But the economy's underlying vitality won't be clear for a few months, because some of the acceleration is the product of a statistically exaggerated swing in net exports. Following the record 4Q swing in net exports, which added 3.5pp to 4Q growth, we now expect a much smaller (0.8%) but significant contribution in 1Q. Some of that is real, reflecting strong gains in exports and a subdued increase in imports. But some is statistical, as another seasonally adjusted dip in imports of petroleum and related products accounts for about two-thirds of the 1Q swing.
In addition, inclement weather is roiling recent data, which also makes it difficult to discern the degree of improvement. January's retailing results exceeded expectations, but weather may have depressed both them and leisure activities. Winter storms likely hammered construction activity, following weather-depressed December results. And as discussed below, there are clear signs of weather distortions in January's employment data.
Two-tier economy. Exports and capital spending continue to pace the expansion, while housing and state and local outlays are major headwinds. For example, the surge in the ISM export orders index hints at much stronger export gains than we have in our baseline - 15% versus our expectation for high single-digit growth. We doubt that export gains will attain such a pace, but there is upside risk. The consumer, helped by short-term tax relief, is the wildcard; we expect 3% growth in consumer outlays this year.
How much labor market improvement? The two-month, 0.8pp plunge in the unemployment rate overstates the improvement in labor-market conditions, just as the 79,000 average increase in nonfarm payrolls understates it. But we continue to expect a hand-off from productivity-led growth to an expansion sustained by job and income gains, and we look for payroll growth to average close to +200,000 per month over the course of 2011.
The two-month slide in the unemployment rate to 9% is the largest since 1954 and could overstate the improvement. It partly reflects declining participation; job hunters have dropped out of the labor force by a monthly average 111,000 over the past four months. But the drop may not be completely outlandish; the January drop was concentrated among adult men, while the rate for women dipped only slightly. After diverging in the recession as construction layoffs caused male joblessness to spike, perhaps the rates by gender are converging again as men are finding jobs in cyclical industries like manufacturing.
In addition, there was clear evidence that unusually severe weather had a powerful impact on the January payroll data. The "Not at Work Due to Bad Weather -- All industries" component of the household survey jumped to 916,000 in January. This represents one of the highest readings on record for any month. In fact, during the past 30 years, this was exceeded only 3 times: Jan 1982 (1.18 million); Jan 1996, the so-called Storm of the Century (1.93 million); and Feb 2010 (1.12 million). A normal reading for January is around 300,000. Based on a simple empirical analysis comparing the household not at work series and deviations from trend employment, we estimate that bad weather subtracted at least 150,000 from the January payroll tally. Bad weather also appeared to depress the average workweek, which slipped by 0.1 hours. The household survey also does a tally of those who "Worked Part-time Due to Bad Weather", and this series soared to 4.9 million.
Other aspects of the employment report were more encouraging and less affected by weather. Manufacturing hours rose and factory jobs posted their sharpest increase since a GM strike ended in 1998. Over the past three months, the household survey shows an average monthly employment gain of +227,000, after adjusting to the payroll concept. This suggests the payroll data may be due for a catch-up at some point. The employment-to-population ratio rose to 58.4% from 58.2% in November; corrected for population controls, it might have risen to 58.5%.
To be sure, labor markets have a long road back from the recession; the employment/population ratio peaked at 63.5% in December 2006. Yet a broad array of indicators now appear to be pointing to an upswing in employment growth, even though this hasn't yet shown up in the official payroll statistics.
Inflation turning point at hand. Core inflation is trending downward by some measures; the core PCEPI tumbled to a record low 0.8% in December. But we think that inflation is bottoming, with a tug of war under way: Significant slack in markets for goods and services, housing and labor will depress inflation. But stable-to-higher inflation expectations, perhaps fueled by rising food and energy quotes, will push it higher. While operating rates are low and the jobless rate is high, changes in those gaps - so-called ‘speed effects' - are promoting an inflation inflection point. That is especially the case for rents, which are a major inflation component and which are already moving higher.
Indeed, we think a turning point is at hand. January's core CPI reading could be a watershed. The forces described above, coupled with the unwinding of quirky seasonal adjustments, could promote a 0.1% monthly gain (we actually expect a rise of 0.14%) and an increase of 1%Y. This is more than arithmetic. January price hikes are often outsized; this year, increases in local transportation fares and other services may pace the rise. Consumer inflation expectations (even 5-10 year) are heading higher. And businesses are stockpiling in anticipation of further price increases - a classic sign of rising business inflation expectations.
Treasuries were crushed over the past week in their worst weekly plunge since June 2009 just as it was becoming clear the recession was ending as strong economic data domestically and overseas led investors to further boost their outlooks for US and global growth. As Treasury yields surged through their prior December highs, mortgages actually outperformed slightly, so this was a much more fundamentally based move than when those prior December high yields were hit during a major, disorderly MBS market rout. On the economic front, in the US blowout results in both ISM surveys, with the manufacturing index reaching its highest level since 2004 and second highest since 1987 and nonmanufacturing index its best level since 2005, showed the expansion broadening and accelerating at the start of 2011. The Fed's Senior Loan Officers survey showed a broad rise in credit demand in the three months through January for the first time in years, a key potential turning point in the recovery, as banks continued to gradually loosen lending standards. The outlook for 1Q and 4Q GDP growth is a bit better after upside in December real consumption and better-than-expected results for January chain store sales and auto sales pointed to an extension of the sharp acceleration in consumer spending seen in 4Q, and significant upward revisions to capital goods orders and shipments in the factory orders report confirmed the sharp ongoing recovery in investment spending. Construction spending in December was weak, with weather likely a significant drag as it probably will be also in January, but building in better results for consumption and investment, we now see 1Q GDP growth tracking at +4.4% instead of +4.3%, and we see 4Q being revised up to +3.3% from +3.2%. And while the +36,000 gain in nonfarm payrolls in January was significantly less than expected, after looking through the details that gave clear indications of a sizable hit from January's severe weather, the results actually looked reasonably solid. We think weather probably knocked at least 150,000 from January nonfarm payroll job growth, so our initial baseline for February is for a gain above 300,000. And surprisingly the household gauge of employment managed to post a nearly 600,000 surge despite the weather, surprisingly lowering the unemployment rate another half point for its biggest two-month decline in over fifty years. Although investors are certainly keeping a watch on developments in Egypt, the upside in the incoming data in the US added to improving economic news in many other countries to significantly boost optimism about global growth, with the week's run of positive global data highlighted by upside in European PMI's, improving labor market conditions in Germany, an export-led upside surprise in GDP growth in Taiwan, and big gains in industrial production in Korea and Japan. After the recent upside in Japanese and global data, our Japan economics team boosted their GDP forecast for 2010 to +2.0% from +1.2% and for 2011 to +1.9% from +1.7% (see the February 3 report Japan Economics: Upgrading Outlook: Swiftly Emerging from the Doldrums by Takehiro Sato and Takeshi Yamaguchi). The most notable negative outlier among the week's mostly strong global economic news was a drop in Brazilian industrial production, but this didn't reflect weak demand. As our LatAm economists have been highlighting for some time, currency strength has increasingly been diverting a robust pace of domestic demand growth - real retail sales surged 1.1% in November for a 9.9%Y gain - towards imports and away from domestic production.
On the week, benchmark Treasury yields surged 21-36bp, through December's highs to new highs since last spring in the worst weekly collapse in a year and a half. The 2-year yield rose 21bp to 0.76%, 3-year 30bp to 1.24%, 5-year 36bp to 2.28%, 7-year 36bp to 3.02%, 10-year 32bp to 3.65% and 30-year 21bp to 4.73%. For now the front end is clearly pinned at low levels to some extent by no indication of any shift in the Fed's plan to remain in easing mode through June, which helped boost 2s-30s to an all-time record high above 400bp early in the week before a slightly pullback to 397bp at Friday's close. Investors are clearly becoming increasingly convinced that the Fed will need to start moving rapidly back towards a more neutral policy stance next year. The January 2012 fed funds futures contracts dropped 12bp on the week to 0.44%, back to pricing the likelihood that Fed rate hikes will start before year-end. And after this earlier start, more tightening is expected in 2012, with the Dec 11 to Dec 12 eurodollar futures spread rising 31bp to 132bp. The Dec 12 contract at 2.11% after a 45bp sell-off on the week is now pricing a 2% year-end 2012 fed funds target, not too far from our 2.5% forecast. While real yields backed up sharply on the week, inflation expectations also rose and TIPS outperformed. The rise in longer-term inflation breakevens was not all that large given the size of the nominal move, but short-end breakevens continued to ramp sharply higher. To the extent Treasuries are maintaining any Egyptian-driven flight-to-safety bid at this point, it is in short-dated TIPS. The 5-year TIPS yield rose 22bp to -0.10%, 10-year 23bp to 1.30% and 30-year 12bp to 2.16%. This left the benchmark 10-year inflation breakeven up 9bp at 2.35%, while 2-year TIPS inflation breakevens rose about twice this much though only to about 1.85%.
As bad as the losses in Treasuries were on the week and with volatility showing some upside from recent quite restrained levels (3-month X 10-year normalized swaption volatility rose 6bp to 117bp, high in a month), a slight outperformance by the MBS market showed substantial resilience. This was certainly a much different market dynamic than when the prior highs in Treasury yields were hit in December amid a disorderly rout in the mortgage market. Unlike in December, when the severe MBS-led backup in rates from early November through mid-December left the market badly out of position and created enormous estimated mortgage convexity selling needs, our mortgage strategists estimate that convexity selling needs created by Friday's sell-off are relatively muted and that paying needs sensitivity will decline if there are continued further rates markets losses from here (see the Mortgage Strategy Brief from the February 4 note Mortgage Strategy Brief: Sell-Off Sparks Convexity Hedging Flows Concerns; We Think They Are Overblown). The big backup in Treasury yields from the November FOMC meeting into mid-December had a significant technical component to as the mortgage-related losses fed on themselves and created mounting selling and paying needs. In contrast, technicals like those in December have not been an issue in this latest surge in yields to new highs, this move has been much more purely based on a continued fundamental reassessment on the growth and inflation outlook.
While the rise in yields was somewhat of a headwind in the second half of the week, equity and credit markets also posted strong gains on the week as growth expectations moved higher. The S&P 500 gained 2.7% to another new high close since mid-2008 on Friday. Cyclicals led and defensives lagged, with materials, energy, tech and consumer discretionary the best performing sectors and utilities and consumer staples the worst. Meanwhile, the investment grade CDX index tightened 4bp to 82bp and the high yield CDX index tightened 20bp to 400bp. This matched the best close of the year for the IG CDX index, though it has been narrowly range bound mostly. The gains in HY CDX have been somewhat more in line with stocks, as the on-the-run HY CDX index hasn't traded tighter since its current 400bp spread since October 2007. Investors clearly at this point seem to be viewing the turmoil in Egypt and some indications of rising unrest in other Middle East countries as country and region specific and not indicative of rising global systemic risks. Indeed, if anything the troubles in Egypt and a technical sovereign default in Ivory Coast seem to have led investors to reassess relative pricing of sovereign risk and decide that they perhaps had been overreacting to fiscal strains in Europe and states in the US, as peripheral EMU yield spreads and muni CDS both tightened substantially on the week. In Europe, 10-year yield spreads of over Germany came in about 40bp for Spain, 25bp for Italy and 20bp for Portugal, while in the US the 5-year MCDX index tightened 16bp to 185bp, the best close in four months after a 5 bp tightening from the worst close hit in early January.
Nonfarm payrolls rose only 36,000 in January, but there were clear signs of a large temporary weather impact that we believe probably knocked 150,000 or more from job growth. If the weather isn't as severe in next month's report (the February survey period is the upcoming week from Sunday the 6th to Saturday the 12th), then our initial baseline expectation for February nonfarm payrolls will be north of +300,000. Indicative of the severity of the weather disruption, the number of people in the household survey who said they were not at work during the survey week because of bad weather spiked to 916,000, one of the highest readings on record for any month and far above a typical January level of around 300,000. Weakness in payroll job growth was also most pronounced in areas that would be expected to be most susceptible to winter weather disruptions, including construction (-32,000), transportation (-38,000), leisure and hospitality (-3,000), and temps (-14,000). On the positive side, manufacturing employment surged 49,000, the biggest gain since mid-1998 after the end of a major auto strike. A dip in the average workweek to 34.2 hours from 34.3 hours was also likely caused by weather disruptions, with 4.9 million people in the household survey who normally work full time saying they were forced by the weather to work part time in January, also one of the highest readings on record. Given the clear indications of a substantial negative weather impact on the establishment survey, strong results in the household survey were quite impressive. The household survey measure of employment (adjusting for a break in the data that occurs every January when BLS incorporates updated population estimates from the Census Bureau) surged 589,000. With the labor force unchanged, this lowered the unemployment rate to 9.0% from 9.4% in December and the 2010 high of 9.8% hit in November, the largest two-month drop since 1958.
A broad range of indicators - including the household survey, jobless claims, ISM employment gauges, Manpower survey, Challenger survey, sharply accelerating withheld tax receipt growth - point to an ongoing significant pickup in job growth. We expect this will become evident in the payroll employment numbers imminently, and we continue to look for nonfarm payroll job growth to average near +200,000 a month this year. As job prospects continue to improve - and as can be seen in recent consumer confidence reports, consumers are increasingly seeing and hearing about this - labor force growth is likely to accelerate as formerly discouraged workers reenter the labor force and start looking for jobs. So at this point we continue to look for only slow further progress on the unemployment rate after the big drop seen the past two months, with our year-end forecast a bit below 8 1/2%.
While bad weather temporarily weighed on job growth in January, the ISM surveys showed a broad acceleration in business activity in both manufacturing and nonmanufacturing sectors. The composite manufacturing ISM index surged 2.8 points in January to a seven-year high of 60.8, with big upside in the key orders (67.8 versus 62.0) and employment (61.7 versus 58.9) gauges, the latter to the highest level since 1973, and a very strong reading for production (635 versus 63.0). The recovery broadened by sector, with 14 of 18 industry groups reporting growth in January led by petroleum refining and primary metals, up from 11 in December. Comments in the report highlighted the favorable export environment. This was reflected also in the export orders index, which surged 7.5 points to 62.0, high since 1988. Meanwhile, the composite nonmanufacturing ISM index rose to 59.4 in January from 57.1 in December, high since 2005, on good gains to elevated levels in the key business activity (64.6 versus 62.9), orders (64.9 versus 61.4), and employment (54.5 versus 52.6) gauges. The expansion by sector was more broadly based, with 13 of 18 industries reporting growth in January, up from 10 in December, led by mining, real estate, utilities and transportation. Comments highlighted in the report from survey respondents were upbeat about improving economic activity in 2011 and reduced business uncertainty.
Either weather was much less of a problem for shoppers than feared or underlying demand is a lot better than thought - perhaps we're seeing a good initial boost from the payroll tax cut - as both auto and chain store sales results showed upside in January, pointing to solid growth in January retail sales. Motor vehicle sales rose to 12.6 million units annualized in January from 12.5 million in December, extending a run of the best results outside of the peak of cash for clunkers since 2008. Meanwhile, taken together monthly sales results from major retailers easily beat cautious consensus expectations. Department stores' same-store sales growth decelerated, with weather blamed by some, but by less than expected, while sales growth at discounters, clubs, clothing stores and drug stores accelerated. Building in the better-than-expected results, we boosted our 1Q consumption estimate to +3.3% from +3.1% after the sharp acceleration in 4Q to a five-year high of +4.4%. Business investment also looks more positive after the factory orders report showed upward revisions to core capital goods shipments in December (+2.0% versus +1.7%) and November (+1.5% versus +1.4%), pointing to stronger equipment investment in 4Q and a better starting point for 1Q. We now see equipment and software investment rising 13.5% in 1Q instead of 12%. On the softer side, while a significant portion of the 2.5% plunge in December construction spending was in the unreliable home improvements component and there were upward revisions to November and October, the results still pointed to softer growth in construction in 4Q and 1Q. Recent downside has been concentrated in state and local government spending, where a burst of activity in the spring and summer as the 2009 fiscal stimulus bill had its largest impact has faded hard since August. Still, taking the construction spending, factory orders, and auto and chain store sales results together, we raised our 4Q GDP estimate a tenth to +4.4%, and we also see 4Q being adjusted up a tenth to +3.3%.
The upcoming week's economic calendar is very light, and focus in the Treasury market will probably be largely on the quarterly refunding auctions - $32 billion 3-year Tuesday, $24 billion 10-year Wednesday, and $16 billion 30-year Thursday. Fed Chairman Bernanke testifies to the House Budget Committee - a very important body in this year's expected budget battles given the unusually large amount of power the Republicans voted to grant Chairman Paul Ryan over appropriations levels when they set this session's House rules - on Wednesday, but it is unlikely that we will hear much new from him after his speech and press Q&A session on Thursday. The most notable economic releases are the Treasury budget Thursday and trade balance Friday:
* We estimate that the federal government ran a $71 billion budget deficit in January, up from $43 billion a year earlier, with tax revenues up 8% and spending 18%. About two-thirds of the spending surge just reflects a calendar shift, as last year's big early January Social Security payment was pulled forward into December. Meanwhile, individual withheld income and payroll taxes held up surprisingly well, growing 9%, little changed from December despite the 2 percentage Social Security tax cut. A favorable calendar in January helped this result, but the upside also suggests significant ongoing strengthening in underlying wage and salary income growth. We look for the budget deficit for all of F2011 to widen to $1.33 trillion from $1.29 trillion, which would result in a marginal narrowing as a share of GDP to 8.7% from 8.9%.
* We look for the trade deficit to widen by $2.2 billion in December to $40.5 billion after hitting a ten-month low in November, with exports up 1.2% and imports 2.0%. Aside from some weakness in high tech products, capital goods exports should show good upside based on aircraft industry data and a surge in machinery shipments. Further elevation in prices and a rebound in volumes from November dips should also lead to decent gains in industrial materials and food exports. Most of the import gain is likely to be in petroleum products, with Energy Department data pointing to significant upside in both prices and volumes. Outside of oil, import growth is expected to remain sluggish based on a slowdown in inbound cargo at the major West Coast ports. Note that our forecast is somewhat more optimistic than BEA's assumption in the advance GDP report and would point to an upward revision of a couple tenths to the already sizeable +3.4pp contribution to 4Q GDP growth from net exports.
Negative Growth for Oct-Dec, but This Is Old News
We expect GDP for October-December (to be announced on February 14) to show negative growth of 1.8% annualized, as consumption drops back after the expiration of eco-car subsidies and exports plus public investment decrease. However, this marks a temporary reaction to the withdrawal of policy stimulus, and does not change the underlying trend of the economy. We expect positive growth to resume from January-March, with early emergence from the recent lull. Support comes from three areas: (1) clear evidence of reacceleration for overseas economies, as double-dip fears have receded in the US on the back of accommodative fiscal and monetary policies, Germany is benefiting from the weak euro, and China's economy also seems to be overheating again; (2) ongoing recovery in production ahead, backed by an export revival and deft inventory management; (3) bottoming out for a variety of sentiment-linked leading indicators.
We now look for a more robust economic pick-up in the first half of 2011 than earlier predicted, and raise our full-year forecasts to +2.0% for 2011 (prev. +1.2%, last revised in December 2010), and also to +2.0% for F3/12 (prev. +1.2%). On a quarterly basis, the most notable changes come from 1Q11, where we now expect 2.9%Q annualized (prev. +0.5%), and 2Q11, where we expect 2.1% annualized growth (prev. +0.9%).
Domestic demand still lacks vigor, of course, leaving recovery reliant as ever on external demand. The price outlook is also for the US-style core CPI (which excludes food and energy) to remain weak due to the continuing output gap, even though it is looking more likely that the Japan-style core index (which includes energy prices) will temporarily turn positive from April due to rising oil price and high school tuition fees. With revision of the base year for the index in August also likely to push rates of price growth down by a relatively large amount, the timing for deflation to end is slipping ever further back. We expect the BoJ to respond to persistent deflation by stepping up ‘comprehensive easing'.
Reason (1): Reacceleration Overseas, Especially in the US
With presidential elections (or their equivalent) scheduled for the US, China, Russia, South Korea, Taiwan and France in 2012, political winds in these countries favour the continuation of accommodative macro conditions to buoy the economy.
The US is the prime example. In response to Obama's extension of comprehensive tax cuts at the end of last year, our US team raised its 2011 GDP growth forecast from 2.9% (as of September) to 3.6%. On a quarterly basis, this marks an upward revision of nearly 1pp from annualised growth of around 3% to around 4%.
The housing sector in the US is still scarred by the bursting of the bubble, and it will take more time to clean up balance sheets in stock terms. However, with the effect of extensive tax relief over the coming two years and solid recent economic indicators, the threat of reversion to negative growth in a double-dip recession has all but gone. Our US team expects the two-tier economy, where strong exports and capex drive economic growth, but vulnerability in the housing sector and spending cuts in state and local governments are a burden, to drag on.
The position of the US as Japan's chief trading partner has long since been ceded to China, but the performance of the US and Japanese economies is still closely linked. Standard econometric models show that a percentage change in the US GDP growth affects Japan's growth by about 0.2-0.3pp, but empirically, the actual linkage seems stronger than the estimate, in our view.
Meanwhile, Europe is likely to maintain a fiscally austere stance as it continues to battle with sovereign debt problems, but the German manufacturing sector has received a substantial boost from recent euro weakness. China continues to face inflationary pressures due to its overheating, but we expect growth to remain broadly in line with our current forecasts, given that interest rates can be hiked if necessary in order to rein in economic expansion while fiscal stimulus can be deployed in the event of downturn.
Reason (2): Recovery in Manufacturing Exports and Output
Domestic industrial production bottomed out last October, and is on a sharp near-term recovery trajectory. METI's Survey for Production Forecast calls for a month-on-month increase in January of more than 5%, centered on autos.
This rapid recovery stems from (1) production rebounding from levels pared back in anticipation of the end of eco-car subsidies, (2) temporary production increases ahead of the lunar new year (February 3-5), and (3) seasonal adjustment distortion. On the second point, we should focus on the average production plans for January-February, which are about 2% higher than for December, as a small decline is forecast for February. Even so, that marks a nice recovery. On the third, the issue is that economic data for January-March become overestimated by seasonal adjustment, as the collapse in production after the Lehman shock gets recognised as a seasonal pattern during this process. But January still shows a significant increase in output even when we correct for this distortion.
After this resurgence in January-March, we look for the production increase to revert to a normal pace from April-June. Exports and production are closely correlated, however, and we expect domestic manufacturing to show stable performance as the export environment remains favourable throughout the year. Recent export volumes have actually been recovering sharply as overseas economies perk up, and to Asia are back to peak levels from before the Lehman shock.
Turning to the effect of yen appreciation, the yen is currently stable and export firms are guiding for profit growth of 70% even with a strong currency. The effect of yen appreciation in the short term is to reduce exports for exporters, and to lower order prices by reducing costs for domestically oriented companies. But the real effective exchange rate - adjusted for the inflation gap between Japan and overseas - leaves the yen still considerably weaker than in April 1995 when the yen was ultra-strong. As long as rates stabilise at current levels, this should not be fatal for Japan's economy. Companies have anyway become more resilient to currency swings during the 15 years of predominantly yen appreciation since 1995, by raising their offshore production ratios. The ability of such firms to cope with a strong yen should not be underestimated.
Reason 3: Better Sentiment Indicators
Compared with the current sharp pick-up in the export sector, there is very little to note regarding developments on the domestic private demand side. We certainly expect negative QoQ growth for personal consumption in October-December after curbing of incentives on eco-car sales, but consumption appears to be maintaining a surprisingly firm undertone in the current January-March quarter, chiefly in relation to services, notwithstanding the narrowing of eligibility for household electricals eco-points. This makes us wonder if personal spending is shifting to services now that incentives for durable goods purchases have lessened, as consumers tire of belt-tightening.
Meanwhile, there are currently signs of improvement in the headline figures in the Consumer Confidence and Economy Watchers surveys. Outcomes of the latter survey in particular tend to lead the direction of the economy by about three months, and true to this pattern point to a dip in October-December but a rally after that. Content-wise too, improvement is ongoing in a wide range of areas - retail, food/beverages, services, housing - suggesting a firm undertone in personal consumption.
Moreover, wages look set to pick up, driven by bonuses, on the back of healthier corporate earnings. In this year's spring wage negotiations we expect unions to tone down demands for growth in base salaries, while management too is showing signs of a desire to avoid base pay increases that would raise fixed costs. Even so, as earnings recover we expect the unions to intensify their demands centering on one-off payments (bonuses), while management too is likely to take a more proactive stance on employee rewards when it comes to bonuses, where levels adjusted sharply in the wake of the Lehman shock.
Risk Factors for Our Outlook
We still see some downside risk for our outlook, primarily from overseas influences. Possibilities include (1) the trend in the oil price, (2) trends in emerging economies, and (3) impact of sovereign debt issues in Europe and monetary tightening.
On (1), the oil price, further growth on concerns about current events in the Middle East bear watching because of how the global economy slowed even before the Lehman shock reared its head as the oil price set in above US$100/bbl in 2007-08. Domestically, a surging oil price signifies weaker real purchasing power due to expansion of trade losses, and carries the risk of fettering a very fragile recovery in domestic private demand.
With regard to (2), on the other hand, there is really no way of knowing whether a bursting of the emerging markets bubble might trigger significant capital reversals before the end of 2011. That said, it is worth recognising that capital inflows into emerging markets have been driven in large part by the global carry trade, which is of course reliant on medium-to-long-term exchange rate trends. Carry traders may start to feel considerably less comfortable if the Fed does indeed ‘tighten' monetary policy by allowing QE2 to expire, but it is also possible that exchange rate corrections could be triggered by factors specific to emerging markets. It is particularly important to remember that risk-reduction measures as arbitrage trades are unwound will tend to have contagion implications for other markets. We should however stress that the specific timing of any bubble's collapse is virtually impossible to predict with any precision.
With regard to (3), we expect the European sovereign debt issues to be a key market theme in 2011. That said, the (admittedly imperfect) safety net that is currently in place should function sufficiently well to prevent an escalation as dramatic as that observed last May, and global asset markets have perhaps grown accustomed to the current situation in any case. Yet, we need look no further than the example of Japan to appreciate the risk of fiscal austerity in a phase of balance sheet adjustment pushing European economies into an even deeper slump.
In terms of domestic factors, political developments may be sources of risk on the upside as well as the downside. Division of control in the upper and lower houses means that the ruling party's lack of a super two-thirds majority renders it unable to undertake decisions made by the upper house. Hence, if the F3/12 budget proposals are passed by the lower house and enacted, say, it is possible that budget-related legislation would not be enacted by the upper house. If the government continues to lose support in public opinion polls, it may be that the price it pays for enacting legislation relating to the budget is the dissolution of the Diet and snap elections. Another possible general election outcome is a fragmented political scene in which no one party secures a majority.
How asset prices perform is the wildcard. In particular, if, as our US team expects, the US seems increasingly likely to pull the plug on QE2 at the end of June, a global correction in risk asset markets is a possibility. In terms of timing, the period around April-May is worth watching. The US employment data in the next two to three months will likely be of considerable importance in determining the fate of QE2.
Monetary Policy Outlook
We see virtually no chance of the BoJ hiking its policy rate before the end of F3/13, given its commitment to maintain ultra-loose monetary conditions until deflationary pressures are eradicated, but we expect the Comprehensive Monetary Easing package announced last October to start demonstrating its true worth over the period in question.
As readers will no doubt be well aware, the BoJ's Comprehensive Monetary Easing involves: (1) replacement of its 0.1% target for the uncollateralised overnight call rate with a target range of 0-0.1%; (2) a clarification of its policy duration; and (3) the establishment of a new fund that will be used to purchase a range of financial assets. In terms of the monetary policy propagation mechanism, it is hoped that (3) will help to reduce the risk premium and thereby drive down longer-term interest rates based on (2) the central bank's commitment to maintain sufficiently loose monetary conditions for as long as necessary, with the BoJ planning to (1) leave funds in the market even if the short end should continue to face downward pressure. Indeed, the BoJ has responded to criticism that the uncollateralised overnight call rate is still relatively close to the upper end of its target range by stressing that its asset purchases have only just begun.
If the BoJ's strategy proves successful, then we would expect to see a gradual decline in the uncollateralised overnight call rate. Moreover, the central bank has stated that its current policy will remain in place until "price stability is in sight". Equating this to a core CPI inflation rate of around +1%, it appears virtually certain that the Comprehensive Monetary Easing policy will be maintained for the foreseeable future, in which case the yield curve should eventually start to be driven down once again from the short end onwards.
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