit. For comparison purposes, last year the primary surplus was just US$1.1 billion. Still, even if we see a deterioration on the fiscal front, it appears that the authorities have the capacity to honor their debt-service obligations this year.
Second, for 2013, the financing outlook is also favourable. We expect no payment of the GDP warrant, which means total obligations - capital and interest - are projected to be US$14.4 billion. Of this, we expect US$7.5 billion to be rolled over by multilaterals and ANSeS. Again, the fiscal is an important moving part. Currently we are forecasting a primary surplus of US$7.8 billion, but it could slip to a deficit of as large as -US$3.9 billion. Thus, the debt obligations next year could be either covered by the primary surplus (our current forecast) or by dipping into the up to US$31 billion in central bank short-term lending and our forecast of US$37 billion of international reserves if the fiscal moves to a deficit. Again, capacity to service debt appears to be very much intact.
The caveat for both 2012 and 2013 is that meeting financing needs should further stoke inflation. After all, the main source of financing is likely to be central bank lending, which is largely financed by monetary expansion. As I have already highlighted, much hinges on the fiscal performance.
Gray: OK. So what I am hearing is that you are pretty concerned that the model is heading in the wrong direction and indeed the recent moves could spark a difficult bout of capital outflows, which in turn could produce a hard landing. Short of that, however, there is some good news on the financing front.
I'd be ready to pull out the Tipping Points, Daniel. That said, the best thing that an economist can do is to challenge themselves and ask where they could be wrong.
One final question from me: what is the chance that we get a positive surprise on the energy front? I can think of other emerging economies where no sooner have the authorities taken over an oil company, than foreign players are ready to step in and engage. Any chances of that in Argentina?
Daniel: That's a great question, Gray, but remember I do macro policy and forecasting. I am hardly an expert on the intricacies of that kind of industry discussion.
But it does appear that the Argentine authorities are searching for partners to help develop the country's energy resources. There are press reports that Argentina has reached out to a major Chinese energy company, to a major French energy company and to the state oil company of its neighbour to the north. In addition, there are reports that the administration has also approached an Argentine energy company that has been a long-time partner in a joint venture with a major UK oil company.
However, I suspect that securing an expert partner and moving forward with developing Argentina's energy resources may be an uphill battle. My sense is that a major oil company is unlikely to jump in before the legal battle with the Spanish former owners is over. This also applies to major oil service providers, who may be reluctant to take on legal risks. Thus, it may prove difficult to get the expertise and the equipment necessary to develop these resources.
And financing is likely to be another challenge. Studies carried out by the former owners suggest that Argentina's main unconventional energy deposit, Vaca Muerta, would require investment in the order of US$25 billion per year for perhaps five years to develop this resource. It is difficult to see how the authorities could finance this kind of investment without turning to international capital markets. However, with Argentine gas prices at US$2.6 per million btu and the oil export price capped at US$42 per barrel by windfall taxes, there is a lack of appropriate economic incentives to attract international investment into the project. Further, the high uncertainty about the institutional framework and property rights only adds to the challenge. In short, without a dramatic change towards a market-friendly policy mix, it is hard to expect financing or expertise to come to Argentina's aid.
And the broader point is still that what we are witnessing now is really not about energy policy per se, it is about whether Argentina is set to do the kind of macro adjustment necessary. Without that, I don't see a way out with a positive ending.
Daniel: One question for you Gray. What does this mean for the rest of Latin America? Are you afraid that the moves in Argentina run the risk of damaging the region's standing among investors?
Gray: Thanks Daniel. I was actually hoping you were going to ask me about the Tipping Points - a year-long series I developed 11 years ago when it appeared that Argentina was heading into heterodoxy and the only real question in my mind was to work through the timing of the ‘tipping', which in turn depended on which Tipping Point would occur first.
I don't want to oversimplify all of this, but what we are seeing in Argentina is an extreme example of what we've been calling the Risks of Abundance. Argentina has had a tremendous run with spectacular GDP growth in the past decade, in large part because it has been in the right neighbourhood. It has enjoyed along with the rest of the commodity-exporters in Latin America (almost all of the region except Mexico), an incredibly favourable terms-of-trade shock and a relatively benign global environment. Faced with that track record, it is not a surprise that policy-makers began to believe that they were responsible for the achievements of the past decade.
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