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Fed may hold rates: JP Morgan

March 20, 2007 16:27 IST

David G Fernandez, head of Emerging Asia Eco & Sovereign Research, JP Morgan, states that Fed is likely to keep rates on hold in the forseeable future.

According to JP Morgan, the US economy could show resilience around the second or third quarter on the housing front, which will increase chances of rate hikes. Risk aversion will stay in the market.

They believe there is a possibility of more unwinding of the Yen cary trade. Yen carry trade may resume in another two weeks.

They feel that Bank of Japan will not hike rates till August or September. Risk aversion, according to Fernandez, will stay for a couple of weeks.

Excerpts from CNBC-TV18's exclusive interview with David Fernandez:

How is the global situation right now, is it hazy or okay?

It is still hazy and people would be wise to stay cautious not just for this week, but potentially for the next couple of ones as well.

Last time when we had been in the middle of this short correction, I had said that it would take a couple of weeks for this uncertainty to clear out and I stick to that view and don't think anything will be clarified after this weeks FOMC meeting and BoJ hasn't contributed much to clear up the picture either.

The sub-prime story persistently will keep troubling the market and so in this environment participants are advised to stay cautious.

There are some expectations that the Fed may say something that is slightly bullish in nature, which might soften the kind of edginess seen in the market. Do you expect anything from the Fed tomorrow?

Not really, although there is hope out there that the Fed would come to the rescue and that would take form, in this Wednesday's statement of dropping the bias of risks towards higher inflation than the Fed has been sticking to for quite some time.

I think it is unlikely that they will change the bias of risks in the statement this week as it was put in place predicated on the idea of higher resource utilisation in the US and since that situation has not changed, the unemployment rate is ticking down and the inflation rate as measured by CPI on last Friday still staying uncomfortably outside the Fed's comfort zone, and if that is why they put the bias inflation in place, there is no reason for them to remove it this week.

There are some who believe that the longer the Fed stays on hold, the greater the chances of a bigger cut. Would you go with that?

It is possible but it is not a scenario that I would go with. I do think that the Fed is going to stay on hold for foreseeable future and there will be clarification for the Fed in terms of inflation picture clearing up - that is something that the Fed has been expressing some hope on and that is something that will change in the statement this Wednesday.

In the previous statements, the Fed has indicated that they thought the growth as well as inflation would slow down. I think it will have to acknowledge that while that hope is still there, the chances of it happening are diminishing as we are seeing inflation stay persistently outside their comfort zone.

I think the Fed will say that growth is very sluggish and our forecast at JP Morgan is that if Q1 growth stayed at around 2 per cent level that is relative to 2.2 per cent at the end of last year in the Q4 of 2006; so sub par growth continues to be the theme, yet inflation stays persistent.

In an environment of worsening growth-inflation tradeoff that the Fed is facing, it will stand still.

The forecast then is what happens 2-3 months from now in terms of growth. My view is that if the US economy once again shows resilience in face of this housing market troubles and bounces up as we reach mid-year, and growth cracks the 3 per cent mark around Q2-Q3 of this year - then in that environment I would say that a Fed on hold increases the likely hood of rate hikes as we get towards the turn of this year, not of rate cuts.

You do track some of the fund activity coming in from Japan. Against this global backdrop, how have you read the concerns on yen carry trade and how much more risk aversion do you expect to see?

There is still a possibility of more unwinding of that, as risk aversion will stay in the market. We have gone quite a way to unwinding it in the first couple of weeks of this recent bout of risk aversion. Right now, people understand that the Bank of Japan is going to stay out of the picture, and it should be clear in Fukui's press conference that you are not likely to see BoJ backing and thinking about rate hikes until August-September at earliest and in that environment, as long as we get back to the view that the Fed stays out of the game and will not cut rates.

People should see that all will eventually be clear for the yen carry trade to be put back on and the capital will continue to flow out of Japan. In that environment, most emerging markets will be the beneficiaries. I think that is where we are going to get you; I do not think we are there yet and it could be couple of weeks for this whole market risk aversion scenario to settle down and once it does, I think the yen carry trade is going to carry on.

Stephen Roach from Morgan Stanley has been writing some scary reports about the sub-prime mortgage market; I am sure you read them. Do you agree with those reports that the market might be missing or underestimating the spillover impact from the housing market out there which could make it self more prominent as the year progresses?

I think it is also fair to say that there are people who have been chronically bearish on the US economy, which should augur some reason to poke at the US economy and to tumble over and certainly the mortgage equity withdrawal last year was going to cause the downfall in the US economy, but didn't happen.

It is possible that the sub-prime problems could spillover and cause a general tightening of lending standards and that credit will not be broadly available in the US, which would indeed be a cause for concern.

If people want to be bearish on the US economy because of the sub-primes you can track, you should see something - for example - happen to mortgage applications, that people should start to pullback, see credit unavailable to them and you could see mortgage application in the US on a high frequency basis start to pullback sharply, which hasn't happened yet.

This is an environment where sub-prime is in fact been correcting now for six to nine months already in the US.

So a lot of the sub-prime unwind has actually occurred already; you haven't seen broad credit availability in the US tighten yet, I am not saying it is impossible, which I do think is a concern. Look at not only the non-foreign payrolls but also the weekly jobless claims and all these high frequency indicators till now as we get towards the end of the Q1 despite the fact that we are six to nine months in the sub-prime already unwinding; you haven't seen the US economies cease up yet.

Track it, follow it now and my view is that you will see resilience again and the US economy is able to, in fact, as it has pulled back, bear in mind we had now two clear quarters that are sub-par US growth Q4 of last year Q1 of this year. If the US economy gets through this, then you are probably going to see growth bounce up, which is our forecast above 3 per cent and I think that a lot of people then will be surprised with that outcome.

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