United States: Review and Preview

The Treasury curve posted another major steepening move over the past week on big front-end gains and small back-end losses as Fed Chairman Bernanke confirmed market expectations for a 50bp rate cut at the upcoming FOMC meeting. Indeed, the Chairman even hinted at the possibility of an inter-meeting rate cut with his statement that “the Committee must remain exceptionally alert and flexible”. We certainly wouldn’t rule out an inter-meeting cut, but think that it’s pretty unlikely.

We don’t see a near-term data release that would provide a clear trigger for such a move. And stabilization in credit markets over the second half of the week – in response first to comments by Berkshire Hathaway that it was actively discussing buying or otherwise supporting a major bond insurer and then to news of the buyout of Countrywide by Bank of America – would seem to remove the need for an urgent response to what at midweek had appeared to be an increasingly disorderly collapse in credit markets. The market, on the other hand, sees an immediate cut as a good possibility. By the end of the week, a reasonably high chance was being priced into futures markets that the Fed would cut the funds target by 50bp as early as Monday and then cut another 25bp at the January 29-30 FOMC meeting, though just a 50bp cut at the meeting was still priced as the modestly more likely outcome. It was a light week for economic data, but key reports were weak. Most notable were even worse-than-expected chain store sales results for December, which pointed to a negative retail sales report on Tuesday, the key release in the upcoming week’s very busy economic calendar. While the soft December comes too late in the quarter to prevent 4Q07 as a whole from still posting a solid gain in consumer spending, it clearly provides a poor starting point for what we expect will be a much worse 1Q for the consumer. Meanwhile, the November trade report was much worse than expected and suggested that net exports will provide only marginal support to 4Q growth after being a major positive in 2Q and 3Q. We expect that exports will be a major support to the economy during the mild recession we forecast for the first half of this year, so the soft results for November coming after the big pullback in the ISM export orders index in December is worrisome. Mostly as a result of the trade surprise, we cut our 4Q07 GDP forecast to +1.2% from +1.7%.

At this early point, the trajectory for 1Q GDP appears to be slightly worse than our -0.8% forecast.

On the week, 2s-10s steepened 9bp to 122bp and 2s-30s 17bp to 180bp, both highs since December 2004, as the 2-year yield fell 14bp to 2.59%, the 5-year 9bp to 3.07% and the 10-year 5bp to 3.81%, while the long bond yield rose 3bp to 4.39%. A much more dovish Fed path was priced into futures markets through the first half of this year, with a more moderate adjustment beyond that. In the very short term, the January fed funds contract gained 4.5bp to 4.10% and the February contract 18.5bp to 3.65%, pricing in roughly a 40% chance that the FOMC will cut the funds target to 3.75% Monday and then to 3.50% at the January 29-30 FOMC meeting. The April contract gained 29bp to 3.315%, pricing a further cut to 3.25% at the March FOMC meeting, the May contract rose 34.5bp to 3.06%, pricing a move to 3% at the April meeting, and the July contract rallied 34bp to 2.875%, pricing a toss up on whether the funds target will be 2.75% or 3% after the June meeting. If not by June, the move to 2.75% is seen as coming shortly thereafter and then a final cut to 2.50% by late 2008 or early 2009, with the Sep 08 eurodollar futures contract gaining 25.5bp to 2.955% and the low-rate Dec 08 contract 18bp to 2.90%. Gains beyond that were significantly smaller, with the 2009 contracts rising 11-13.5bp and the 2010 contracts 12-14bp. Given the strong language coming from the Fed Chairman, it’s no surprise that investors are pricing such an aggressive near-term Fed path. We’re more stuck by how pessimistic investors are about the how successful the Fed’s actions will be in getting the economy back on track in 2009 and beyond. The Dec 09 eurodollar futures contract at only 3.305% and the Dec 10 contract at 3.925% point to significant pessimism about the possibility for a decent cyclical rebound from the expected 2008 recession. The 5-year TIPS yield at just 0.84% sends an even more dire message about market expectations for the prospects of a post-recession rebound.

Stocks ended the week a bit worse after rebounding off their midweek lows, with the S&P 500 down 0.8% on the week. The week’s much bigger story in risk markets was credit. The credit markets seemed to on the verge of an increasingly panicked rout through late Wednesday before staging a solid rebound off the lows following the Berkshire Hathaway and Countrywide news. In late trading Friday, the 5-year HiVol CDX index was trading 9bp wider at the week at 240bp and the broader investment grade index 8bp wider at 97bp, but this represented a big improvement from the all-time wides hit Wednesday afternoon just before the Berkshire Hathaway interview on CNBC of 278bp and 107bp, respectively. Meanwhile, money markets continued to show signs of improvement. 3-month LIBOR fell sharply on the week to 4.26% from 4.62%. The more important improvement relative to expected fed funds was significant, but much more modest given how big the Fed repricing was, with the 3-month LIBOR/3-month OIS spread falling 12bp to 62bp. This represents a big improvement from the 100+bp levels seen in early December before the TAF program began, but is still above even levels in the mid-40s hit in late October, not to mention more normal levels near 8bp. Meanwhile, significant improvement continued in the asset-backed commercial paper market. The amount of ABCP outstanding rose for a second straight week after a prior string of 20 straight declines. This could be a key development in prompting further improvement in LIBOR/OIS spreads to the extent that banks become more comfortable that demands are fading to pull asset-backed securities backed by off-balance sheet ABCP programs on balance sheet or otherwise provide support to these programs. Term ABCP yields also fell substantially on the week and tightened versus LIBOR, while our desk noted a significant pick-up in term activity relative to overnight post-Bernanke.

It was a very light week for economic news, but the key data that were released were negative. Most notable were even worse chain store sales results for December than already weak expectations, with particularly terrible numbers from department stores and clothing retailers. Incorporating these results, we cut our retail sales forecast to -0.2% overall and -0.5% ex-autos from our preliminary estimate of -0.1% and -0.3%, respectively. We also trimmed our estimate for the key retail control to -0.4% from -0.2%. This had a marginally negative impact on our outlook for 4Q GDP growth, though our 4Q consumption estimate is still rounding up to +2.9%, in large part thanks to the surge in November retail sales, which looks likely to be at least partly unwound in December. Clearly a negative consumption number in December would provide a much softer starting point for 1Q. We expect 1Q consumption growth to be little better than unchanged at this point.

A much bigger negative for the 4Q growth outlook was a far worse than expected November trade report. The trade deficit widened to a more than one-year high of US$63.1 billion in November from US$57.8 billion in October as imports surged 3.0% and exports rose only 0.4%. The bulk of the import gain was accounted for by petroleum products, mostly a result of higher prices, but real petroleum imports also rose sharply. Consumer goods imports also posted a big gain, in line with a pick-up in West Coast port activity after several sluggish months. Almost all of the export gain was accounted for by a good gain in services, which lifted the services surplus to a record high. Goods exports were little changed, as upside in food and petroleum products was offset by drops in non-energy industrial materials and a sharp pullback in aircraft from October’s record high. Even with much of the worsening in the nominal trade gap coming from higher prices, the real goods deficit still widened a couple billion dollars, much worse than the slight narrowing we had anticipated. We now see net exports only adding 0.1pp to 4Q GDP growth.

Meanwhile, the underlying details on capital goods exports and imports overall were in line with our assumptions, and had no impact on our investment forecasts. We see 4Q equipment and software investment falling 1.7% and overall business investment rising 4.6% thanks to a 19% spike in structures investment, based on extremely robust trends in private non-residential construction spending in November. The significant drop in non-residential construction employment in December, however, suggests that support from that sector is quickly fading moving into 2008.

The much worse-than-expected results for November exports coming after the sharp drop in the ISM export orders index for December provided another hint that the global outlook may not be as robust as is widely believed. We’re still assuming that exports will be a big positive contributor to US growth in the first half of 2008, helping to keep the likely recession mild. Risks on that front certainly seem to be rising, however.

Combining our slightly lower consumer spending estimate and the significantly lower estimate for net exports with a small positive offset from a slightly higher-than-expected wholesale inventory result for November, we cut our 4Q GDP forecast to +1.2% from +1.7%. However, the worse starting point for 1Q consumption we now see from a weaker December retail sales report and a likely slightly bigger inventory drag after incorporating the small 4Q wholesale upside suggest that 1Q growth is probably starting off running somewhat weaker than our -0.8% forecast. Note also that that -0.8% forecast builds in a 1.2 percentage point positive contribution from net exports, which would require substantial improvement in the upcoming monthly trade results – about a US$1 billion narrowing in the real deficit each month from December through March – after the much worse-than-expected November outcome.

The economic calendar in the upcoming week is packed. The most notable economic release will be retail sales on Tuesday, which we expect to add to previously released data suggesting the economy may have slipped into recession in December. The inflation numbers – CPI Wednesday and PPI Tuesday – will attract some attention, but they are of limited importance at this point. For all the lip service the FOMC may continue to pay towards its vigilance over inflation, when push comes to shove, we think that it is very unlikely that it will hesitate to cut rates aggressively – including the now highly likely 50bp rate cut at the upcoming FOMC meeting – if the economy continues to fall into recession, regardless of what the incoming inflation data show. Chairman Bernanke will be testifying on the economic outlook Thursday, but his prepared remarks will likely be quite similar to the message delivered Thursday.

The Budget Committee members will likely be most interested in trying to get the Chairman to support their various fiscal stimulus plans, so the Q&A probably won’t provide any significant new information either. In addition to the retail sales and inflation reports, data due out include the Empire State manufacturing survey and business inventories Tuesday, industrial production Wednesday, housing starts, the Philly Fed survey and jobless claims (where we look for a big rise in initial claims to reverse the past week’s drop that we think was fully a result of seasonal adjustment problems) Thursday, and leading indicators and Michigan consumer confidence Friday:

*We forecast a 0.2% drop in overall December retail sales and a 0.5% decline ex-autos. Unit sales of motor vehicles point to a modest gain in the auto dealer category. However, we believe that seasonal adjustment quirks contributed to the surprising spike in November non-auto sales, and thus we look for some significant offsetting declines across a broad range of categories in the December report. In fact, our translation of the chain store results implies sizable pullbacks in key categories such as apparel, general merchandise and pharmacies. The only notable gain is expected to be a modest price-related uptick in gas station sales.

*We look for a 0.1% decline in the overall producer price index in December and a 0.1% rise ex-food and energy. A modest pullback in wholesale gasoline prices following the near-record surge in November should be partially offset by a jump in quotes for food. Also, the volatile motor vehicle category is expected to flatten out following an unusually large jump in November. This should help to lead to only a fractional rise in the core measure.

*We expect weakness in retail inventories – with unit figures pointing to a significant drop in autos and ex-autos also likely to be soft on the surge in November ex-auto retail sales – to partly offset big gains at the manufacturing and wholesale level, leading to a small 0.3% gain in overall inventories in November. The I/S ratio should fall two-tenths to an all-time low of 1.24.

*We look for the December consumer price index to rise 0.2%, overall and ex-food and energy. The energy category is expected to post a far more modest gain than seen in recent months. This should help contain the headline result in December. Meanwhile, we expect the core to post a trend-like rise, with a rebound in hotel rates and a further climb in airfares being partially offset by some softness in motor vehicle prices. The risks this month appear to be slightly tilted to the upside since our unrounded estimate for the core is +0.21%. Finally, on a year-on-year basis, we look for the core to tick up again this month (to +2.4%).

*We forecast a 0.1% rise in December industrial production. The employment report pointed to significant weakness in the manufacturing sector, with relatively sharp declines in both employment and hours worked. However, some of the sectors that have the highest weightings in the Fed’s calculation – such as food, chemicals and aerospace – held up reasonably well. Moreover, motor vehicle production came in higher than implied by the original assembly plans, and thus we look for a modest positive contribution from the auto sector. All of this should add up to a fractional rise in the key manufacturing component of IP. Finally, electricity output is likely to register a partial rebound following some weather-related softness in prior months, but this should be about offset by a dip in oil drilling.

*We expect December housing starts to fall to a 1.15 million unit annual rate. The inventory of unsold new homes remains quite elevated and the labor market data showed considerable weakness in the construction sector during December. So, we look for a further 3% decline in starts this month. Moreover, we expect starts to decline by an additional 25% over the course of 2008, bottoming in the 850,000-900,000 unit range late in the year.

*Positive contributions from vendor deliveries, money supply and stock prices should be offset by a decline in the manufacturing workweek and a rise in jobless claims, leaving the index of leading economic indicators unchanged in December.

By Ted Wieseman & David Greenlaw New York
Morgan Stanley
January 14, 2008