NEWS / Foreign Exchange

Factory Sector Shows Convincing Signs of Slowing Conditions

The Fed remains focused on fighting inflation with a warning of possibly weaker economic conditions included in their outlook statement. Historically, the Fed has not been able to achieve soft-landing without lowering the federal funds rate, with the 1995 episode the most recent case in point. Financial markets are watching closely the recent trend of major indicators to establish the extent of slowing conditions. The ISM manufacturing survey results for March present a convincing sign of persistent slowing conditions in the nation??™s factory sector. The composite index fell to 50.9 in March from 52.3 in February. The 6-month moving average of the composite index at 50.9 is the lowest since August 2003.

Indexes tracking new orders, production, employment, inventories, imports, and backlogs fell in March. The employment index (48.7) is the lowest since October 2003. The survey publishes comments from respondents. In March, three out of the five respondents??™ comments ran as follows: (1) ???Slowdown evident (Computer & Electronic Products).??? (2) ???General business conditions show significant sings of slowing in the manufacturing sector (Transportation Equipment).???(3) ???Business is slowing, but we are slightly ahead of last year??™s sales. We are projecting a flat year in sales for 2007 (Furniture & Related Products).??? The comment from the furniture industry should not be surprising given weak conditions in the housing sector. However, other comments are noteworthy.

Japan: The Latest Tankan Shows Us More of What We Have Already Seen

The Tokyo markets start off every quarter with the Bank of Japan??™s release of the Tankan survey, and the headline series of large manufacturing enterprises is taken quite seriously (though some smaller surveys such as the Shoko Chukin survey have been rising in prominence). Today??™s Tankan release suggested that while sentiment dipped by two points in the actual conditions and forecast conditions indices, the larger companies still performed well in Q1 and were expected to post good, if slightly lower, figures in Q2 as well. This is good news you believe the Tankan is a nice leading indicator of economic performance, but as indicators go we prefer describing it with a different term ??“ lagging.

Since the revision of the Tankan that created a new series starting at the end of 2003, we have monitored the performance of the index for forecasting business conditions for manufacturing companies. There is a certain relationship between real GDP growth and the forecast series when the latter is adjusted forward by three quarters (i.e. the Q1 2006 forecast shows up in Q4 2006 GDP data), but this relationship is not strong by any means (r=0.47) and the turns in the cycle (the parts that really count) do not tie together whatsoever. In fact, a slightly stronger relationship exists when the forecast series is backed up by two quarters (i.e. the Q2 2007 forecast explains what happened in Q4 2006. The correlation is a little stronger (r=0.53) and the turns in the series are a little more in sync.

We will grant that the last two quarter of our GDP series do not fit handsomely with the lagged Tankan forecast series, but it is indeed curious to notice that the areas that fit better at the peaks and troughs are in 2003 through 2005 ??“ a span where the GDP data have already been revised and polished in an effort to better show the ???true??? economic performance. The Tankan does not receive such revisions ??“ what we see is what we get. Therefore, our interpretation of the Tankan release is as follows: The economy in 2006 was strong, with fairly even growth throughout the year after a pronounced acceleration in 2005.

India: Intra-Meeting Rate Hike Suggests Strong Concerns by Reserve Bank

After market close on March 30, the Reserve Bank of India (RBI) made an intra-policy meeting announcement that it was raising the repo rate by 25 basis points to 7.75%, effective immediately, and raising the cash reserve ratio (CRR) by 50 basis points to 6.50%, to be implemented in installments throughout April. The market consensus had been expecting a rate hike at the next RBI policy meeting on April 24, so this surprise move has been scrutinized more for its odd timing rather than its direction or magnitude.

The RBI has been in a tightening mood since mid-2004. Since that time it has increased the repo rate and the reverse repo rate by 175 basis points and 150 basis points respectively, alongside 125 basis points of CCR increases (not including the just-announced tightening). This has been done in an effort to cool an economy that has seemingly been growing faster every quarter and is now believed to be overheating. Inflation has accelerated over the past twelve months, despite RBI tightening over the course of 2006. Yesterday the Labor Bureau of India announced that year-over-year inflation had touched 7.6% for the industrial worker CPI and 9.5% for the rural worker CPI, and both indexes are on a sharp upward trajectory. There is now concern that price increases may not be able to be pulled back down to the RBI??™s preferred 5.0-5.5% range.

Technically, the RBI??™s announcement was made before the CPI data were formally released, but there was plenty of evidence that could have led the Reserve Bank to assume that the inflation report would be unpleasant, and therefore announce a rate hike to pre-empt the bad figures. More importantly, we believe that this timing coincides with the new fiscal year, which officially started on April 1. Despite annual promises from the national and state governments to curtail spending excesses, it seems that a few extra checks get written every year and the deficits always extend beyond projections ??“ a little more so if elections are approaching. There is a good chance that the RBI recognized the inflationary potential of the new budget for fiscal year 2007-08, and sought to ease the impact it would have on prices.

While the RBI has insisted that rates are not necessarily at their peak, and that further hikes will depend on the behavior of inflation, we believe that the end of this tightening cycle may be seen in either this quarter or in Q3. We took a little look at the behavior of M2 over the past few years, and noticed that in cases where M2 growth exceeded nominal GDP growth by a significant amount, inflation was soon to follow. The correlations suggested that a six-to-nine month lag existed, but the tightness of this relationship was not exactly perfect. What is evident, however, is that Q1 2006 M2 growth was running over 14% higher than nominal GDP growth, and that during the following three quarters it has slowed dramatically. If this relationship with price increases holds, then inflation might just peak this quarter and provide the RBI with a reason to hold off on further increases by June or July, depending on the timing of the data releases.

For now, we believe that the RBI will raise at least one key interest rate after its April 24 meeting, and quite possibly both the repo rate and the reverse repo rate will get bumped up by a quarterpercentage point. After that time, we will also be watching the CPI reports along with the Reserve Bank, and we will be expecting inflation to top off by June (June data will be released around end-July or early August).