Turkey
Main Takeaways from a Recent Trip - Sticking with Our Base Case
January 26, 2010

By Tevfik Aksoy | London

Trip to Ankara and Istanbul: We visited officials at the Turkish Treasury, the Central Bank of Turkey and the IMF Representative Office in Ankara, as well as private and public banks and a political consultant in Istanbul. Our impressions are summarised below. In general, we see no immediate upside or downside risks to our base case scenario and accompanying forecasts that we presented in the Turkey section of our CEEMEA 2010 Outlook on January 18.

Some encouraging news on the fiscal front: Based on the discussions we had, there seems to be more encouraging news on the fiscal front than otherwise. First, the budgetary realisations in the last few months of 2009 had been better than expected, mostly due to the rise in revenues. In fact, the budget deficit was some TRY 9-10 billion lower than envisaged and provided some better starting ground for 2010. Combined with the recent tax hikes and price adjustments on certain administered services, the prospects of a better fiscal picture have risen. The rise in special consumption tax on tobacco and petroleum alone might bring in some additional TRY 8-9 billion to the budget. According to the officials, most of the fiscal risks that could be witnessed in 2010 have materialised to a large extent, especially considering that the salary and pension adjustments had taken place. Most of the adjustments on the revenue side had been assumed in the budget and further positive news is expected as the reforms on the health and drug administration take effect, lowering the outlays. The additional cost of increases in the pensions of retirees (which is estimated to be around TRY 3 billion) would be offset by the tax hikes, the increased tolls as well as the recently introduced fees on banks' branches, etc.

Fiscal rule preparations in progress: Second, the preparatory work for the fiscal rule in underway. Our understanding was that the officials were trying to finalise the details and the exact nature of the parameters of the fiscal rule by consulting with the industry, academia and various interested parties. The initial date of expected legislation for the fiscal rule was 1Q10, but our conversations point to a possibility of 1H10 instead. The key point is that the intention to introduce the rule is there and the 2011 budget will be based on this practice. That said, we believe that a fiscal rule alone might not be sufficient to provide full confidence for the market, given the possible lags between fiscal deviations and corrective actions as well as lack of clarity on the accountability aspects. Therefore, we will be watching progress on this front closely.

Lower debt rollover ratio possible: Third, there had been some slight positive news on the financing and the debt rollover side. With improved prospects of a better-than-planned budget for 2010, which might reverse the 0.3% of GDP primary deficit (planned) to a flat or even a slight positive figure, officials believe that the rollover rate could decline. In comparison to the domestic debt rollover rate of 99.5% set for 2010, officials think that the number could ease to 93-94%. We had been reminded that the privatisation proceeds assumed for the financing programme for 2010 stood at TRY 5 billion, whereas the official budget assumed TRY 10 billion. Hence, there seems to be some further downside to the rollover ratio as the assumptions had been made on the conservative side. Officials believe that there is no imminent need to raise electricity prices (which is good for inflation dynamics) but there might a case for adjusting natural gas prices higher, which partially depends on the course of the currency. 

A tough year for the CBT: Our impression from the CBT was somewhat mixed with regards to the market impact of the possible actions by the monetary authority in terms of the response that it might give to rising inflation in the coming months. To start with, the CBT seems to be preserving the rather dovish stance, believing that the slow growth in credit, the presence of a large output gap and uncertainties surrounding the external demand conditions would cause inflation to decline after a brief rise in the first few months of the year. According to the CBT, the growth figure for 2010 could easily exceed 4% and reach 5%, as the statistical carry-over (of some 2.5pp) and the inventory cycle would contribute significantly to the headline number. Still, the output gap is not expected to close before end-2011 or early 2012. Credit demand improved somewhat but remains weak and government consumption is expected to be limited, given the anticipation of fiscal discipline.

Rates to remain on hold for some time: Our impression was that the CBT would try to keep the policy rate at the current level as long as possible as it believes that core inflation would remain low and diverge from the headline CPI. According to the CBT, inflation might rise in the early stages of 2010 on the back of the one-off rises in taxes and administered prices as well as base effects. However, again based on base effects and the possibility of a decline in unprocessed food (especially meat prices), inflation might decline even lower than the targeted rate.

Inflation expectations are key: For the central bank, the main issue seems to be monitoring inflation expectations, which the CBT does not want to see diverging too much from medium-term targets. Hence, the CBT is likely to focus on the developments on this front in setting rate decisions, in our view.

The CBT might be watching the employment levels in the industrial sector, some components of the PMI data (such as the indications related to labor hiring, etc.) as well as the developments in the credit market. While the policy rate might be kept unchanged for some time, officials admit that inflation could rise to levels that might influence expectations adversely, which might need to be addressed. Our conversations pointed to the possibility that the CBT might first resort to liquidity-tightening measures (while keeping the policy rate unchanged) by raising the reserve requirement ratio and perhaps altering the funding size and tenor via repos. Currently, the CBT funds local banks via weekly and 3-month repos while drawing excess liquidity in the overnight market.

No new information on the IMF front: Our discussions with IMF officials essentially were in line with the Turkish officials' rhetoric and confirmed the general market view that the decision to go for a deal would primarily involve PM Tayyip Erdogan's decision to invite an IMF team to Ankara. The message was that the daily correspondence would continue and that the IMF was ready to send a mission immediately after an official invite. Our impression on the future course of the IMF discussions is that the government might decide to complete the work on the fiscal rule to a large extent and finalise all the fiscal action needed before deciding to invite the team. Following the IMF mission's study of the outcome of the 2009 realisations and its assessment of the fiscal outlook, the Fund might suggest more fiscal measures, or be content with the current picture. If the additional measures were acceptable by the government we would expect a deal to go through. However, we did not get the impression that a Stand-By Arrangement is seen as crucial (other than its positive impact on growth), especially if it involved sizeable adjustments. One of the sticking issues in the past was related to the status of the Revenue Administration body. Previously, the IMF requested that the Revenue Administration body is made independent, while the government refused to do this. However, our understating is that progress had been made on this front and the government is willing to improve the legislation significantly to make the operational independence and effectiveness as good as possible while the IMF might be relatively more accommodating. Hence, the future of the relations seems to hinge on whether an invitation would be sent to Washington DC soon, which is nothing new for the market. Recently, there had been discussions in the media that Turkey might apply for the Flexible Credit Line (FCL) with the IMF. This option had broadly been dismissed in Ankara, and our view is that an FCL seems to be a very unlikely outcome, as by definition it would not serve Turkey's purposes. 

Istanbul is cautious: In Istanbul, market participants seemed to have been enjoying the constructive start of the year, especially with the decline in yields and relatively smooth progress in Treasury borrowing auctions. Almost all participants that we spoke with share the view that 2009 had been an extraordinary year in terms of profits (on bonds) and that the results would show it. That said, the common view was also pointing to a likely presence of significant window dressing in balance sheets to be disclosed for year-end, especially on the size of the loan books and deposits. In fact, early credit and deposit data for January, as disclosed by the CBT, show rather sharp declines. In terms of the financing programme and the upcoming auctions, banks expect the Turkish Treasury to roll its debt successfully, but a common view is that yields are unlikely to decline from the current levels even if an IMF Stand-By Arrangement is agreed soon. When asked about how much downside they would expect on yields (in case an IMF deal were to be announced today), the answers ranged from 20-50bp with a subsequent take-profit move.  In terms of credit growth outlook, the general view was that demand was picking up very marginally and even in the housing sector where growth had been most visible, there had been a sharp slowdown recently. The good news seems to be on the non-performing loan side, with the NPL ratio gradually declining amid banks' increased efforts to improve collections.

No urgent issue on the political front, but the noise will likely be there: We can easily claim that politics had not been a high-ranked agenda item during our meetings. Only one of the private banks mentioned possible escalation of political noise later in the year, mostly in relation to approaching general elections, some issues surrounding constitutional amendments and legislation on the mechanics of a referendum.

Important Disclosure Information at the end of this Forum

United States
Review and Preview
January 26, 2010

By Ted Wieseman | New York

With a very quiet domestic economic calendar, market focus over the past week was dominated by further moves towards policy tightening in China and politics in the US, helping Treasuries post moderate gains largely as a result of falling commodity and stock prices.  The markets' perception of excessively easy Fed policy and disappointment with the lack of any movement towards an exit strategy has been mollified over the past couple of weeks by the far more proactive Chinese monetary policy and banking regulation authorities, which finally brought a halt to the bear steepening of the Treasury yield curve to all-time highs and the near continual run-up in TIPS inflation breakevens since the end of 3Q.  Both trends peaked on the day before China's initial required reserve ratio hike on January 12 and then were given a further push in the latest week by reports that bank regulators in China were moving to slow lending growth and rising expectations after these steps coming in such close proximity that a move towards quicker rate hikes could be coming.  On the domestic political front, the White House, which had encountered significant headwinds getting legislation through Congress even with a 60-vote Democratic super-majority in the Senate, called for slowing the pace of negotiations on healthcare reform when the election in Massachusetts gave the Republicans enough votes to sustain a filibuster.  So it seems unlikely that any major new initiatives will pass anytime soon.  Still, the Democrats' apparent new strategy of stepping up regulatory proposals after the defeat in Massachusetts rattled financial markets broadly, with sinking equity and credit markets adding to the more fundamentally driven bid in Treasuries coming from concerns about the impact on global growth and liquidity from China's initial policy tightening steps.  With these issues in focus, a light and mixed calendar of domestic economic releases attracted little notice.  Housing starts were weaker than expected in December, which we view as a good thing really, since it will help inventories of unsold new homes continue to move back towards balance as the key spring selling season approaches.  The PPI was up slightly and, in a rarity these days, wasn't badly distorted by seemingly random noise in the measurement of car and truck prices.  The index of leading economic indicators extended a huge rebound off its March low, posting the best nine-month gain since the very strong 1983 economic recovery.  Indications for the key early round of January data were generally positive.  Claims were up in the latest week, but the Labor Department attributed the increase to more technical than fundamental reasons, and the trend over the past month remains quite positive.  We look for a 75,000 increase in January non-farm payrolls.  The Philly Fed survey was steady at positive levels on an underlying basis to go along with the previously reported strength in the Empire State, and we continue to look for the national ISM to hold steady at a robust 56.0 in January. 

On the week, benchmark Treasury yields fell 6-8bp, with a small further outperformance by the intermediate part of the curve.  The 2-year yield declined 6bp to 0.81%, 3-year 6bp to 1.37%, 5-year 8bp to 2.34%, 7-year 8pb to 3.07%, 10-year 8bp to 3.59% and 30-year 7bp to 4.51%.  The squeeze at the very short end was back on after a minor bit of relief the prior week, with the 4-week bill yield down 2bp to 0.01% and 3-month 1bp to 0.05% as there was another in a run of big bill paydowns on Thursday, which should continue into the first part of February.  TIPS lagged as concerns about the impact of policy tightening in China contributed to significant further declines in commodity prices, with March oil falling 5% and the LME's industrial metals composite index down 2%.  The 5-year TIPS yield rose 1bp to 0.21%, 10-year fell 3bp to 1.30% and 20-year fell 3bp to 1.95%.  Against this underperformance, a resilient performance by the normally very energy price-sensitive short end of the TIPS market has been quite strange, considering the weakness in commodity prices.  Even with oil prices down US$8 a barrel since the beginning of the year, TIPS breakevens in the 1-year area are up about 30bp.  With a flight-to-safety accounting for much of the Treasury market bid, relative performance by mortgages was soft, and swap spreads widened.  Current coupon MBS yields were down slightly to near 4.35%.  Still, this remained near the lows since mid-December and should allow average 30-year conventional mortgage rates to hold near 5%, not far from the record lows hit at the beginning of December.  Swap spreads, meanwhile, rose somewhat after recent moves to cycle and historical lows, with the benchmark 5-year spread up 4bp to 33bp after having hit record lows of 28bp several times over the past few weeks. 

Risk markets had their worst three days since the middle of last year to end the past week and send them into the red for the year, which largely drove the upside in Treasuries, hurt by worries about the implications of China tightening and especially the impact this had on commodity prices, unease with the populist rhetoric coming out of Washington, and unhappiness with earnings reports in the tech sector.  The S&P 500 fell 4% to move to 2% down for the year.  The worst-performing sectors were materials (-6%), financials (-5%) and energy (-5%), while the defensive consumer staples (-2%) and healthcare (-2%) areas did best, the latter the most directly helped by the Massachusetts election.  Credit also did quite badly on the week to extend a rough recent performance, with the investment grade CDX index widening 12bp to 96bp compared to the 85bp close at the end of 2009 and the recent tight of 76bp reached as recently as January 11.  The high yield CDX index was 44bp wider on the week at 546bp at Thursday's close and plunging another point in late trading Friday.  The HY CDX index ended December at 518bp and got as tight as 468bp on January 11.  The leverage loan LCDX index had a bad week also but continued to hold in much better than high yield so far this year.  Performance this month (after a very strong first couple of days) by the commercial mortgage CMBX market was already relatively soft coming into this week, and the poor showing was extended.  The AAA CMBX index is now down 3% this month and the junior AAA 5%.  The muni bond market has been doing poorly almost all year as the sovereign debt concerns, most acute recently in Greece, have added to worries about the state budget position.  The 5-year MCDX index was another 15bp wider on the week at 168bp in Friday afternoon trading, a more than 30bp widening so far this month to the worst level since July. 

The economic calendar was very light the past week, with early indications for the key round of initial January data the most notable releases.  The weekly jobless claims report was weaker for the first time since mid-2009, although the Labor Department accompanied the release (in an unusual step) with comments attributing the worsening to technical instead of fundamental factors.  Initial jobless claims rose 36,000 in the week of January 16 - the survey week for the employment report - to 482,000, which boosted the 4-week average by 7,000 to 448,250.  This broke an incredible run of 19 straight declines.  According to the Labor Department, the increase this week was "administrative" instead of "economic", since it was driven by states catching up with a backlog of filings built up over the holidays when offices were lightly staffed.  Of course this means that claims were somewhat understated in recent prior weeks.  Still, the 4-week average shows a big net improvement over the past month since the reference week for the December employment report.  Our preliminary forecast is for a 75,000 gain in January non-farm payrolls (including an estimated 25,000 temporary census workers) and a 0.1pp dip in the unemployment rate to 9.9%.  Meanwhile, the Philly Fed manufacturing survey pulled back a bit in January but remained positive.  The headline sentiment measure fell to 15.2 from 22.5.  Underlying details held up better, with an ISM-comparable weighted average of the key activity measures dipping to 52.5 from 52.6, close to the improved results for the Empire State survey reported the prior week.  Our preliminary forecast for the national ISM is for a marginal increase to a strong 56.0 in January from 55.9 in December. 

The upcoming week's domestic economic calendar is much busier and might become more of a focus of market attention, though US politics are going to remain on the front pages, with the president's State of the Union Address on Wednesday, and any further policy tightening steps in China will clearly be closely watched for.  The FOMC meets Tuesday and Wednesday and will likely give investors what we view as an unwelcome reminder of how cautious and slow moving they continue to be in scaling back quantitative easing after focus had shifted to more proactive Chinese policymakers the past couple of weeks.  It's also another week of heavy debt issuance, US$118 billion in 2s, 5s and 7s from Tuesday to Thursday.  The Street tried to start setting up for this Thursday morning but was run over by the bid created by the sell-off in equity and credit markets after the president's remarks on proposals for increased regulations in the financial sector.  A bit of a concession started to get priced in when things calmed down Friday, but the market still certainly appears to be coming into this supply on the rich side.  Key releases in a busy economic data release calendar include existing home sales Monday, consumer confidence Tuesday, new home sales Wednesday, durable goods Thursday, and GDP and ECI Friday:

* We look for December existing home sales to decline to a 6.00 million unit annual rate.  The original homebuyers' tax credit was due to expire on December 1, and there was considerably uncertainty regarding prospects for an extension as the deadline approached.  So there was a rush of activity in September, October and November that no doubt pulled forward a large volume of sales.  While the tax credit was ultimately extended (and expanded), we are likely to see a payback effect for the next couple of months.  Thus, we look for about an 8% drop in resales for the month of December.

* We expect the Conference Board's measure of consumer confidence to be steady at 53.0 in January.  A disappointing employment report, rising gasoline prices and the arrival of unusually severe winter weather in some parts of the nation all probably helped to restrain sentiment in January.  So, even though we believe that consumer confidence is poised for some notable improvement in the coming months, we look for little change in the Conference Board index for January relative to the 52.9 that was posted in December.

* We look for December new home sales to fall to a 340,000 unit annual rate.  The homebuilders' sentiment survey has edged a bit lower in recent months.  Also, some sales were probably pulled forward as a result of uncertainty tied to the possible extension of the homebuyers' tax credit.  Moreover, weather conditions took an unusually severe turn across parts of the nation during December, and this may have contributed to a slowdown in home shopping and contract signings.  Factoring in all of this, we look for about a 4% dip in sales of newly constructed residences in December.

* We forecast a 1.7% rise in December durable goods orders.  Company reports point to a rebound in the volatile aircraft category, which should help to lift overall bookings for durable goods this month.  Also, the ISM survey implied a solid pick-up in underlying order activity.  So, we look for a 0.6% rise in the key core component - non-defense capital goods excluding aircraft.  Finally, we look for a modest rise in capital goods shipments (+0.5%) and a slight dip in inventories (-0.2%).

* We forecast a 4.8% rise in 4Q GDP.  The growth in final sales during 4Q (+1.5%) is expected to be identical to that seen in 3Q.  However, a sharp moderation in the pace of inventory destocking is likely to have a powerful impact on GDP.  In fact, we look for a +3.2pp contribution from inventories - the largest since 4Q87.  It's important to note that the big push from inventories reflects a slower pace of decline - not an outright accumulation.  Thus, concerns that an inventory rebuild will eventually lead to a slackening in production are misplaced.  In fact, we don't expect to see outright accumulation of inventories commencing until 2011.  Getting back to the 4Q data - we look for a modest 1.8% rise in consumption, a slight uptick in equipment investment, another sharp drop in non-residential construction, another solid gain in residential construction, a neutral contribution from net exports and a modest rise in government.  Finally, the chain weight price index is expected to match the 3Q reading of +0.4%.

* We look for a 0.5% increase in 4Q employment cost index.  Our reweighted aggregation of the hourly earnings data from the employment report points to another contained reading for the ECI.  Specifically, we look for a 0.4% rise in private wages and salaries and a modest rebound in the government category following a highly abnormal decline in 3Q.  Meanwhile, the benefits component of the ECI is expected to be +0.5% - right in line with the recent trend.  On a year-on-year basis, the ECI is expected to slip to +1.5% - which would represent another new all-time low in the 27-year history of the series.

Important Disclosure Information at the end of this Forum

United States
Higher Yields Won't Kill the Economy
January 26, 2010

By Richard Berner, David Greenlaw, Ted Wieseman & David Cho | New York

Higher yields and a stronger economy can coexist.  Investors don't buy our call for higher US real yields because they think a) such a rise will kill the economy, or b) the economy is too weak to generate any revival in private credit demands, or c) both.  The heightened uncertainty and renewed risk-aversion dominating financial markets over the past week have only served to elevate their concerns - and their pushback.  They worry that President Obama's financial regulatory initiatives will hobble the economy.  Notwithstanding the new proposals, we have not changed our view.

In our view, higher yields and a stronger economy can coexist; indeed, we think that an improving economy will help drive yields higher.  Of course, changes in interest rates do matter for economic activity.  But the coming rise in interest rates is a by-product of recovery, not a headwind for it.  Two key factors mean that the higher rates we envision won't crush the economy:

•           First, causation runs from the economy to credit demand, not the reverse.  Several factors - such as strong global growth - are reviving US output and income.  In addition, the credit crunch is abating.  In our view, credit-sensitive demands like housing and inventories will benefit and, in turn, will help revive mortgage and loan demands later this year.  Combined with accelerating Treasury bond issuance, we think that revival will push up 10-year nominal Treasury yields to 5.5% without stalling growth.

•           Second, credit-sensitive outlays are less responsive to interest rates than most believe.  In fact, interest rate sensitivity is not constant, but instead varies with the credit cycle and financial leverage.  The reduced leverage in the system today should suppress interest rate sensitivity until leverage is again significantly higher.

Let's examine each of those propositions in turn. 

Proposition 1: Causation runs from the economy to credit.  Our reading of both theory and empirical evidence confirms that causation runs from the economy to credit demand.  Theory suggests that the start of a recovery in consumer durables and private investment outlays is typically financed out of saving or internal cash flow built up in recession.  Credit follows a couple of quarters later as lenders and borrowers gain confidence, creditworthiness improves and default risks fade.  Statistical tests hint that consumer durables and overall investment outlays lead the sum of household and non-financial business credit by two quarters, and that the former ‘causes' the latter.

The lags may be longer this time, because the credit crunch is still restraining credit supply.  The most serious financial crisis in 70 years and a deep credit crunch is still a headwind.  But two sets of forces are promoting recovery.  First, policy stimulus, strong global growth and an unwinding of excess are key sources of strength in our US outlook.     Rising output is beginning to generate longer working hours and higher income, which should improve spending and debt-servicing power.  Rising wealth is boosting creditworthiness and stemming the pressure to save. 

Second, while it is still a headwind, the credit crunch is abating.  The evidence is hard to come by, because credit outstandings are still contracting and banks were still tightening lending standards through October 2009.  In our view, much of the decline in outstandings now is driven by weak demand rather than restraints on supply.  That's impossible to prove.  But recalling the dynamics of the credit boom and bust, the relevant signposts point to fading supply restraints. 

Boom dynamics.  In the boom, leverage soared as perceptions of default risk melted in the glow of healthy growth and low inflation; both fueled credit availability.    The combination of lower interest rates and higher leverage fueled the credit and housing booms.  Conversely, the unprecedented magnitude and speed of deleveraging through the financial system drove the bust, despite aggressive declines in interest rates.    Deleveraging of household balance sheets was (and is) of secondary importance, as that primarily affects the demand for, rather than the supply of, credit.   

During the credit boom, the dramatic increase in financial leverage by 2006 was evident in thin ‘haircuts'.  An intermediary buying an AAA mortgage-backed security faced only a 1.6% haircut, meaning it could borrow 98.4% of the value, implying leverage of 60 to 1.  Subsequently, haircuts soared in the crisis, pulling leverage down to 1.2 to 1.  The deleveraging in other securities was less dramatic, but losses that eroded the capital base of leveraged lenders promoted a dramatic contraction of balance sheets and credit availability - an epic credit crunch.

But the lags won't drag on forever.  That was then.  Today, the credit crunch is abating, thanks to massive deleveraging in financial institutions.  As a result, there may well be positive surprises for the economy: The deleveraging process has unfolded faster and gone further than is commonly recognized, and financial conditions are improving as a result - central elements of our macro view.   

Various measures of credit stress have improved dramatically since March, suggesting that the credit crunch is abating and that credit terms are reverting to an ‘old normal' - one that harks back to at least the 1990s.  Haircuts and margins have receded from 50-80% to 5-30%, depending on the collateral.  Leveraged lenders have substantially rebuilt capital and provisioned for bad loans.  LIBOR-OIS spreads are at or below pre-crisis levels.  Many markets that had closed during the crisis are now open: High yield and IG spreads have collapsed to pre-crisis levels and issuance has soared.  The TALF has helped to restart securitization in consumer ABS - so much so that it is no longer needed.  Yet there are only faint signs that the intermediaries in these markets are levering up again. 

Proposition 2: Credit-sensitive outlays are less responsive to interest rates than most believe.  To evaluate this, we must analyze the channels through which interest rates influence the economy.  The theory is straightforward: A lower cost of borrowing will make investment more attractive and boost housing and other credit-sensitive outlays.  But in our view, the influence of interest rates on investment is smaller than commonly perceived.  Three factors make that so: 

First, proportional changes in economic activity are more important factors driving investment than similar changes in capital costs.  For example, income, wealth and household formation are dominant factors driving the demand for housing stock.  If rising income or output creates excess demand, housing starts will tend to rise even if rates go up.  Conversely, housing starts will continue to decline despite falling interest rates if there is a shortfall of income or output.  Changes in interest rates are important, but they primarily influence the decision whether to rent or buy and whether builders want to build, and thus moderate the timing or strength of investment.  

Second, factors other than interest rates affect the rent-versus-buy decision, and they are generally more important.  The so-called ‘rental price of capital' includes the cost of depreciation, the revenue from owning the capital and expected capital gains, taxes, tax incentives, and the choice between debt and equity financing.  In the tech hardware industry, for example, the efficiency gains that buyers derive from the assets, and the falling prices thereof, swamp the financing costs.  In similar fashion, the expected capital losses in housing have lately swamped the impact of low interest rates, weakening demand in the bust.  This mechanism will begin to operate in reverse as housing prices stabilize and turn up.

Third, it takes time for a change in rates and other factors to affect investment.  That's because adjusting stocks to their desired level by raising or cutting investment or by boosting production of durables takes time, so the flow of investment fills the gap gradually.  Moreover, the time lags between rate changes and the effects on the stock demands are significant.  Together, those factors imply that lags can stretch out over several quarters or more.

Consequently, analysis of the traditional transmission channels shows that interest rate sensitivity is lower than commonly thought.  In equations explaining the sensitivity of investment to changes in rates and changes in output, income and wealth, changes in the cost of finance are a statistically significant explanatory variable.  But the magnitude of the effect is small in practice. Moreover, other factors affecting the user cost of capital - such as collateral and expected price change - matter more.  In practice, empirical results show that a one-percentage point change in interest rates has about 20-40% of the impact of a one-percentage point change in income or wealth on credit-sensitive demand.  In other words, income and wealth are two to five times more important than interest rates for assessing demand for housing and other interest rate sensitive goods and services. 

Financial leverage affects rate sensitivity.  More subtly, we believe that the interest rate sensitivity of credit supply also depends on leverage at financial intermediaries.  An increase in leverage will boost the returns from carrying securities (magnifying the returns for a given change in interest rates), push up asset values, and expand the capacity of intermediaries to lend.  Conversely, a decline in leverage will magnify the cost of carrying securities, depress asset values, and promote balance sheet contraction.  This process is strongly procyclical, aggravating credit booms and busts.  Thus, aggregate liquidity depends not just on the supply of reserves from central banks, but also on the ability of financial intermediaries to expand their balance sheets.   

This is equivalent to saying that higher leverage increases the impact of any interest rate change, and lower leverage reduces that impact.  Comfort about default risk and high leverage increase the potency of any interest rate change, while stress and deleveraging reduce it.  Intuitively, that makes sense; in a credit crunch, the cost of finance has little bearing on financing ability; lenders' willingness to extend credit dominates.  Compared with two years ago, we think that the combination of an improving economy and lower financial leverage has significantly reduced interest rate sensitivity. 

Non-financial leverage also affects credit-sensitive outlays.  While financial leverage contributes to the supply of credit, household and business leverage influences the cost and the borrower's expected ROE.  Lenders often dictate such leverage through down-payments and collateral requirements, which also magnify the impact of changes in the availability of credit:  On the plus side, as lenders become more comfortable with corporate credit (default) risks, they may reduce today's high collateral requirements for business borrowers.  That will free borrowers' cash flow at the margin and reduce the cost of capital.  Macro factors will drive lenders' perceptions of those risks: In housing, where the risks are mixed, expectations of further declines in home prices today may keep lenders wary and down-payment cushions elevated, while rising incomes would greatly improve creditworthiness.

Housing: Illustrating the importance of non-financial leverage.  While the importance of leverage on the credit cycle and even on interest rate sensitivity may seem straightforward, no one has yet articulated the macro framework that connects all the elements.  Consequently, it may be convenient to look to numerical examples to flesh out their relative importance. 

Housing is the most obvious place to illustrate leverage, using housing affordability.  Indexes of housing affordability have many limitations, but they capture the ability to service debt, the cost of credit, and the willingness of lenders to extend it in a single measure.  Affordability indexes compare monthly payments on a typical home with typical family income, assuming an 80% LTV and a 30-year, conventional mortgage, thus combining rates, home prices and the means to service debt. 

Each of those factors affects household monthly payments; compared with income, those determine affordability.  Plunging home prices and rising incomes have made houses more affordable; we expect the former to decline by 5-10% this year, and the latter to grow strongly. 

Translating changes in these factors into borrowers' cash flows shows that a 10% drop in housing prices has about the same impact on affordability as a 1% decline in mortgage rates.  And a 1% rise in income would boost affordability by a similar amount. 

In periods of credit restraint, a higher down-payment could mean the difference between getting a mortgage or not; lenders will derive comfort from a bigger equity cushion and lower monthly payments.  Importantly, we think that a stronger economy that boosts income will improve aggregate creditworthiness and credit availability as it slowly spreads to mortgage markets, qualifies more borrowers, and gives lenders the incentive to lower down-payments to ‘normal' levels. 

Aggregate debt-service calculations also show the importance of income versus rates.  For example, a one percentage point increase in income will reduce debt/income and debt service/income by a similar amount.  And similar-sized paydowns or write-downs of debt will have similar effects.  In contrast, the benefits from refinancing existing mortgages are smaller.  A permanent, one percentage point decline in mortgage rates will reduce debt service in relation to income by only 60bp; it takes time to affect the average interest rate on the stock of mortgage debt.  

Consistency of calls for economy and yields.  These considerations - relatively low interest rate sensitivity and an improving economy - are critical for assessing the consistency of our calls on the economy and yields.  We expect real yields to rise because higher rates will clear the market as investment picks up significantly relative to saving (aided by uncertainty about inflation, the sustainability of US fiscal policy, and the appetite of global investors for US debt).  Put differently, the causality runs from the economy to interest rates, not from interest rates to the economy.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosure for Morgan Stanley Smith Barney LLC Customers The subject matter in this Morgan Stanley report may also be covered in a similar report from Citigroup Global Markets Inc. Ask your Financial Advisor or use Research Center to view any reports in addition to this report.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.