Ukraine
Ukraine: Support from East and West
April 27, 2010

By Oliver Weeks & Alina Slyusarchuk | London

The conclusion of a favourable gas price deal with Russia is positive in removing one large hurdle for a new IMF deal: A draft memorandum leaked to the local press indicates significant progress in negotiations.  Gas prices have still only returned to last year's levels, and we expect further difficult negotiations over Naftogaz support.  However, we continue to think that a deal is likely in the next month and remain positive on the interest rate outlook, with our USDUAH forecast still at 7.0 for end-2010. 

With the Treasury still almost empty and the government's ability to borrow essentially dependent on the expectation of IMF support, an IMF deal remains crucial to Ukraine's macro prospects.  We expect rapid progress on this in the next few weeks, with the gas settlement paving the way for the 2010 budget finally to be submitted to parliament this week.  Ukrainska Pravda has published a leaked version of a draft memorandum on economic policy from the government to the IMF, which the government has confirmed as genuine (albeit preliminary and incomplete).  The main points of this are:

•           Deficit: The 2010 general government deficit should be no more than 6.0% of GDP, including 1.0% of GDP spent on Naftogaz.  2010 VAT refunds will be completed and UAH 12 billion of 2009 VAT indebtedness will be covered by bonds issued at market rates in June. 

•           Revenue: Unspecified hikes in excise taxes on alcohol, tobacco and luxury goods.  Cancellation of VAT exemptions and lowering the threshold for payment of the single enterprise tax. 

•           Spending: A more targeted revision of the proposed law on social standards (unspecified), withdrawal of subsidies to enterprises (unspecified), and cancellation of the proposed 33% hike in the lowest category of state wages.  Cutting by half pensions paid to working pensioners and lowering the threshold for some social aid programmes to 50% of the subsistence minimum.

•           Gas: Immediate hike in the gas price for households by 75% and by 50% for utilities, followed by quarterly 25% increases until market levels are reached.  Subsidies for sugar, fertiliser, metals and chemical production to be cancelled by May.  (This drafted before last week's import price cut.)

•           Monetary: The law on NBU to be revised to make price stability the primary goal. The NBU to allow more exchange rate flexibility, to make interest rates its main instrument and announce regular rate-setting meetings.  Policy rates to be hiked and kept positive in real terms. The NBU to limit base money growth to 12% in 2010.  NBU independence to be reinforced and Council members with business and political interests to be excluded.  The tax on FX transactions and other restrictions on the FX market to be removed.

•           Banks: Up to UAH 20 billion to be spent on bank recapitalisation.  NBU to cut refinancing support to banks.  Nadra Bank to be recapitalised or liquidated by June.

The main areas of dispute now are likely to remain social spending and gas prices: The government, including Mr. Tygipko, has remained strongly and publicly committed to large minimum wage hikes.  The large gaps in this area of the memorandum underline that negotiations here have some way to go.  However, we think that the government will have little choice but to agree, given its pressing need for funding.  The gradual expansion of the Rada coalition with more defectors will tend to reduce the government's reliance on the Communist deputies most committed to the wage hikes.

On gas, we also expect negotiations still to be difficult.  While we suspect that the full detail of the agreement with Russia on gas prices will not become public for some time, the import price cut was at the high end of our expectations.  However, an import price of US$230/tcm is still only around the average for the last three quarters of 2009 (prices were higher in 1Q09 but little was imported at that price).  The government has been quick to claim that retail gas prices will not now need to be hiked.  The basic gas price for households is currently at UAH 348/tcm before VAT, equivalent to US$44, lower even than in Russia.  Utilities pay UAH 593, US$75; metal and chemical enterprises pay UAH 1,899, US$240; fertiliser producers UAH 1,584, US$200; and other corporates UAH 2,020, US$255 - so only the latter may see marginal reductions.  Households are supplied by domestically produced gas so it is possible that prices do not need to reach import parity, but local production has been falling, down 9.1% to 5.1 bcm in 1Q, due to unprofitability.  (Shale gas exploration has begun but does not look like a near-term prospect.)  The IMF was insisting on retail price hikes at last year's import price levels and looks unlikely to change its view on this.  In addition, Naftogaz ran a 2.5% of GDP deficit at last year's prices, and is likely to have been accumulating a deficit at an even higher rate in 1Q.  Without large retail gas price hikes, the target of a 1% of GDP Naftogaz deficit for the year seems unrealistic to us.  Naftogaz transparency is also likely to remain a contentious issue. 

We remain positive on the outlook for local rates and the UAH: The IMF requirements on the National Bank and FX policy have appeared in previous policy memoranda and largely been ignored.  Indeed, President Yanukovich last week appointed several new politicians and private sector bankers to the NBU Council.  We also think that the government and NBU will remain keen to limit UAH appreciation and prefer to build up reserves, given the interests of well-connected exporters.  Nevertheless, IMF pressure for a more flexible exchange rate is likely to have an impact at the margin.  The NBU has informally reported that the current account deficit was US$239 million in March while the financial account surplus was a huge US$1,271 million.  As cash and deposits return to UAH and foreign inflows pick up, appreciation pressure is likely to be significant.  Even if the NBU hikes policy rates, we think that pressure on local bond rates is likely to remain downwards, given high liquidity, high nominal rates and a gradually stronger UAH.  Demand for local debt should also be boosted by an NBU decision to allow 100% of required reserves (UAH 11.6 billion at the end of March) to be held in OVGZ government bonds.  Previously only 50% of required reserves had to be held at the NBU and only 20% of those could be in OVGZ, which yield far more than the 3.1% paid on required reserve deposits.  Execution of the IMF agreement may not be smooth, particularly as related to Naftogaz, but for now the likely announcement of a large (US$12.5 billion) deal looks still positive to us.

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CEEMEA
CEEMEA: A Survey of FX Intervention Policy
April 27, 2010

By CEEMEA Economics Team | London

We look at the various forms, nature and impact of FX interventions being practiced by the central banks in the region. As usual when looking at such a diverse region, there are a variety of approaches. Some central banks pursue a very active interventionist policy (Russia); others adopt a more hands-off approach (South Africa). The CBT accumulates reserves but its aim is not to affect the exchange rate. In Central Europe, each central bank has openly spoken against FX gains, though the attitude to FX intervention varies: Romania, Hungary and most recently Poland all keep the door to direct FX purchases open, though they do not buy foreign currency on a regular basis. Israel has been accumulating vast amounts of reserves to cap the rise in the shekel, pursuing a policy which ultimately looks unsustainable - hence our bullish view on ILS. And although the rhetoric regarding official FX accumulation in South Africa has increased, the SARB's policy stance on FX intervention remains one of ‘leaning against the wind'. We look at each sub-region in detail below.

Central Europe: FX Intervention Takes Many Forms

Historically, central banks across CEE have not adopted a uniform view on intervention. The Romanians and the Hungarians have intervened in the past, the Czechs have used rate policy in response to undesired moves in the koruna, whereas the Poles have adopted a more ‘hands-off' policy to the whole issue. At the present juncture, it looks clear to us that there is resistance to currency gains across the region, though, as always, country specifics matter a great deal. Despite the intervention threat, we continue to think that the zloty has upside, whereas we believe that the authorities will do their best to cap RON, CZK and HUF.

•           Poland: A new-found interventionist policy? Not so fast: The NBP surprised markets two weeks ago by intervening in the currency markets for the first time since 2000. As we wrote in the last CEEMEA Macro Monitor, we believe that the NBP's new-found interventionist streak aims at introducing two-way risk rather than targeting a specific level. Exporters are profitable with a EUR/PLN rate of up to 3.60, according to the latest NBP survey (7% lower than current). Crucially, this rate changes with the economic cycle (and indeed, EUR/PLN). Also, we do not think that the NBP objects to medium-term appreciation pressures, and neither does the Min Fin: the official convergence programme envisages a drop in the EURPLN rate to 3.55 in 2012 as its base case scenario. Once again, we think that the speed of the appreciation is the issue, not the process itself, which is simply a by-product of convergence (real convergence implies nominal price convergence too). Looking ahead, despite the March discussion of a possible rate cut, we think that the NBP will continue to act verbally and intervene as soon as it feels the zloty is running ahead of itself. But the overall trend of PLN gains should remain intact, we think.

•           Hungary: FX trade-off is skewed heavily towards exporters: The large amount of FX loans in the private sector (37% of GDP) makes HUF gains beneficial to a great deal of borrowers. However, as one of the most open economies in CEE, exporters are clearly less keen on currency strength. The authorities' views on this trade-off vary, and they are a function of: i) the level of HUF; ii) the growth backdrop; and iii) the inflation outlook. At present, all of these point to little or no appetite for HUF gains: at 265 versus EUR, the HUF is very far from levels that cause serious stress for borrowers (around EUR/HUF = 300); in addition, growth is almost entirely export-led, so the traded sector is absolutely crucial for growth and employment; and finally, the NBH forecasts sharp disinflation in 2010 and beyond even with a stable HUF at 269. We think that a move lower of EURHUF to the 250-260 area, especially if sudden, could easily be met with a larger rate cut, direct FX intervention or both.

•           Czech Republic: An even clearer preference for capped FX gains: In the Czech Republic, an economy as open as Hungary but without any meaningful presence of FX loans, the preferences around the currency are even clearer. As the growth outlook remains uncertain, the central bank has made it abundantly clear that fast FX gains are unwarranted. In addition, the inflation outlook remains benign for now (i.e., CZK gains not needed from that point of view), and CZK is trading close to the bank's end-2010 forecast, having appreciated 4.5% year-to-date versus the euro. Much as in Poland, the bank has no opposition to medium-term appreciation, but believes that a pace of around 3% in nominal terms is ideal. Direct intervention on the market seems unlikely. But a rate cut remains a distinct risk, perhaps as early as at the May meeting.

•           Romania: Intervention can be very effective: The National Bank of Romania has cut rates by a total of 375bp in this cycle, motivating the last few moves (in part) as driven by RON gains. The bank has recently, as others, expressed dislike of excessive leu gains. In the region, its track record shows that its direct interventions can be very effective: its heavily managed status is the reason why RON avoided a massive sell-off during the downturn. While we have been constructive on RON, recent speculation of intervention has tempered our enthusiasm somewhat.

Israel: Too Much of a Good Thing?

In Israel, in an attempt to take advantage of the FX inflows and hence fortify FX reserves as well as to provide liquidity to the market, the BoI started purchasing FX from the market on a daily basis in March 2008. The initial daily amount of US$25 million was raised to US$100 million in July 2008. As part of the decision to gradually remove the unconventional measures of monetary easing, the daily purchases were halted in August 2009. Since then, the BoI has been practicing a policy of directly intervening in the market with the aim of preventing the currency from appreciating markedly and possibly in a disorderly fashion. Over the past few weeks, the BoI has been active in the FX market almost every day, being the main buyer of FX against shekels. As a result, the FX reserves continued to ascend, reaching a new record of US$62.5 billion as of end-March. Based on BoI buying, we understand that, in March alone, the interventions reached US$500 million. Our preliminary calculations indicate that with the ongoing pace, the total purchases in April could easily exceed the levels seen in March and bring reserves to new highs.

Is this sustainable amid monetary tightening? This remains a rhetorical question as we believe that the BoI cannot (and should not) defend the shekel from appreciating for a very long time while raising interest rates. Not only is the effort to control both the rates and the currency not economically feasible, but it might also become more and more expensive as the sterilisation costs mount on the back of the rising size of sterilisation and the interest paid. As Governor Fischer indicated a few months ago, the intervention policy "cannot continue forever". For all intents and purposes, the size of the FX reserves is more than sufficient in our view as certain external risk ratios have improved dramatically, perhaps even more than necessary to justify the costs of maintaining a considerable level. In terms of the coverage of months of imports, at around 15, the figure is fairly high compared to the average of 10 months for a group of countries including Turkey, South Africa, Ukraine and the CE-4. Especially in terms of the size of FX reserves to the size of the economy, Israel stands out and compares with Saudi Arabia and Russia. The same ratio is also very high for Hungary, but a significant portion of FX reserves are comprised of funds received from the IMF, which we see as temporary. In our view, the reason behind the appreciation in the currency is not only because of the interest rate differential, but also due to the improvement of the macro indicators. While the reason behind the interventions had been to avoid loss of competitiveness, especially as the main trading partners such as the US and euro area still face risks to growth, so far export performance has been satisfactory. 

Russia: Very Active Interventions

In Russia, FX intervention remains extremely active, despite a long-term aspiration to move towards a more flexible RUB.  The CBR distinguishes two types of intervention.  ‘Planned' interventions are daily purchases of an amount set at the start of the month according to a formula that is non-public but linked to the CBR's estimate of the current account. Unplanned interventions come at the edge of the informal 3 RUB corridor, recently at the rate of US$700 million for a 5 kopeck shift in the corridor. In the last few weeks, the CBR seems to have significantly raised the rate of planned intervention to at least US$300 million daily, from US$150 million daily in March. The CBR's stated intention is to shift intervention almost entirely to pre-planned purchases, cutting back the edge of corridor intervention, but as yet there is little sign of the latter. Political resistance to RUB appreciation remains significant, and may currently be boosted by the disappointing pace of growth in 1Q. However, we expect intervention gradually to slow as growth and inflation pick up, and if, as we expect, CNY strength and EUR weakness allow appreciation against the basket with limited movement on the RUBUSD and RUBCNY axes. The CBR aspires to reduce intervention in order to regain control of interest rates and inflation. The Finance Ministry argues that while the oil Reserve Fund mechanism is not active and the government is spending all current oil revenue and more in a situation of balance of payments surplus, the effective choice is between nominal appreciation and inflation. We agree. The monetary base was up 48%Y in March. The CBR has massively stepped up OBR bond issuance to sterilise this, but is constrained by the risk of attracting more inflows with higher rates. We still forecast the RUB at 31 to the basket by year-end.

South Africa: Non-Interventionist Policy

In the case of South Africa, the SARB adopts a hands-off approach to currency intervention. This is partly due to the bitter lessons it learnt in 1998, when it dug a huge US$27 billion hole in its balance sheet while trying to defend the currency by selling US dollars forward. It took the bank the better part of the following five years to fully recover. After eventually closing out the Net Open Forward Position in May 2003, the SARB has steadily built up FX holdings of some US$38.3 billion as at March 2010. This level of reserves, although welcome, is woefully inadequate when one considers that the average daily turnover in the FX market in 2009 was as much as US$10.8 billion (US$2.7 billion in the spot market, US$7.4 billion in swaps and US$0.6 billion in forward transactions). The turnover statistic rises to US$14.2 billion when one includes transactions against third currencies. In other words, the country's FX reserve coverage ratio is no more than three days of turnover.  

Reserve accumulation strategy: The SARB's FX accumulation strategy is one of ‘creaming off' excess liquidity in the FX market, and/or ‘leaning against the wind' in times of undue pressure on the ZAR. In fact, the SARB frequently finds it necessary to reiterate its preference not to influence the value of the ZAR in the interest of achieving its inflation target, or in the interest of balanced and sustainable growth. The market, however, tends to think otherwise - especially after the Minister of Finance indicated in his February 2010 Budget speech that "We have [...] agreed with the Reserve Bank that we will continue to take steps to counter the volatility of the exchange rate and to lean against the wind during periods of rapid capital inflows, including reserve accumulation and further exchange control reform".

It is therefore not surprising that after the March FX reserves data showed a relatively high accumulation of US$2.6 billion; some market participants were concerned that the SARB must have changed its policy stance of only ‘leaning against the wind' to one that was more interventionist with the view to drive the currency weaker. We beg to differ:

Our analysis shows that, after adjusting for valuation effects, the US$2.6 billion reading was largely inflated by the proceeds of a US$2.0 billion Yankee bond issued by the National Treasury, with naked foreign exchange purchases by the Treasury accounting for US$ 0.6 billion. It is important to note that the naked foreign exchange was purchased by the Treasury - as confirmed in the March 2010 provisional financing figures of the government - and simply placed on deposit at the central bank. The Treasury reserves the right to draw down on the deposited funds as and when needed.

Whether the purchase was made by the SARB or the Treasury is irrelevant, as far as the impact on the market is concerned. The real issue, in our view, is whether the pace of accumulation suggests that the authorities have stepped beyond their ‘creaming-off' guidelines into ‘interventionist territory'. To investigate, we map historical FX purchases against movements in the currency, and conclude that, while the US$0.6 billion purchase in March is admittedly higher than the average change of US$0.4 billion in 2009 and the negative prints that have been recorded since the start of the year, it is broadly commensurate with the SARB's historical reaction function, given the extent of currency appreciation.

Turkey: Passive Interventions in Place

The history of FX interventions dates back to 2002 - the commencement of the policy of intervening in the volatility rather than the level of the currency as justified by the central bank administration at the time. During the era of very high real and nominal interest rates, the surge in capital inflows led the CBT to intervene in the currency directly but also resulted in the introduction of purchasing FX from the market on a daily basis via auctions. The direct interventions were mostly tilted towards reserve accumulation that reached a total of US$25.5 billion between 2002-06 against merely US$2.1 billion of FX sales. However, with the easing of real interest rates, lower volatility and the switch from an implicit to explicit inflation-targeting regime, the CBT's attitude shifted almost completely towards directly intervening to keeping the reserve accumulation effort limited to daily purchases. The CBT accumulated the bulk of the FX reserves during 2005-08, but since then the pace of increase slowed down obviously due to the global crisis and lack of sizeable inflows that led to a period of no auctions. In August 2009, the daily auctions commenced with a pace of US$30 million a day plus the optional US$30 million that would bring the theoretical daily maximum to US$60 million. So far in 2010, the auctions brought in US$3.6 billion and, given the average daily purchases of US$48 million, we calculate that the total size could reach US$11.3 billion (which would be a new record).

In our view, the daily FX auctions serve only two purposes: First, and most important, the CBT manages to accumulate reserves in a steady manner without disrupting the regularity of the market. Second, it helps lower the volatility to some extent, excepting occasional periods of heavy inflows or outflows. Other than that, we do not believe that the purchases have any impact on the level of the currency and we are not sure if the CBT would want to influence the currency anyway.

Comparatively low level of reserves: With the ongoing removal of liquidity in the market and our expectation of policy rate hikes in 2H10 as well as in 2011, we suspect that the strengthening tendency in the currency might necessitate raising the size of the daily auctions. This could be done via an outright increase in the base amount and/or the doubling of the optional amount. As we have mentioned earlier, the level of FX reserves in Turkey looks somewhat low, especially in comparison to the countries in the region. In terms of reserves to GDP, Turkey stands out as having the smallest ratio, while in terms of short-term external debt to reserves comes third after Poland and Ukraine. Hence, we believe that any effort to accumulate FX reserves in the coming months or years would improve these ratios and also stem the appreciation pressure on the currency that could otherwise place extra pressure on exports that are struggling with low external demand.

Saudi and UAE FX Policy: Infinite Interventions?

The currencies of Saudi Arabia and the UAE are strongly pegged to the US dollar. As such, this dictates continued government intervention in the FX market to keep the currency at the preset level. Saudi Arabia and the UAE have fixed their currencies to the US dollar at same level since 1987 and 1997, respectively. In our view, there will be no change in the exchange policy in these countries in the short term, and we believe that there is sufficient reason to argue for keeping the currency peg in place.

Our Case Favouring the Currency Pegs in GCC

We believe that a change in the exchange rate policy of Saudi Arabia and the UAE is unlikely over the near term, mainly because:  

i) The peg to the US dollar has served these countries well in the past and continues to be a strong anchour during these volatile times.

ii) It helps shield the domestic economy from fluctuations in oil markets and is somewhat aligned with the overall trade composition of Saudi Arabia and the UAE.

iii) Wavering on the official position regarding peg may invite counter-productive currency speculation at this critical juncture. 

iv) The US and the GCC economic cycles are currently aligned - both favouring low interest rates. However, our US macro team is forecasting a gradual tightening in US policy rates starting in 3Q10. Should this materialise, it may put pressure on the Saudi and the UAE monetary authorities to follow suit. Whether or not they do will depend on the strength of their economic recovery at that point. Regardless, we do not believe that this will affect their stance on the peg in the near term.

v) Political considerations and the potential impact of a change in the exchange rate regime on the US dollar may further reduce the incentive to veer away from the current policy.

In terms of the level of FX reserves in Saudi Arabia and in the UAE, there are some interesting facts to consider. For instance, the estimates of reserves differ widely between Saudi Arabia and the UAE, mainly due to the way official foreign assets are held in those countries. In Saudi Arabia, most of these assets are held with the monetary authority (SAMA), which in turn manages them very conservatively. We therefore use SAMA's net foreign assets of about US$415 billion as a surrogate for FX reserves, as does the IMF. In the case of the UAE, however, the vast majority of official foreign assets are held in sovereign wealth funds. These funds, the largest of which is the Abu Dhabi Investment Authority (ADIA), are not fully transparent, especially with respect to the size of assets under management. Moreover, according to anecdotal evidence, these funds have a more aggressive investment strategy than SAMA. A recent ADIA report shows that 45-65% of its portfolio is invested in equities, with an additional 7-18% invested in private equity and alternative investments. Due to this, only the central bank assets were included in our estimates of FX reserves. However, although these reserves may seem modest in size (about US$30 billion), we need to keep in mind that ADIA may at any point repatriate some of its significant foreign reserves (which according to market estimates are valued at around US$300-450 billion) to shore up the central bank's reserves, should the need arise.

Lowest import coverage ratio in the UAE: In the case of the UAE, we should note that a significant share of the country's imports is destined for re-exports and therefore do not necessarily require reserve coverage. Given the role of the UAE, and of Dubai specifically, as a regional trading hub, re-exports account for about 60-70% of non-oil exports. As such, if we were to exclude re-exports, the UAE's FX reserves in months of ‘net' imports would increase from about 2 to 3.5 months, which would bring the ratio somewhat more comparable to that of the Czech Republic and Turkey.

Conclusion

Despite its active interventionist policy, we see that ultimately RUB strength will be inevitable, and continue to see the RUB trading at 31 against the basket by year-end, especially as we think that official intervention pressures will slow as growth and inflation pick up. Similarly, we remain constructive on ILS, as it seems to us that the current FX policy is not feasible, and fundamentals (growth, current account) amply justify more shekel gains. On the ZAR, we acknowledge that opportunistic reserve accumulation is likely to continue, subject to the availability of fiscal resources. However, with a reserve coverage ratio of less than three days of turnover, SARB activity is unlikely to be aggressive. Also, we acknowledge new risks to our bullish PLN view coming from the NBP's new-found interventionist streak, but continue to think that the central bank will aim at introducing two-way risk in the market, rather than targeting a specific level. Therefore, the zloty remains our favourite currency pick in Central Europe.

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United States
Review and Preview
April 27, 2010

By Ted Wieseman | New York

A continued run of strong economic data and heavy upcoming supply pressured the short and intermediate parts of the Treasury curve over the past week, with the curve flattening significantly.  This negative domestic backdrop more than offset a flight-to-quality bid through midweek as the Greece situation rapidly worsened.  The severe financing strains that led the Greek government to formally request the implementation of the EU and IMF support program on Friday and concerns about the possibility of similar problems spreading to other fiscally troubled European countries boosted Treasuries through the first part of the week when there was little on the domestic economic calendar.  But even as the weakness in Greek government bonds severely intensified Thursday and saw little improvement Friday, Treasuries sharply reversed course as a good Greece-focused rally on Wednesday was more than reversed as investor attention shifted back to the domestic situation, where a run of strong data and another big supply announcement ahead of this week's FOMC meeting and run of four days of auctions from Monday to Thursday more than reversed the prior flight-to-safety bid.

It was a light week for economic data but the figures released showed big upside, extending the run of strong March reports and suggesting continued momentum into April.  Surprisingly robust capital goods order and shipments results pointed to better-than-expected 1Q business investment, leading us to boost our 1Q GDP forecast to +3.4% from +3.0%, and a strong starting point for further upside in 2Q.  We forecast similar 2Q GDP growth of +3.5%, but upside risks have become increasingly apparent as the economy appears to have had a lot of momentum in March heading into 2Q.  Home sales also saw major gains in March.  Decent renewed upside ahead of the expiration of the extended homebuyers' tax credit was widely expected, but the March results were still a lot better than anticipated.  And initial jobless claims saw a big drop in the latest week during the survey period for the employment report, reversing most of some recent elevation that appears largely to have resulted from Easter seasonal adjustment problems.  Our initial forecast for April non-farm payrolls is +250,000, which assumes 125,000 in temporary census hires and a notable further pick-up in underlying hiring.  The FOMC seems unlikely to make significant changes in its Wednesday statement after recent generally still cautious remarks on the economy and inflation outlook by a number of Fed officials, but if the improvement in growth extends into 2Q and core inflation shows signs of bottoming out, as we expect, we are probably getting close to meaningful further movement towards implementation of an exit strategy.  Recent press reports and Fed communications point to increased focus on asset sales to drain reserves, and we think a modest selling program could be announced soon, but we also still that think large-scale reverse repos and term deposits will also be needed.  Even with little expectation of action this week, futures market pricing of the Fed saw a decent adjustment the past week as the data showed surprising strength.  Fed funds futures pricing is now nearly in line with our forecast that the first rate hike will come in September, though the initial pace of tightening that is priced in is a lot slower than we think is likely.

On the week, benchmark Treasury yields were flat to up 13bp and the curve much flatter.  The 2-year yield rose 12bp to 1.07%, 3-year 13bp to 1.67%, 5-year 12bp to 2.59%, 7-year 9bp to 3.28% and 10-year 5bp to 3.82%, while the 30-year was flat at 4.67%.  This left 2s-30s down 13bp at a five-week low of 359bp.  TIPS performed relatively well, extending a gradual move higher in inflation breakevens that has been underway through April.  With the dollar strengthening significantly against the euro and yen, though weakening a bit against the Canadian dollar as the Bank of Canada dropped its version of "extended period" and warned of an imminent rate hike, commodity prices were little changed on the week.  TIPS were helped by a pretty bad PPI report, though, with the headline measure surging 0.7% on the biggest gain in food prices since 1984, the core showing a bit of underlying upside, and early-stage readings showing major acceleration in price quotes for cyclically sensitive industrial materials.  The 5-year TIPS yield rose 7bp to 0.31%, 10-year was steady at 1.44% and 30-year fell 2bp to 2.00%.  This lifted the benchmark 10-year inflation breakeven 5bp to 2.38%, high since early February. 5-year/5-year forward implied inflation rates have also been moving gradually higher recently and are moving back towards the top end of their historical range seen over the past decade after moderating through February and March.  Treasuries outperformed swaps, mortgages and agencies during the sell-off, in line with a recent pattern of relatively lower-beta moves in both directions by Treasuries relative to other interest rate markets.  The benchmark 10-year swap spread rose 2.75bp to zero.  Mortgage underperformance was minor, but by Friday, Fannie 4.5% MBS was trading just above par, with current coupon MBS yields up about 10bp to a bit below 4.5%.  This should be consistent with 30-year mortgage rates near 5.125% if sustained, slightly above the 5.07% average of the past two weeks. 

T-bill yields were little changed the past week, but there were notable moves in financing and interbank markets.  The overnight agency repo rate averaged slightly below Treasuries Thursday for the first time before they moved back on top of each other at 0.20% Friday, which itself has still been an unusual recent development as Treasury collateral supply has surged and agency repo market liquidity has been restrained by Fed buying.  Fed buying has also been an important issue in reducing mortgage collateral in repo markets.  Even aside from the reserve-draining needs, reverse repos of MBS and agencies by the Fed would be helpful to repo market trading by increasing collateral in these areas relative to Treasuries.  Meanwhile, there was a significant repricing of the Fed in fed funds futures and additional weakness on top of this in eurodollar futures.  The October fed funds contract lost 5.5bp to 0.36% and November 7bp to 0.435%, shifted the expected timing of the first rate hike towards our September forecast, though we think the initial pace of tightening will be a lot faster than the gradual move to only 1.5% by the fall of 2011 that futures are pricing in.  3-month LIBOR has been trending gradually higher since the Treasury began draining reserves for the Fed in late February through SFP bill issuance, but the rate of increase accelerated the past week with a rise to 0.321% from 0.305%.  Forward Libor/fed funds spreads also widened significantly on top of the Fed repricing, with 17bp losses by the June 11 and Sep 11 contracts the worst-performing eurodollar contracts.  This partly appeared to reflect some spillover from European funding pressures related to Greece concerns. 

Risk markets also largely were able ultimately to brush off the turmoil in Europe and focus on domestic fundamentals, with broad and substantial upside in 1Q earnings reports providing support for equities.  The S&P 500 gained 2.1% on the week to move to a new high since 2008.  All of the net gains came during a fairly steady move higher Thursday and Friday from an initially soft start Thursday that marked the peak in both US equity and Treasury market concerns about Greece for now.  Performance by sector reflected the improving economic backdrop, with the cyclical energy, consumer discretionary and industrial sectors performing best for the week and the more defensive healthcare, telecom and consumer staples areas lagging.  Corporate credit markets were more negatively impacted by the pressure on sovereign credit and concerns about the impact of changes to financial market reform and oversight, with the investment grade CDX index widening a couple of basis points to 89bp.  High yield did a bit better after at times late in the week holding in better with the stock market upside.  The high yield CDX index was 6bp tighter at 483bp through Thursday and was seeing small further improvement in late Friday trading.  Resilience of the municipal bond MCDX market was impressive as Greece's spreads over Germany hit new highs and this had significant spillovers into Portugal, Ireland and Spain.  The 5-year MCDX index was trading only a couple of basis points wider on the week near 123bp Friday afternoon after having reached its best level of the year of 115bp at Tuesday's close.  When Greece was previously under major pressure in early February, the MCDX index blew out to as wide as 180bp in sympathy.  Meanwhile, some differentiation developed over the past week between the subprime ABX market and commercial mortgage CMBX market after both had seen very sharp rallies in the first half of the month following the White House's announcement of its mortgage principal forgiveness plans.  This didn't have any obvious implications for poor commercial real estate credit trends, but the CMBX apparently got swept up in a short covering wave as ABX ramped up.  Over the latest week, the AAA ABX index kept rising by another 2% for a 21% rally so far this month.  But CMBX gave back some of the prior upside, with the previously strongest recently rallying sub-AAA areas doing worst - junior AAA down 6% on the week, AA 4% and A 5% (though this still left them much higher on the month). 

Durable goods orders fell 1.3% in March but only because of a 67% plunge in the volatile civilian aircraft component.  Excluding this category, order rose 2.5%, and non-defense capital goods ex aircraft orders, the key core gauge, were stronger, surging 4.0%.  Machinery continues to lead the upside in capital goods, surging 9% in March for a 22% rise over the past year, high in the available data back to the early 1990s.  Capital goods shipments also showed big upside, pointing to stronger investment in 1Q and a robust starting point for further gains in 2Q.  Non-defense capital goods ex aircraft shipments rose 2.2% in March on top of an upwardly revised 1.5% gain in February.  We now see business investment in equipment and software rising 6% in 1Q instead of 2%, a smaller payback from the 19% surge in 4Q that was partly a result of activity pulled forward ahead of the expiration of accelerated depreciation schedules at the end of last year. 

New home sales spiked 27% in March to 411,000 units annualized, just below the post-recession peak of 419,000 hit last July, while existing home sales surged 7% to 5.35 million.  That peak in new home sales came ahead of the initially scheduled expiration of the homebuyers' tax credit in November, and now we are seeing major renewed upside ahead of the extended April deadline to sign contracts for home sales to qualify for the credit, which then must be closed by the end of June.  Because new home sales are counted at contract signing and existing at closing, the former will probably see more near-term strength and quicker payback, while upside in the latter should extend through 2Q.  It won't be clear for a while how much of this improvement in sales is sustainable beyond the tax-related support, but housing affordability remains unusually high based on low mortgage rates and home prices, and consumer fundamentals are improving as the labor market improves and the credit crunch eases, so we expect the underlying trend to be modestly positive once we get through another period of volatility around the tax credit.

The upcoming week is busy, with Treasury market focus likely to be largely on supply and the Fed in the first part of the week and then shifting to economic data later in the week as investors start to look forward to the initial run of key April data that will be released during the first week of May.  The Treasury kept nominal issue sizes steady again at the record levels where they've been since December, while boosting the 5-year TIPS a bit more than expected, resulting in $129 billion in gross coupon supply in four days of auctions this week - $11 billion 5-year TIPS Monday, $44 billion 2s Tuesday, $42 billion 5s Wednesday and $32 billion 7s Thursday.  With underlying tax revenue growth having sharply turned the corner into positive territory in March and remaining solid so far in April and recent TARP repayments lowering outlays somewhat, a modestly improved financing outlook should allow Treasury to start gradually cutting nominal coupon sizes at the May refunding.  This would be in line with the outlook presented by Treasury at the February refunding announcement, when Deputy Assistant Secretary for Federal Finance Rutherford said that coupon sizes had peaked and could move lower over the course of the year depending on budget developments.  The Treasury asked the best way to implement coupon size reductions going forward in the dealer meeting agenda released Friday, and we think it should pursue moderate across the board cuts in nominal sizes in coming months and then probably eliminate the 3-year before too long if the budget continues on an improving trend into fiscal 2011.  TIPS, on the other hand, should continue to see increased issuance, and, in response to another question in the dealer agenda, we think that the addition of a second 5-year next year to fill out the calendar to have one TIPS auction a month is a good option. 

The FOMC meets Tuesday and Wednesday, and it appears likely that the statement released Wednesday will highlight the improvement in the incoming economic data while also continuing to suggest that the fed funds target will remain "exceptionally low...for an extended period".  Looking ahead, we think that the Fed might be best served by retaining "extended period" in June while dropping "exceptionally" from the key sentence - implying that monetary policy is likely to remain accommodative for a long time, but that this does not have to mean a zero policy rate.  The FOMC will likely also spend a lot of time discussing how best to proceed with draining of excess liquidity now that the SFP bill program has been fully ramped back up and will not be drawing down any more excess reserves going forward.  In our view, a small program of $50 billion or so of MBS sales over the first year starting around mid-year would probably have minimal market impact but would still represent an important first step in the right direction from the standpoint of the advocates of such sales.  We still believe that the Fed is going to have to rely largely on reverse repos and term deposits to accomplish the bulk of the draining over the coming year and that they should start to be ramped up over the summer. 

The economic data calendar is not too busy in the coming week.  Key releases include consumer confidence Tuesday and GDP and the employment cost index Friday:

* We expect the Conference Board's measure of consumer confidence to be flat at 52.5 in April.  Despite the recent rally in financial markets and a pick-up in consumer spending, sentiment still appears to be mired at a very low level.  Indeed, both the University of Michigan index and the weekly ABC barometer showed some deterioration during early April.  Interestingly, the text of the Michigan report cited enactment of healthcare reform as the key factor that has driven sentiment lower in recent weeks.  Since the Conference Board sentiment gauge was already lagging behind these other indicators, we look for an unchanged reading in April.

* We forecast a 3.4% rise in 1Q GDP.  This would be a moderation from 5.6% gain seen in 4Q, but all of the swing appears attributable to a smaller contribution from inventories.  Indeed, final sales are expected to be up 2.1% in 1Q - which would exceed the 4Q performance.  Meanwhile, the inventory swing is expected to add 1.3pp - down from the unusually large +3.8pp contribution seen in 4Q.  A pick-up in consumer spending (3.8%) should be the main bright spot in this quarter's GDP report.  However, both business fixed investment and residential construction appear likely to post outright declines on the heels of the modest gains seen in 4Q.  Finally, the GDP deflator is expected to show only a fractional increase (+0.5%) again this quarter.

* We look for a 0.5% rise in the 1Q employment cost index, matching the moderate rise seen in 4Q as a softening in the wage component is expected to be about offset by a bit of a pick-up in the benefits category.  On a year-on-year basis, the ECI is expected to tick up to +1.7% - still well below the +3.3% pace seen as recently as early-2008.

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