My Diary 405 --- The Confusion over Central Bank; The Anchorless

My Diary 405 --- The Confusion over Central Bank; The Anchorless Bond Seas; The Darkest Time Before Down; The New S&D Story of Oil

June 14, 2008

There is always hope in our lives. Thanks to God, Mom’s operation went well. We are waiting for her recovery. On behalf of my family, I want to sincerely say thank-you to many friends’ support and concern over the past three weeks. In addition, a special thank to Howard for his family prescription.

Time to review the markets as there was a sea change over the past several weeks, as stocks tumbled while USTs got sell-off driven by real rates and inflation expectations remained largely flat. Indeed, the surge in energy prices has heightened popular inflation fears, but global financial markets showed conflicting signals.  For the past week, DM stocks declined 1.3%, while EM slipped 4.6%. 2yr UST ended 66bp higher than a week ago at 3.03%, whilst 10yr rose 5bp to 4.25%, up 35bp wow.  A note worth for some inks here is that such a steep rise in yield curve has pushed US mortgage rates up accordingly, with 30yr conforming FRM up 23bp wow and up 47bp mom…I believe Fed should have seen the number … Moreover, rising US yields helped USD gained 2.5% vs. EUR (1.538) and 3.1% vs. YEN (108.18). Meanwhile, 1MWTI oil closed at $134.86/bbl, down $4 wow. However, the looking forward issues is even a flat crude curve  will exert upward pressure on retail fuel prices in coming months due to time lags and US retail gasoline prices have already moved up about $1/gal so far this year to more than $4. Furthermore, due to bad weather, corn and wheat prices surged 14% and 10%, respectively…

The surge in oil and food expenses has caused traders to bet Fed and other major central banks to raise borrow costs in the near term. It is surprised to observe how quickly the market sentiment has shifted from worries about a US recession in March to concerns about a global inflation outbreak…I don’t think this is creditable as the whole economy just can not move from deflation to inflation within a few months…Having said so, I also think the golden time of central bankers, underpinned by rising productivity, cheap energy, increased international trade, disinflation forces of cheap Asian labour and imports have all come to an end … It is time to see some change and there are always some uncomfortable things to happen during a changing period … I still think weaker growth is the bigger risk than inflation, given the banking system problems, ongoing deflation in US housing and elevated gasoline prices. We as investors need to be cautious in the near term as the worsening energy problem may have reached a critical threshold that may cause the growth outlook to deteriorate, along with hawkish G7 central banks.

The Confusion over Central Bank
Even in the face of a domestic recession and housing deflation, Fed has recently sounded more hawkish, worrying the rise in shorter-term expectations. But let us brief go through the recent US macro data before focusing on the inflation fears. Over the week, we saw consumer sentiment fell to the lowest level (56.7) since Jimmy Carter, and May CPI increased 0.6%, after a 0.2% gain in April. Core CPI climbed 0.2%, matching the market consensus. In addition, retail sales in May rose 1%, twice as much as economists forecasting, as consumers spent tax rebates…It is now seemed that US GDP is likely to grow around 0.5- 1% in2Q08.

At the meaning time, with headline CPI yoy reached 4.2% and unemployment at 5.5%, there were calls for Fed to raise rates as ppl do not want to see another lost decade like the '70s and then ultimately see some future Volker forced to raise rates and drive unemployment back to 10%. Regarding the inflation, I think Bernanke is in a very difficult position as inflation by any standards is too high, but a rising FFTR is unlikely to have much effect on oil or food prices, unless we put the US and world economies in a serious recession. Even though Bernanke and its FOMC colleagues will continue to talk tough, their talks can not change the weak economic fundamentals and I can name some --- 1) the falling housing prices; 2) the rising unemployment rate and a dying US auto industry; 3) the slowing non-residential investment and a slumping business confidence; 4) a falling bank credit since March and Fed's monetary base is barely growing.

As a result, I really doubt that FOMC will raise rates this year. Bernanke recently said “so far the pass through of high raw materials costs to the prices of most other products and to domestic labour costs has been limited”, while yesterday, Paulson also spoke in G8 summit in Osaka, Japan, that “the recent increase in oil prices risks prolonging the US economic downturn…We are still working through housing and capital markets issues, and expect to be doing so for some time”.  Thus, it seemed that the only reason to raise rates would be to protect USD from a serious collapse.

Over in Europe, a week after ECB president Trichet virtually promised the markets a series of rate hikes, there were several unusual speeches by other ECB members, disavowing Trichet's promise --- we aren't talking about a series of rate hikes. Maybe, just possibly, we would raise in the event of more inflation …What did they want to say? To hike rates, oh, probably, but may not, oh, maybe a little … There is clearly not consensus at the ECB and there are confusion and conflicting signals in the markets. Elsewhere, Asian countries would laugh to death if they see a 4.2% inflation, as Indonesia is at 10.4%; Vietnam at 25%, while China is 7.7%. No doubt, inflation is wakening up throughout emerging Asia, but by a large part, the problem in Asia is food and energy… How to deal with it? There are no easy answers and each country will try on its own kitchen, i.e. China is raising interest rates, increasing bank reserves, and allowing its currency to continue to rise…In fact, China has managed to trend down its headline CPI, although it is still high.

Bottom line:  Worries about a major global inflation outbreak are overdone. The cause of the inflation is not something in the Fed's control and raising rates in any serious manner would whip inflation but would kill the economy at this point. I do think the chances of FFTR raised by 75bp at the end of this year are quite low…Will Chairman Bernanke like to be named as Junior Paul Volker, if he successfully brings headline inflation back to 2% in the coming quarters. The whole world is facing the same conundrum within the risk of higher unemployment and inflation.

The Anchorless Bond Seas
Bond markets recent were drifting anchorless at sea. Only a week ago, the likelihood that Fed would raise its benchmark rate at the August 5th meeting was zero, while now the odds were + 65%.  What I can see here is that human being’s emotion and expectations travel faster than the speed of sound nowadays. As a result, USTs posted their worst two months since 2004.

The extreme volatility in debt markets has continued on Friday. 2yr UST rose, pushing yields down from their highest (3.05%) this year, after core CPI matched economists' estimates and consumer confidence fell in June… Having said so, the implied inflation priced by TIPs has only risen from a recent low of 226 bps on May 1st to 249 bps on June 10th. And the 2-10yr yield curve has flattened to 120bp so far. Now , question remained is -- If Fed raise rates by 75bp,  it would bee much more difficult for financial service companies to be able to and therefore less able to lend to businesses and consumers, do they really want to make things worse?  An interesting note here is that there are times that sell-offs at the front end proven to be poor predictors of policy rates. It was only last August that Fed viewed the risks to the economy as weighted toward higher inflation. One month later, the Fed cut the inter-bank rate by 50 basis points, followed by another 275 basis points in the next seven months…Do not forget, a slowdown in housing will have a long lag before it feeds through to the retail sector…And anyone remembers when was last time that the base rates were raised 75bp higher, when economy and job markets are struggling.

Same sell-off happened in EU bond markets as European 10yr gov. bonds declined for the fifth consecutive week on speculation the central bank will be forced to raise interest rates more than once this year to stem accelerating inflation. The losses sent the yield on the German bund to an 11-month high (4.633%). But there is a near term worries, that is despite almost EUR70bn ($110bn) of capital raisings since Q307, the capital "deficit" for European banks has increased by a further 20% and now stands at over EUR250bn ($400bn). And there is scope for further deterioration as HSBC expected the overall sector’s cumulative profits for 2007/08 are 24% lower than previously estimated, while two-thirds of banks in the sector have increased their leverage over the past 6 months. Echoed the study, the LIBOR-OIS spread closed at about 69bp, down from a high for the year of 90bp in April. It averaged about 19bp over the past five years…Stay cautious…

Corporate credit eased a little bit after in-line consumer price report. The CDX NA IG fell 4bp to 116.5, according to Lehman, and ITraxx Asia HY closed 7bp tighter at 513. But ECB move the opposite as iTraxx Crossover Index rose 7bp to 487, according to JPMorgan.

The Darkest Time Before Down
Local equities markets have fallen like a rock one the back of failed expectation for government to save A shares and the vivid sentiment on the higher borrowing costs underpinned by inflation fears. As a result, A shares fell 14.6% wow, H shares lost 9.2% and MSCI HK slipped 6.7%.  In addition, there was one of the worst period for IPO firms as the only one out of six new listed companies registered positive return. Here is the list – 1) PoSheng 3813HK, -27%; 2) ChongQing Mach 2722HK, -20%; 3) Xtep1368HK,-20%; 4) CentralChina 832HK, -19.3%; 5) LittleSheep 9689HK, -0.62%; 6) A8 Digital 800HK, +12%.....Good luck for those IPOs fans…

In general, I think that the recent decline in equity prices has occurred on the back of inconsistent market signals.  I still believe the positive prospect of share prices for the medium term, suggesting overweight H shares. Certainly, staying at such an irrational moment, the markets could still retest the lows seen earlier this year…Thus, it is very important to control risk positions and sector exposures as the PPI –CPI spread is likely to widen, benefiting upstream while hurting downstream. This trend could trigger another round of market speculation on CPI sensitive sectors, or even real government intervention, such as hike/liberalize controlled prices on gasoline/diesel and electricity.

Looking forward, the correction could continue into the next weeks and it is still likely that HSI will retest Mar08 low (20572). Empirically, if we used Hengsang index as the benchmark, the past 3 biggest bear markets (-4200ppts in 94-95, -8820pts in 97-98, -9397pts in 2000-03) suggested, we have seen the bear market rally. This time, HSI dropped 11385pts from Oct2007 record high of 31958 to 20573 Mar08, rebounded to 26387 pt. Looking foreword, by Q3, if China's tightening measures will come to an end, and oil price come down and stabilize, I wish this bear market cycle will end then.

Having talked about market outlook, let us sit back and look at the regional market over the past week. Flow wise, there had accelerated US$5.5bn outflow in AxJ markets, with +50% leaving Korea due to Won sell-off. Across the region, risk appetite fell substantially, witnessed by further reduced trading volumes. Valuations contracted in both A and H shares with MSCI CN ended 14.3X 08EPE vs. 22.9% 08EPSG, CSI 300 at 16.9 08PE vs. 26.8% 08EPSG and H shares at 13.9X 08PE vs. 23.3% 08EPSG. The MSCI AxJ is averaged at 13.3X 08EPE vs. 13.4% 08EPSG. Given the best traded off of valuation and growth mix, I do think it is time to add H shares as there is not too much down side from here…It is the darkest time before we see the dawn.

The New S&D Story of Oil
As I discussed in the past diary, energy price is one of the dominating factors in the global financial markets. And I think the past 16 months of price run-up reflects the long-term trends in global S&D and strong economic growth, plus a follow-on consequence pf under-investment in oil production in the late 1990s. The late good news is that Saudi will start pumping oil from its new 500K/bbl/day in its Khursaniyah field within the next month.

But with days of easy and light oils are behind us, the key issue now is there lacks enough refinery capacity for heavy sour crude. That is why OPEC keeps saying there is enough supply. On the demand side, high prices have reduced US demand with gasoline usage down about 4%, and the luxury US car drivers may have to fit themselves into some types of smaller, more fuel-efficient cars…So more diet program, less food consumptions...aha, moving into right direction, American…However, even though the base consumer is slowing down, we have to remember Asia. Much of Asia is used to subsidize oil prices to their consumers. Fortunately, that is changing, as Indonesia, Sri Lanka, and Taiwan have announced they are decreasing their subsidies, as the cost is simply too much. Malaysia now spends 25% of its budget on oil subsidies. China now accounts for around 75% of incremental demand for oil, and there is no sign that economic growth. Fuel subsidies are another problem as SUV sales in China are rising at a rate three times faster than sedans …Wow… if even a tenth of Chinese turned into American life-style, you will not see Chinese oil imports slowing down and there are talks that Even China is likely to start to raise costs after the Olympics

With respect to the currency world, the tone from the contributors was generally more USD positive than had been the case in recent weeks as EURUSD outlook was more evenly balanced. The biggest change is the decline of  Asian currencies over the week, led by South Korea's Won, on speculation record oil prices will damp growth in Asia and prompt overseas funds to sell assets.  According to Korea Exchange, fund managers outside the nation sold a net 969 billion won ($939 million) of local shares on June 12, the most since January. The Won has dropped 10.1% vs USD ytd, the 2nd -worst performer in the region. In fact, 6 of the 10 most-traded Asian currencies outside of Japan fell this week, including NT Dollar (-0.4%) and SGD (-1.1%) .

Good night, my dear friends!