United States: Review and Preview

The Treasury curve posted a significant bear steepening sell-off over the past week, after a big front end-led rally to start the week was sharply unwound in a largely curve-neutral way over the rest of the week in response to solid economic data, a rebound in stocks and a positive response to the White House’s plan to freeze resets on some adjustable-rate subprime loans. While the economy clearly seems to be skirting with recession at this point — we see 4Q GDP running barely positive at +0.4%, up slightly from our +0.2% estimate coming into the week because of a boost to our consumption estimate — the downturn did not start in November. Both ISM surveys, while moderating a bit, remained in growth territory. Motor vehicle sales and chain store sales results in November were both better than expected, pointing to a robust retail sales report, at least in nominal terms. And, most important, the employment report showed a second straight month of solid job growth, along with a steady unemployment rate and a significant rebound in earnings that along with the gain in jobs pointed to good growth in overall personal income. While not out of the question, practically speaking it’s quite unlikely that the NBER would mark a recession as having started in a month of solidly positive job growth, even if 4Q GDP growth does dip into slightly negative territory. Continued worsening in interbank lending markets, what this is telling us about intense and worsening pressures on bank balance sheets and capital, and the implications of this for credit availability and pricing going forward, however, continue to point to significant downside growth risks. So, despite the solid early run of key November data, the Fed is still quite likely to cut rates on Tuesday, though the employment report took any meaningful suspense out of the likely magnitude of the cut. We think that the Fed is highly likely to cut the fed funds target by 25bp to 4.25% and not the 50bp the market had been increasingly hoping for before the jobs report.

We do still think, however, that there is a good chance that there will be further action on the discount window to more directly address the pressures in the interbank lending market. We look for a 50bp cut in the discount rate to 4.50% and a further extension in available loan terms to 90 days from 30 days.

For the week, benchmark Treasury coupon yields rose 7-19bp, with the long end hit particularly hard, leading to a significant curve steepening. The 2-year yield rose 7bp to 3.12%, the 5-year 9bp to 3.50%, the 10-year 15bp to 4.11%, and the 30-year 19bp (a more than 3-point price plunge) to 4.585%. Just about all the steepening occurred in a big front end-led rally to start the week Monday that didn’t have any particularly obvious triggers. As these gains were sharply reversed over the rest of the week, mostly in big losses Thursday and Friday, the longer end suffered as much as the shorter end, leading to no reversal of Monday’s bull steepening as the market reversed course. Even as oil prices ended very little changed for the week (with January crude oil dipping to US$88.28 from US$88.71), TIPS performed horribly, with the benchmark 5-year inflation breakeven falling 11bp to 2.15% and the 10-year 8bp to 2.26%. The solid run of initial November data (and perhaps also a bit of optimism about the subprime reset freeze plan) led the market to significantly scale back near and medium-term Fed rate-cutting expectations, with most of the adjustment in response to the solid employment report. Looking to Tuesday’s FOMC meeting, a 3bp sell-off in the January fed funds contract to 4.185% cut the odds of a 50bp rate cut to about 25% from 40%. That still seems quite high to us after the employment report, but admittedly the Fed did surprise us and most everyone else by cutting 50bp instead of 25bp in September. Meanwhile, the February contract only lost 1bp to 3.99%, so whether it’s 50bp Tuesday and a pause or 25bp then another 25bp in January, the market made essentially no adjustment in its firm expectations for a 4% funds target after the January 29-30 FOMC meeting. The April contract lost 4bp to 3.84%, and the May contract 8bp to 3.72%. Eurodollar losses were long end-led, in line with the Treasury curve steepening, though there were also sizeable losses at the short end as the market built in current LIBOR pressures remaining worse for longer, with the Mar 08 contract losing 23.5bp to 4.405% and the Jun 08 contract 21.5bp to 3.945%. On the other hand, while the front Dec 07 contract did sell off 14bp to 4.985%, it is still building in a meaningful pullback in 3-month LIBOR in the ten days remaining before this contract settles. Looking a bit further out, the reds (Dec 08 to Sep 09) lost 16-19bp, with the low-rate Dec 08 contract closing at 3.625%.

Risk markets had a modestly positive week to extend the improvement seen since the recent lows right before Thanksgiving, continuing to leave the badly stressed interbank lending market as the major focus of current financial market worries, though trading conditions in asset-backed commercial paper have also seen a substantial recent renewed deterioration as well. The S&P 500 rose 1.6% on the week to move above 1500 for the first time in a month, having now rallied 6.2% since the pre-Thanksgiving close on November 21. In afternoon trading, the 5-year HiVol CDX index was 2bp better on the week at 200bp and the investment grade index flat at 76bp, representing 25bp and 8bp of tightening, respectively, since November 21. The high yield index was 22bp better on the week at 471bp through Thursday’s close and the index was trading narrowly either side of unchanged through the day Friday, while the leveraged loan LCDX index had improved a slight 5bp on the week to 311bp midday Friday. Although an initially very positive reaction Monday to the subprime rescue plan was quickly mostly reversed, the subprime ABX market did still continue to gradually extend its modestly improving trend off the lows hit around Thanksgiving for the week. The biggest gain was posted by the AA index (43.00 versus 39.22). The AAA index (72.81 versus 71.81) also saw modest improvement. These two highest-rated indices that have become the focus recently are still way below the mid-90s for the AAA and mid-80s for the AA where they were trading in the first part of October, but they’ve managed a decent bounce off the lows in the mid-60s and mid-30s hit around Thanksgiving. The commercial mortgage CMBX market also had a good week, with all the indices reaching their best levels since the very sharp sell-off this market experienced in the first week of November (when a period of significant contagion spillover from then ongoing ABX meltdown seemed to have started).

While the economy certainly seems to be flirting with the start of a recession — at least by the old rule of thumb of two negative GDP prints if not by the more rigorous official NBER analysis — the key round of early November data released over the past week made clear that a recession did not start last month. Employment growth was solid for a second straight month. Both ISM surveys pointed to growth, albeit slightly slower growth than in October. And consumer spending growth appears to have been surprisingly solid in November, leading us to boost our 4Q consumption forecast to +1.6% from +1.3% and our GDP forecast to +0.4% from +0.2%.

Non-farm payrolls rose a solid 94,000 in November on top of a 170,000 gain in October, though there was a significant downward revision to September (+44,000 versus +96,000). November job growth was led by retail (+24,000), government (+30,000), business services (+30,000), healthcare (+25,000), and leisure (+26,000), which offset weakness in construction (-24,000), a relatively small decline in manufacturing (-11,000), and strike-related downside in information (-6,000). Other details of the report were positive. The unemployment rate held steady at 4.7%. Average hourly earnings surged 0.5% after a couple of sluggish months. Along with a 0.1% rise in aggregate hours worked, this lifted aggregate weekly payrolls to a 0.5% gain, pointing to strong nominal personal income growth in November. The income gain will be significantly smaller in real terms, however, given what is expected to be significant upside in headline inflation caused by a surge in gasoline prices. The retail gasoline price surge topped out in mid-November, however, and has started to move slightly in the other direction the past couple weeks, pointing to support for consumer spending power going forward. Details of the employment report along with motor vehicle assembly results also pointed to a solid gain in industrial production in November.

Consumer spending appears to have been surprisingly robust in November.

Motor vehicle sales posted a slight increase to a 16.2 million annual rate from 16.1 million in October rather than the further small decline to 15.8 million we had expected. And chain store sales results were better than expected also. A weighted average composite we put together of the major companies showed overall comp store sales up 4.4% overall and 4.6% excluding drug stores. The latter was well above the +3.1% consensus. While a calendar shift to an earlier Thanksgiving boosted results and we were therefore conservative in translating them into retail sales estimates, they still pointed to better outcomes for several key discretionary components than we had previously assumed.

Incorporating the motor vehicle and chain store sales results, we raised our retail sales forecast to +1.0% overall and ex autos from our preliminary +0.5-0.8% estimate. We also boosted our forecast for the key ‘retail control’ grouping, which along with the boost to motor vehicle sales led us to raise our 4Q consumption forecast to +1.6% from +1.2%, raising our GDP forecast to +0.4% from +0.2%.

Meanwhile, both ISM surveys pointed to growth in November, though a bit slower than in October. The composite manufacturing ISM diffusion index dipped marginally to 50.8 in November from 50.9 in October. Among the key components, orders (52.6 versus 52.5) were little changed, production (51.9 versus 49.6) partially rebounded from a big drop last month, and employment (47.8 versus 52.0) hit a four-year low. The production gain suggested that last month’s weakness was likely partly related to the GM strike, while the move in the employment index below 50 left it more consistent with steady declines in factory payrolls over the past year.

Growth by industry was narrowly based, with 7 of 18 sectors reporting expansion in November, down from 9 in October. The prices paid index rose 2.5 points to 65.5, with the upside attributable to energy and energy related items. The non-manufacturing ISM survey’s headline business activity index fell to 54.1 in November, down from 55.8 in October but remaining well above the 50 boom/bust line. Ten of 18 sectors reported growth (led by information, retail, real estate and government), six contraction (including finance, strike-impacted entertainment and transportation), and two no change. Key activity measures were softer, with the orders index falling to 51.1 from 55.7 and employment to 50.8 from 51.8. The prices paid index surged to 76.5 from 63.5, with a wide range of energy and energy-related items reported up in price.

While economic data released the past week provided no real basis for a rate cut at Tuesday’s FOMC meeting, we continue to see significant downside risks going forward from the intense and worsening squeeze on the banking system, which continues to be starkly illustrated by upward pressure on term LIBOR. While the relentless move higher in 3-month and 1-month LIBOR that had run to three straight weeks of uninterrupted daily increases finally stopped over the second half of the past week, the deterioration in this market since the last FOMC meeting at the end of August remains highly disturbing — including clearly to Fed officials, given the focus placed on this development in Fed Vice Chairman Kohn’s key recent speech. At the end of the latest week, 3-month LIBOR fixed at 5.14% (pulling back just barely from the 5.15% peak hit Wednesday), up from 4.89% at the end of October, while 1-month LIBOR closed the week at 5.24% (also just marginally off Wednesday’s 5.25% high), up from 4.71% at the end of October. Of course, Fed expectations have turned much more dovish since the last end of October FOMC statement’s warning not to expect a December rate cut. The spread of 3-month LIBOR over the expected average fed funds rate over the next three months has blown out to 103bp from what was already a very high, if at the time at least improving, 43bp at the end of October. The current spreads of 3-month LIBOR over expected fed funds has moved beyond anything seen during the August/early September market turmoil.

This deterioration in interbank markets is the key risk facing the economy at this point, in our view, and, judging from the emphasis it received from Vice Chairman Kohn, it seems in the Fed’s as well, providing the basis for a rate cut Tuesday that the economic data are not really calling for at this point. The LIBOR stress is a problem in two ways. First, term LIBOR, in particular 3-month LIBOR, is in and of itself a key benchmark rate for various markets and loans. So, the upward pressure on 3-month LIBOR is a direct restraint on the economy. Second, and more important, is what the LIBOR situation is telling us about the severe and apparently significantly worsening pressure on bank balance sheets and capital, with clear and possibly severe negative repercussions for credit availability and pricing to businesses and consumers — pointing to increasing downside risks to capital spending and consumption going forward. These risks, and the signs that they are getting worse implied by the blowout in LIBOR/fed funds spreads since the last FOMC meeting, appear likely to be the key basis of downwardly revised economic forecasts that FOMC members probably discuss Tuesday and base their likely rate cut on.

Still, with the economic data not looking all that bad up to this point, we think it’s quite likely that the Fed to confine itself to a 25bp rate cut to 4.25%, bringing the cumulative reduction since September to 100bp — quite a bit of easing in anticipation of an economic downturn that in large part has not yet emerged, though it does appear clear that growth, if it’s positive at all, will be dramatically slower in 4Q than the very strong middle quarters of the year. Rather than more aggressively cut the funds target, we instead look for the Board of Governors to try to more directly address the term interbank lending squeeze through the discount window. We expect a 50bp cut in the discount rate to 4.50% from 5.00%, cutting the spread over the funds target to 25bp from 50bp currently and 100bp in normal times. We also look for the available loan terms to be extended to 90 days from 30 days currently and 1 day normally. Policymakers received some encouraging news on the potential efficacy of the discount window to tackle these problems the past week. As 1-month LIBOR blew well through the current 5% discount rate at which loans are available for a month, there was a significant amount of discount window borrowing in the latest week. This appears to have been the first meaningful such borrowing since terms were first eased in August that was based on purely economic considerations. A prior significant round of borrowing shortly after the initial adjustments were made was solely symbolic in nature, as the banks that did the borrowing clearly had cheaper funding alternatives available, since 1-month LIBOR at that point was still below the lowered discount rate.

In addition to the main focus on the Fed, a number of key data economic reports will be released in the coming week, including the trade balance and Treasury budget Wednesday, retail sales and PPI Thursday, and CPI and industrial production Friday:

* We look for the trade gap to widen a bit less than a billion dollars to US$57.3 billion after hitting a two-and-a-half-year low last month, with exports rising 0.6% and imports 0.9%. On the export side, we look for decent upside in capital goods, led by high-tech products, partly offset by some moderation in food after the incredible surge seen over the past few months and some slowing in autos in line with more sluggish assembly schedules. The import gain should be accounted for by energy products, with both petroleum products and natural gas expected to show decent upside ahead of some bigger price-related gains in coming months. On the other hand, continued sluggish activity at key West Coast ports suggests continued softness in non-energy goods imports.

* We expect the federal government to report a November budget deficit of US$95 billion in November, US$22 billion wider than a year ago. However, the bulk of this swing is attributable to calendar effects.

Specifically, roughly US$20 billion of regular payments typically made at the beginning of the month were pushed forward because December 1 fell on a weekend. We continue to see the budget deficit tracking at US$200 billion in FY 2008. Finally, note that we have long assumed a series of temporary extensions of AMT relief, so the latest Congressional action has no impact on our budget estimates.

* We forecast a 1.0% surge in November retail sales, overall and excluding autos. The chain store results were considerably stronger than expected, but came with a cautionary warning that some of the upside was attributable to calendar effects that are likely to be unwound in December. This makes it even more difficult than usual to translate the company figures into a retail sales forecast (because it is hard to identify the extent to which the seasonal adjustment factor will compensate for the calendar shift). As a result, we have tried to be conservative in extrapolating the chain store figures, but still come up with sharp gains in key categories such as general merchandise and apparel. Also, the motor vehicle unit sales point to a modest advance in the auto dealer component. And, of course, much of the elevation in November sales is still expected to come from higher gasoline prices — our estimate for sales ex autos and gas stations is +0.4%. Finally, even after shaving our assumptions for December, the changes to our November expectations take our 4Q consumption forecast to +1.6% which moves the tracking estimate for 4Q GDP from +0.2% to +0.4%.

* We expect the headline producer price index to surge 1.9% in November, matching a 30-year high due largely to an unprecedented spike in gasoline prices. Indeed, the seasonal adjustment factor this month should magnify an already sizeable jump in spot market quotes for gasoline. Meanwhile, we look for the food category to flatten out following outsized gains in both September and October. Finally, the core should rise 0.3%, a sharper advance than seen in recent months, but just about all of the anticipated upside is attributable to a likely rebound in the quirky light truck component.

* We look for the November consumer price index to rise 0.6% overall and 0.2% ex food and energy. A nearly 10% spike in gasoline prices is expected to lead to the sharpest jump in the headline CPI since May. The elevation in the energy component should more than outweigh an expected moderation in food prices, driven by some recent softening in quotes for meat and dairy items. Meanwhile, the core is expected to be right in line with the October result (+0.17% before rounding), with a rebound in hotel rates being about offset by modest outright declines in the apparel, motor vehicle, and communications categories. The core should hold at a year-on-year rate of +2.2% in November.

* We forecast a 0.4% rise in November industrial production. The employment report showed the first uptick in manufacturing hours in the past several months. So, despite a likely pullback in the utility category tied to unusually mild temperatures, headline IP is expected to post its sharpest advance since July. A rebound in motor vehicle assemblies is expected to lead the way, but solid gains are also anticipated in categories such as electrical equipment, computers and plastics. Finally, it’s worth noting that the upswing in production may prove temporary because the latest automaker assembly schedules plans point to a sharp cutbacks in output in both December and January.

By Ted Wieseman & David Greenlaw New York
Morgan Stanley
Deccember 10, 2007