Market Economics | Interest Rate Strategy - BNP PARIBAS ...

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of consolidation, which of course may be violent. However, weaker emerging-market currencies should be seen as providing buying opportunities. Rebalancing economies via currencies In fact, stronger EMK currencies will help rebalance the global economy and, from this perspective, are good news. However, this does not mean that EMK currency strength comes without costs. EMK authorities were happy running undervalued exchange rates for a long time, allowing their economies to accumulate liquid foreign assets, mainly government bonds, at an ever-increasing pace. The strategy was convenient and came with few short-term risks as long as Western demand for EMK products was solid and inflation in emerging markets not an issue. However, overleveraged Western economies will not offer the buoyant demand for foreign-made products compared to the times when leverage was built up. Moreover, Asian inflation has started accelerating, requiring Asian monetary authorities to tighten policy. Emerging markets will thus have to change their growth strategies, becoming less export- and more domestic-demand oriented; their monetary authorities will have to tighten policy in order to deal with higher inflation rates. The combination of stronger domestic demand growth with a higher valuation of domestic currencies will boost industrialised exports into this region, which is positive. The bad news is that Asia will not export as much capital to Western financial markets, weakening liquidity conditions here. China’s inflation will reduce liquidity The next few months could see some dramatic changes in respect of Asian liquidity’s effects on Western markets. Chinese money supply and credit growth peaking at 28% (M2) and 35% (private credit) has unleashed a dramatic real estate boom. Real estate has often become an object of speculation, pushing valuations to extreme levels. Price to income levels have generated alarm with the political elite seeing the risk of a boom-bust scenario coming into play. Within a closed capital account system, money supply exceeding nominal GDP must lead either to higher asset prices or a higher level of consumer price inflation unless the GDP-exceeding supply of money is neutralised by a decline in monetary velocity. Unfortunately, monetary velocity has increased over the past year, leaving China monetary authorities little option but to tighten monetary conditions. Some analysts argue that administrative measures to calm the housing market would do the trick of easing the inflation risk. We agree that administrative measures such as increasing funding costs for second or third home purchases should dampen demand in the overheating real estate market. However, if the excess of money supply is not channelled into buying Chart 3: USD Rally is Supported by US Productivity Gains Source: Reuters EcoWin Pro, BNP Paribas Chart 4: Asian Currency Reserve Growth has Rolled Over Source: Reuters EcoWin Pro, BNP Paribas assets, consumer price inflation will rise unless authorities take quick and drastic actions to absorb excess liquidity. China’s PPI and CPI data will be released on 10 May and an upward surprise might not send only Shanghai’s equity market lower. China absorbing domestic liquidity will have global ramifications. The chance of seeing risky asset markets trading lower on the back of China tightening liquidity should not be underestimated. USD liquidity still important Meanwhile, the Fed confirmed in its latest interest rate statement its intention to keep rates low for an ‘extended period of time’. The Fed is referring to the repo rate but market rates have already moved higher as the Fed’s balance sheet is longer expanding. However, US liquidity conditions will not be influenced very much by the Fed’s rate policy; they will be affected by the Fed considering selling assets off its inflated balance sheets and, potentially more importantly, by changes in the regulation of the US financial sector. The balance sheet implications of moving the derivative holdings of banks into special entities suggests the US banking sector losing USD 285bn of equity; this could force shrinking balance sheets and reduced lending. This Hans Redeker 7 May 2010 Market Mover, Non-Objective Research Section 62 www.GlobalMarkets.bnpparibas.com
type of regulation would reduce monetary velocity and, if the decline in velocity were not compensated by a sufficient increase of central bank liquidity, would push the USD higher. In addition, less USD liquidity would not bode well for risky assets, which in recent years have enjoyed a liquidity-supported rally. EMU’s contagion and liquidity Most commentators are debating the pro and cons of a currency union in terms of diverging intra-EMU competitiveness and wealth levels, leaving liquidity considerations outside the debate. The IMF and EMU on the one hand and Greece on the other have finally agreed on a EU 110bn support package spread over three years, with Greece committing itself to a substantial budget consolidation programme. Concerning the liquidity implications of the programme, we have to differentiate between IMF and EMU funds. IMF funds have a liquidity increasing effect as the IMF takes SDRs out of its balance sheet and converts them into EUR. Hence, IMF funds work like a monetary/fiscal support programme. The EMU part of the programme has fiscal but no monetary effects. EMU has provided Greece with a EUR 75bn bridge loan aimed at keeping the country out of capital markets for three years. EMU countries will mostly raise these funds off balance sheet by issuing bonds and transferring these funds to Greece. If these offbalance-sheet programmes have no effect on national budgets in the sense that expenditure plans are left unchanged, raising these funds in the capital market would be a plus from a global liquidity point. However, national budget deficits are high across the eurozone and off-balance-sheet funding will not fool financial markets with regard to the risk premium to be paid for these assets. Remember the German unification days when GDR-related expenditure was funded via unification bonds? At that time, German bond yields reflected the higher German borrowing needs and the market did not care if the additional funds needed for German unification were funded on or off the federal balance sheet. Nowadays there will be no difference. In order not to see their own financial credibility being undermined, EMU countries supporting Greece financially will have to cut domestic expenditure or increase domestic taxes. This will especially apply to countries with high debt or deficit levels such as Portugal, Spain, Ireland, Italy and France. So the EMU bridge loan represents a fiscal transfer, but will not increase the pool of fiscal means available for the eurozone. In this sense, the EMU package is different from the IMF money, which in fact brings new funds into the eurozone and hence provides a measure of relief. However, we still believe that EMU instability will negatively affect global liquidity. Greece illustrated how the sovereign crisis has undermined the banking Chart 5: Liquidity versus Equities Source: Reuters EcoWin Pro, BNP Paribas Chart 6: EURUSD Rate Differential to Turn Negative Source: Reuters EcoWin Pro, BNP Paribas sector. Financial interdependencies among the Greek insurance and the banking industry are a worry given that Greek pension funds were not using the golden rule of investment diversification. Rather, they were putting most of their assets into domestic bonds and to a lesser degree into equities. Greek pension funds hold EUR 29bn of Greek bonds. Meanwhile, Greek banks’ access to private money market funding is not sufficient to allow their liquidity needs to be covered by ECB repos. Hence, ECB collateral rules will be crucial for Greek bank funding. On Monday, the ECB loosened its collateral rules. This does not only effectively represent an easing of monetary conditions, it will also expand the ECB’s balance sheet risk –working against the EUR. Bank funding conditions have tightened The spread between euro-denominated German T- Bill rates and rates paid on the interbank market has moved to its highest level since November 2009, indicating that money market risk premia are on the rise. Banks of peripheral countries in particular are facing higher funding costs and, while the TED spread may not have reached alarming levels we watch it to assess the level of financial risks. A further widening of this spread in conjunction with tightening monetary conditions in Asia and the US implementing financial sector reform may cause Hans Redeker 7 May 2010 Market Mover, Non-Objective Research Section 63 www.GlobalMarkets.bnpparibas.com
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Market Economics | Interest Rate St
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UK: all eyes on the election US: re
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Event response The ECB is being ove
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Eurozone Periphery: Compare and Con
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over 20% in Q1) and, last but not l
Page 11 and 12: Market Stress Charts • Signs of s
Page 13 and 14: Chart 7: Greek Bank CDS* 900 Greece
Page 15 and 16: • The plan also contains a number
Page 17 and 18: Germany: Downs and Ups • The impa
Page 19 and 20: Retail sales data from month to mon
Page 21 and 22: On inflation, the statement was als
Page 23 and 24: quarterly average of 2.7% in the fi
Page 25 and 26: US Credit: Still the Recovery’s B
Page 27 and 28: Japan: Rising Chance of Sales Tax H
Page 29 and 30: BNP Paribas Surprise Indicator •
Page 31 and 32: UK headline After surprising to the
Page 33 and 34: US: Supply Could Affect Swap Spread
Page 35 and 36: steep curve is typically associated
Page 37 and 38: decline. We continue to maintain ou
Page 39 and 40: Chart 12: 90-119 Day Dlq for FRE 90
Page 41 and 42: the gamma sector for some time now.
Page 43 and 44: EUR: Limited Nervousness at ECB Ten
Page 45 and 46: with the big redemption (EUR 17.7bn
Page 47 and 48: measures are not promptly taken to
Page 49 and 50: Table 1: BNP Paribas' Inflation For
Page 51 and 52: Table 3: BNP Paribas' Inflation For
Page 53 and 54: Table 1: BNP Paribas Carry Analysis
Page 55 and 56: What’s the call? It is relatively
Page 57 and 58: Update on FIN SEN and FIN SUB 5/10y
Page 59 and 60: Germany 10y: Within MT falling wedg
Page 61: Judging Currencies by Liquidity •
Page 65 and 66: Euro Dives • The euro is collapsi
Page 67 and 68: Currency Spot Trade Recommendations
Page 69 and 70: Economic Calendar: 7 - 14 May (cont
Page 71 and 72: Key Data Preview Chart 1: US Payrol
Page 73 and 74: Key Data Preview Chart 5: UK Manufa
Page 75 and 76: Key Data Preview Chart 9: French GD
Page 77 and 78: Key Data Preview Chart 13: US Indus
Page 79 and 80: Treasury and SAS Issuance Calendar
Page 81 and 82: Central Bank Watch Interest Rate EU
Page 83 and 84: FX Forecasts* USD Bloc Q2 '10 Q3 '1
Page 85: RESEARCH DISCLAIMERS: IMPORTANT DIS
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