Priced for Perfection....For Now!

Even if you believe that inflation will play fair, investors seem to be receiving no compensation at all for the macroeconomic risks that have surely made an indelible impression over the last two years, or for the fiscal risks that abound. Finally, such sanguine expectations in US bond markets put downward pressure on bond yields elsewhere in the world, making it difficult for central banks that wish to tighten policy ahead of the major central banks to gain significant traction through higher bond yields.

Priced for perfection... MS FAYRE generates its fair value estimate using the real fed funds rate, 1-year ahead CPI inflation expectations from the SPF conducted by the Philadelphia Fed and the 5-year rolling standard deviation of inflation as a proxy for inflation volatility (for more details on the MS FAYRE model, see Fairy Tales of the US Bond Market, July 26, 2006). With the fed funds rate at 12.5bp, core PCE inflation tracking at 1.3% and the 4Q09 number for 1-year ahead CPI inflation expectations from the SPF coming in at 1.6%, MS FAYRE produces a fair value of 3.3% for 10-year bond yields, which is exactly where the 10-year yield is now (interested readers should contact us for a user-friendly spreadsheet for simulating the FAYRE model). Forward-looking bond markets thus seem to be pricing in altogether too rosy a scenario for the foreseeable future.

...for now: With actual bond yields bang in line with our fundamental fair value estimate, investors seem to be receiving no compensation for macroeconomic or fiscal risks. Risk premiums declined precipitously before the Great Recession and should return to a reasonable level, particularly in light of the macroeconomic risks that have made themselves felt over the last couple of years. Further, with the bulk of the approved fiscal package in the US yet to be spent, the successful handling and eventual retirement of debt seems very far away with plenty of risks along the way. Bond markets have clearly not turned their attention to these issues yet, but it is unlikely that they will ignore them forever.

Our forecasts look for bond yields to rise in 2010: Our US economics team expects bond yields to rise to 5.5% by the end of 2010 - an increase of 220bp that outstrips the 137bp increase in the fed funds rate expected over the same horizon (see Don't Fear the Double-Dip, October 6, 2009). Our US interest rate strategy colleagues suggest that this bear steepening of the curve in 2010 may well be preceded by slightly lower 10-year yields in 2009 (see Liquidity Aplenty but Rising Sensitivity to Rates, October 22, 2009).

And that's without inflation risks: Inflation expectations, as Chairman Bernanke points out in his speech, are a good forecaster of actual inflation and an integral part of the price-setting mechanism. We have previously pointed out that rising inflation expectations also seem to have been a trigger for policy tightening in the past (see "Growing Pains", The Global Monetary Analyst, September 23, 2009). The importance of inflation expectations clearly needs no debate. What is more contentious is Chairman Bernanke's argument, and ECB President Trichet's comments to the same effect, that longer-run inflation expectations are stable.

Inflation expectations don't seem to be anchored... The SPF measure of long-term CPI inflation expectations in the US has indeed remained stable, as claimed, since the median expectations have held steady for nearly a decade now. However, a look at the dispersion of the individual forecasts in this survey suggests that significant uncertainty still surrounds inflation on a ten-year horizon.

Further, our conversations with clients also suggest a split into two fairly distinct camps. A smaller set of clients are bearish on the economic outlook and believe that inflation will be extremely low or even be outright negative for the next few years. The rest believe that inflation risks, and probably inflation itself, will rise within a year or so as the recovery becomes sustainable. The important point here is that it is difficult to find investors who believe that inflation over the medium-to-long run will be precisely in line with central bank targets. Both pieces of evidence do not support the argument that inflation expectations are anchored.

...and markets are keenly aware of policy trade-offs: In the past three months, there have been three instances when dovish comments from the Fed have pushed front-end yields lower by tempering expectations of rate hikes. In September, a series of speeches by central bankers in the major economies refuted the rapid hikes in policy rates priced in by markets. At the November 4 FOMC meeting and in Chairman Bernanke's last speech, a reiteration of the commitment to exceptionally low rates for an extended period was interpreted as a dovish stance by markets. On every occasion, breakeven inflation has fallen by less than (or risen by more than) the change in nominal yields. This suggests that markets are attuned to the inflation trade-off facing the Fed and other central banks. Breakeven inflation has clung on to its gains in 2009, but breakeven rates are not yet at levels where serious inflation risks are being priced in.

Locally sanguine, globally dangerous: Finally, the sanguine outlook embedded in US bond markets creates risks for central banks wishing to tighten policy ahead of the major central banks. Synchronised policy easing to fight off the Great Recession means that the world's central banks will also be tightening monetary policy in a cluster, much like cyclists in a peloton (see "The Peloton Holds Firm", The Global Monetary Analyst, November 4, 2009). The front riders in a peloton typically have more flexibility but also face stronger headwinds than the other riders, who are content to reduce their wind-drag by riding in the mass of the group. Early-hiking central banks, similarly, face the dual headwinds of currency appreciation and unresponsive asset markets since the latter have strong ties to their counterparts in the major economies. Low bond yields in the US and other major economies tend to put downward pressure on bond yields elsewhere in the world. Early-hiking central banks like the BoI, the RBA and the Norges Bank, and later the RBI and the BoK, will likely find it difficult to raise long-term interest rates while bond yields in the major economics are priced for perfection...for now!

No serious risk in the near term but yields might be stretching the limits: In terms of inflation and both nominal and real yields, Turkey is still sailing in uncharted waters. The real policy rate is near zero while the benchmark 2-year bond carries approximately a 2% real rate. So far, the ultra-dovish stance of the CBT has been justified and it seems like its easing bias might linger for a while. However, a few points on the data front, especially from a forward-looking perspective, suggest that the CBT might have to consider pausing in order not to risk its position to be perceived as falling behind the curve.  Here are some considerations that are likely to set the course of interest rates in the coming months:

Inflation to bottom out in November: Despite the high monthly inflation print of 2.4%M in October, 12-month trailing inflation eased to 5.1% thanks to the base year effect. There is a possibility that a similar base effect-driven drop in inflation might be witnessed that would pull down inflation to sub-5% for a month.

However, we will be entering a period where base year effects will start working to the disadvantage of the CBT as we project inflation to bottom out in November and gradually escalate. In fact, we recently revised our year-end forecast to 5.7%Y and our 12-month forward-looking forecast stands at 6.4%Y. Once the upcoming inflation data start pointing higher rather than lower, we suspect that inflation expectations might adapt rapidly, making the central bank's job even more challenging. Moreover, any one-off price adjustments in utilities and/or tax adjustments are likely to add further uncertainty to the inflation outlook. In an environment where growth is set to improve rather than weaken, and quite possibly coupled with a partial rise in commodity prices, we see still little reason to expect further downside to inflation.

Industrial production to start posting noticeably high growth rates: Recent data on industrial production (IP) continued to remain on the weak side with an 8.6%Y decline in September, while the private sector capacity utilization (CU) rate is flagging a lack of sufficient orders in the manufacturing sector. The CU for October was 71.9%, which suggested that some marginal pick-up in IP growth could be seen. In comparison to the previous months, we expect IP to start posting rather stronger prints. We first expect a near-flat reading in October, followed by a marginal rise in November but a very sharp (double-digit) increase in December. In fact, looking forward into 1Q10, we project IP growth rates to reach significantly high levels thanks to the strong base year effects, i.e., less so on the back of real economic activity.

At any rate, once the sharp growth rates on IP start rolling out, this might result in the formation of a perception that the economy might be gaining speed and some price pressures might soon be building.

The end of the easing cycle is near: The CBT's stance had been ultra-dovish so far and the wide output gap and lack of external and domestic demand pressures led the policy rate to be cut by 1,000bp. Based on the recent statements, we expect the CBT to lower the pace of easing to 25bp on November 19. Our base case expectation is that the CBT might decide to pause afterwards, but we believe that the risks remain on the downside. At any rate, we are not convinced that a few more 25bp cuts will be sufficient to draw investors into bonds.

High debt redemption profile in 1H10: The lack of sufficient external demand for local bonds on the back of risk-aversion for most of 2009 and the widening fiscal deficit placed significant pressure on the Turkish Treasury and the local banking system to roll a sizeable amount of debt throughout 2009. Since December is set to see minimal amount of redemptions, one can assume that the borrowing program is nearly complete for the year. However, 2010 does not look easy, with a sizeable concentration of redemptions in the first half of the year.

Especially taking into account that the yields on government securities had been looking less attractive for some time, the added pressure of a high rollover rate in the initial months of 2010 does not suggest a further decline in yields but quite possibly the opposite. In fact, anecdotal evidence suggests that the big local players had been gradually positioning in such a way that higher inflation and/or interest rates could harm their overall profitability at a minimum. Local banks have been buying CPI linkers and coupon bonds to partially hedge their overall exposure, which seems a logical strategy, in our view.

A high debt rollover ratio for the full year: In terms of the overall financing picture for 2010, we see a delicate balance such that there seems to be little room for error on the fiscal front. By making conservative assumptions on privatization and primary deficit, and also assuming that some TRY8 billion worth of bonds held by the CBT that are due to mature next year would be fully rolled, we calculate the domestic debt rollover rate at nearly 100%.  Any slippage on the fiscal side, weak privatization and/or risk-aversion on a global scale would all contribute to a higher rollover ratio.

One of the main implications of such a high rollover rate is that it leaves a limited amount of funds available for credit expansion, i.e., the crowding out factor that is leading to a lower growth potential. This had been the case in 2009 as well, except in 2010 the profit potential on government securities seems much less for local banks. The prospects of lower profits on trading and the rising non-performing loans mean that the banking sector might end up with a low appetite for loan growth.

An IMF deal for growth, and nothing but the growth: While the debate on whether the Turkish government had done the right thing not to sign a Stand-By Arrangement with the IMF continues, it is exactly due to the crowding out factor that a deal is needed to secure better growth in 2010, in our view. That is, access to less-expensive and ample funding from the IMF seems the easiest way to ease the rollover ratio and free up resources for credit growth. In order to provide some perspective, we would argue that for each US$10 billion (cash) received from the IMF, the rollover ratio would decline by around 7-8pp. Otherwise, we believe that an IMF Stand-By Arrangement is not necessary, as we see minimal risk on the external front.

Key Risks to Our View

CBT's choice: We believe that, given a choice between falling behind the curve towards inflation and erring on the side of caution towards growth, the CBT might choose the former. That is, until clear evidence of inflationary pressure build-up is seen and/or a strong conviction is achieved that Turkish growth prospects have improved, the central bank might opt to leave the monetary policy loose. Since the inflation target for 2010 officially stands at 6.5%, the CBT might believe that there is ample room to maneuver, as its inflation forecast for end-2010 remains at 5.4%. There are two issues here: First, the bank is alone in terms of predicting lower inflation in 2010, as the consensus forecast stands at 6.3%, while our forecast is at 6.4%. Second, when demand starts picking up at some point in 2010, we suspect that it might bring inflation rather rapidly with relatively low levels of inventory.

Agreement with the IMF: Another risk to our defensive view towards Turkish bonds is the possibility of signing an IMF deal, i.e., the virtual Stand-By Arrangement turning into a real one. As we mentioned previously, if Turkey receives some US$20 billion from the IMF in 2010 (assuming a front-loaded program), then the rollover rate would ease to around 85% and that would cause yields to drop noticeably along with a significant improvement in GDP growth outlook as the excess funds would be channeled to domestic credit.

Foreign positioning: The other issue is that positioning had been rather clean and those positions currently being held by the non-residents are mostly long-term bonds and CPI linkers (as well as some very short-term T-bills) where liquidity had been rather low. This broadly suggests that the possible deterioration in asset prices might be fairly limited, in our view.

Low market liquidity until early January: There is a good chance that the ongoing drop in liquidity and trading volumes in various markets might persist until January. This is mostly because of the fact that investors will try to hold on to their accumulated profits and at least minimize the possibility of getting last-minute surprises hurting their performances.  While the drop in liquidity, in general, would be considered a negative development for assets, it might not be the case for Turkey since the market is driven by local banks which are likely to provide support to asset prices for year-end balance sheet fortification purposes. Given the fact that December will see the lowest debt redemptions of the year, there should be no borrowing pressures, and the lack of liquidity might contain pressures on yields. However, this could act as a double-edged sword, and those looking to take profits might face a challenge due to insufficient demand.