Yield Spread Analysis 05/15 – 05/22
Both short term and long term rates around the world rocketed higher over the course of the past week as funds drained out of bonds and into equity markets, which continue to breach new highs. In Canada, shorter term bonds saw yields rocket higher amidst stronger-than-expected core CPI and hot retail sales, leading markets to consider the potential for policy tightening later in the year. The curve for the UK felt a similar impact, as money supply growth goes on undeterred and BOE Governor King sees the potential for further policy tightening.
Japan was the one exception last week, as softer-than-forecasted expansion in
the first quarter hurt prospects for rate normalization this year, leading
yields lower. However, BOJ Governor Fukui has remained somewhat hawkish. See
“BOJ – Weighing Their Options” in this piece for more on that.
US-China Trade Talks – Time For a Truce?
US legislators have lambasted China for policies they see as serving as a subsidy for Chinese trade. Furthermore, the US appears almost offended by the People’s Bank of China’s decision to widen the yuan trading band as an effective means to let the currency appreciate:
Charles Schumer, US Senator
“This is a nice gesture, but in the past, most of their gestures have not produced any concrete change. To widen the band is well and good, but if they don't use the band, nothing will happen. The Chinese should recognize that they face the prospect of strong WTO-compliant legislation if there isn't significant progress.” – May 18, 2007
Meanwhile, Paulson continues to play referee in order to balance the US movement towards protectionist measures and China’s slow reforms as he and Wu Yi meet today in Washington for closed-door talks:
Henry Paulson, US Treasury Secretary
“The reason I want progress so much now is that, with the presidential election coming up, I don't want people in the United States to use the lack of progress as a reason for saying, 'Dialogue doesn't work, we need tougher legislation or we need to make China an issue in the election'. We have to keep making progress because we need some sign posts to show that we are not just talking the talk but walking the walk.” – May 22, 2007
Wu Yi, Chinese Vice Premier
“There are some in the US who overstate the US trade imbalance with China and blame China for problems that arise as the US adjusts its economic structure to respond to challenges posed by economic globalization. Some even advocate trade protectionism. Such irresponsible acts can only obstruct economic globalization and hinder the fundamental interests of both China and the US, our peoples and the sustainable and steady growth of the world economy. As to differences and disputes, it is important that China and the US, both being stakeholders and constructive partners, should address them in a cool-headed, objective and responsible way.” – May 17, 2007
“The two countries should look domestically to seek ways to resolve their economic problems and help each other to address respective issues through cooperation, instead of blaming each other for their own domestic economic problems.” – May 22, 2007
US Fed – Too Little Too Late?
Some central bankers appear to be starting to show a slightly dovish bias:
Thomas Hoenig, Federal Reserve Bank of Kansas City President (Voter)
“Our policy rate is 5.25 percent. In my judgment, that's modestly firm, allowing the economy to move forward and expand. The outlook is generally positive with recognized risks on both sides.” – May 16, 2007
Michael Moskow, Federal Reserve Bank of Chicago President (Voter)
“Our expectation is that inflation rates will continue to come down as well during this period and I would expect the unemployment rate will not go up a great deal.” – May 22, 2007
However, many officials continue to harp upon the housing sector and how the problems of subprime lenders will not filter throughout the economy. With first quarter GDP down to 1.3 percent (and expected to be revised even lower), it seems the effects have already begun to take their toll on expansion:
Ben Bernanke, Federal Reserve Bank Chairman (Voter)
“We at the Federal Reserve will do all that we can to prevent fraud and abusive lending and to ensure that lenders employ sound underwriting practices and make effective disclosures to consumers.” – May 18, 2007
Donald Kohn, Federal Reserve Bank Vice Chairman (Voter)
“The ripple effects of subprime lending problems are one sign of how derivatives and other innovations have created new channels for the transmission of shocks within the financial markets and into the economy.” – May 16, 2007
Robert Kimmitt, US Deputy Secretary of the Treasury
“I informed my colleagues that our fiscal deficit continues to decline and the US economy is making the transition to a sustainable growth path. While the economy grew modestly in the first quarter, we are confident it will return toward trend over the year. We see evidence that housing is stabilizing and that rising delinquencies in the subprime mortgage market have not spread more generally. Inflation remains contained and the job market is strong.” – May 21, 2007
BOE – 5.75% in June?
The Bank of England has made it clear that they are considering raising rates even higher. The question is: when will they do it?
Mervyn King, Bank of England Governor
“The path of interest rates assumed in this projection anticipates a further rise in the bank rate.” – May 16, 2007
“The crucial question for monetary policy is where inflation is likely to be once energy prices have settled down. At that point inflation will reflect the balance between money spending and supply capacity in the economy as a whole…Overall, the balance of risks to inflation around the central projection two years or so ahead is, in the Committee's judgment, on the upside. The Committee will monitor those risks carefully over the coming months. Indicators of pricing pressure are particularly important at present. If they remain elevated, that would be consistent with the possibility that inflation expectations had moved more persistently upwards or margins were being raised more aggressively, and that the upside risks were crystallizing. If, however, wage pressures were to diminish, that would suggest that the upside risks had receded…The Committee will look through the short-run volatility to the outlook in the medium term. It is determined to meet the 2 percent target, and will take whatever further action may be required to do that.” – May 16, 2007
Gordon Brown, Chancellor of the Exchequer
“Not only is inflation this month coming down as expected, but...we will hold to the forward-looking, proactive framework. We will never take any risks with inflation or with the stability of the economy…Our British model, our framework...is, and remains, the right approach to anchor inflation expectations and to keep inflation low.” – May 16, 2007
Moreover, will it be necessary? Evidence has started to emerge that house prices – a contributor to inflation pressures – have started to cool:
David Dooks, BBA Director of Statistics
“High house prices and increasing monthly repayment costs are causing a slowdown in the mortgage market.” – May 21, 2007
BOJ – Weighing Their Options
The Bank of Japan may not be desperate to raise rates, but they’ve certainly indicated rate normalization will be in the cards at some point. Will they consider doing so in July when the Semi-Annual Outlook is released?
Toshihiko Fukui, Bank of Japan Governor
“Low interest rates, if left too long at levels that do not reflect economic fundamentals, could distort the distribution of resources and hinder the economic recovery. So, when there is a strong possibility of the economy sustaining growth amid stable price trends, there is a need to adjust interest rates in tandem with the pace of improvement in the economy, while monitoring various risks.” – May 17, 2007
“I'm not saying we can raise rates any time when prices are falling. But if we examine everything, it is possible to raise rates even when prices are falling…Those comments that we are determined to raise rates desperately are completely wrong.” – May 17, 2007
Atsushi Mizuno, Bank of Japan Board Member
“Financial markets are too pessimistic on the economic outlook and that the Tankan survey (in July) could dispel their concerns.” He also says that he has no concrete idea on when the Bank should raise rates, but notes that the “mid-term review” of its semi-annual economic outlook report in July could be a good opportunity. “Within the next couple of months, we'll have the necessary data and environment that will give us a clearer picture on the economic outlook…I hope the board will deepen debate on the third, the fourth and the fifth rate hikes, including whether we need them.” – May 22, 2007
As usual, government and fiscal officials exhibit a preference for leaving rates low:
Hidenao Nakagawa, Secretary-General of the Liberal Democratic Party
“I would like the monetary authority to be well aware of the government's economic policy. We are aiming for ending deflation and achieving sustainable growth. Normalizing interest rates is not the only purpose of the monetary policy…They (the BOJ) should manage their policy in accordance with the annual and mid-term economic policy plans agreed by the government and ruling parties.” – May 18, 2007
Hiroko Ota, Japanese Economics Minister
“We expect the BOJ to support our efforts to pull Japan out of deflation…the government and the BOJ share a common economic goal and Governor Fukui has clearly said that it was wrong to think the BOJ was desperate to raise rates.” – May 18, 2007
“The new growth data show that the Japanese economy is recovering overall…Although the strength of recovery is still a little weak because of slow growth in wages, consumption keeps recovering…Thanks to careful macroeconomic management (for the last several years), there have been many improvements in price conditions and the end of deflation is in sight.” – May 17, 2007
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