United States
Review and Preview
November 26, 2007

By Ted Wieseman/David Greenlaw | New York

The Treasury market saw yet another week of huge short and intermediate-led gains over the past holiday-shortened week that left the curve near another set of new highs since early 2005. The gains again combined the fundamental support of a major further dovish repricing of the Fed – with futures now not only fully pricing in a 25bp rate cut next month but actually some risk of 50bp, while also lowering the expected rate-cutting trough to 3.25% from 3.50% – with an additional pure flight-to-safety premium, which continued to be most glaringly illustrated by a series of record-highs for 2-year swap spreads through the first part of the week before a partial reversal Friday. And, as usual recently, both the Fed repricing and the flight to safety were driven by weakness in other markets – stocks, credit, subprime mortgages and, more recently, renewed funding pressures, which have left investors increasingly jittery about year-end. A light calendar of economic data was ignored. The most notable release was a decent rebound in housing starts in October, but only because of a sharp rebound in the volatile multi-family category after a collapse in September. Single-family starts fell significantly to a new low, which was in line with the homebuilders’ survey, which was unchanged in November at an all-time low for the more than 20 years it has existed. The data calendar is quite busy in the coming week, but will probably continue to be mostly ignored in favor of focusing on activity in risk and funding markets, particularly with the key early round of November data due out the following week. Main fundamental focus will probably be on a Wednesday speech by Fed Vice Chairman Kohn.

If the Fed is going to signal a reversal of its previous consistent rhetoric that has attempted to guide the market away from expecting a December rate cut, this would appear to be the most likely forum to do so ahead of the December 11 meeting.

On the week, benchmark coupon yields fell 9-26bp. Gains were 5-year -led, but the front end also put in a very strong performance, sending 2s-10s another 11bp higher to +93bp and 2s-30s 17bp to +102bp, with a partial flattening reversal on Friday pulling these spreads back somewhat from the nearly three-year highs hit Thursday. The 2-year yield fell 24bp to 3.08%, the 5-year 26bp to 3.415%, the 10-year 14bp to 4.01%, and the 30-year 9bp to 4.435%. TIPS relative performance was mixed even as oil closed in on US$100 a barrel, with the benchmark 5-year inflation breakeven falling 2bp to 2.28% but the 10-year rising 3bp to 2.39%, sending the benchmark 5-year/5-year forward breakeven up 8bp to 2.51%. The Treasury rally was supported by another big dovish repricing of the Fed. In the nearer term, the January fed funds contract gained 3.5bp to 4.24%, pricing in a marginal risk of a 50bp cut at the December FOMC meeting, the February contract 7.5bp to 4.015%, the April contract 9.5bp to 4.835%, and the May contract 11bp to 3.675%. Looking further out, eurodollar futures gains were led by 22bp rallies by the Jun 09 and Sep 09 contracts to 3.75% and 3.885%. The low-rate Dec 08 contract rallied 17.5bp to 3.585%. So essentially, the market is pricing in a 4.25% funds target after the December meeting, 4% after the January meeting, 3.75% after the March meeting and then a further move to either 3.50% or 3.25% later in the year – a path we would consider to be consistent with expectations of a recession. In addition to the more fundamental support of this Fed repricing, Treasuries also continued to be further boosted by a flight to safety. The benchmark 2-year swap spread spiked another 10bp on the week to 96.75bp, pulling back Friday from a record 101.5bp hit Wednesday. Similarly, the 2-year Treasury richened another 8bp on the week versus the 2-year overnight index swap (a measure of the expected average fed funds rate over the next two years) to trade 58bp through.

Both the Fed repricing and the flight to safety continued to be driven by weakness in stock and credit markets – which really didn’t end up being all that bad on the week after a Friday bounce – a further meltdown in the ABX market, with its implications for further subprime write-downs, recently renewed pressures in funding markets, and just general fear about the states of various markets and their implications for the economy. The actual economic calendar, however, was light and the incoming data continued to be ignored. On the week, the S&P 500 fell 1.2% after a good rebound Friday. Credit spreads similarly saw modest net losses on the week after a Friday rally. Mid-morning Friday, the 5-year HiVol CDX index was trading 6bp worse on the week near 215bp and the broader IG index 3bp worse at 80bp. On the other hand, the subprime ABX market resumed its prior collapse after the brief, small bounce seen the prior week. And again the higher-rated indices led the losses, as they have since they went into utter freefall in mid-October. The current series AAA index plunged 5.17 points on the week to 66.41 and the AA index 5.46 points to 35.04, both all-time lows. On October 15, these indices closed at 94.47 and 81.50, respectively. The absolutely stunning collapse since then provides a clear warning sign of potentially significant further subprime write-downs to come to the extent that firms are using this market to mark their positions to market, even if the current prices might not bear any reasonable relation to likely actual losses. On this score, the Wall Street Journal reported comments from Freddie Mac’s CFO on Friday noting that default rates on its AAA rated subprime mortgage holdings would have to exceed 50% before the company would experience any losses. Such a scenario may be getting priced into the ABX market, but it’s almost impossible to believe that the reality will come anywhere close to that. Meanwhile, the ABX meltdown continued to have some contagion effect on the commercial mortgage market, with significant further weakness in the CMBX market on the week. The current series AAA CMBX index widened 19bp on the week to 101bp for a 54bp deterioration over the past three weeks, while the AJ (‘junior’ AAA) index widened 19bp to 259bp for a 127bp move the past three weeks. That huge gap between the AJ and AAA spreads is a striking sign about how riskaverse investors have become and how much they are willing to pay for the added credit enhancement of the senior AAA. Jay Kotowsky from our SPG research team notes that a year ago in the cash market the spread differential between AJ and AAA was just 6bp.

On top of the weakening in risk markets, investors were increasingly concerned by renewed pressure in funding markets and fears that things could get a lot worse as we move towards year-end. Term LIBOR settings moved slightly higher every day the past week even as the more dovish path for the fed funds rate was being priced in, with 1-month LIBOR rising 5bp on the week to 4.79% and 3-month up 9bp to 5.04%. Concerns about year-end pressures remained elevated, but moderated slightly over the course of the week, with a 7bp rally in the Dec 07 eurodollar contract to 4.81% slightly outpacing a 4bp rally in the average of the overlapping Dec, Jan, and Feb fed funds contracts to 4.19%. Still, this 62bp gap remains sharply wider than the 37bp at the end of October.

The rising pressures in the interbank markets also continued to spill over into worsening trading conditions in the asset-backed commercial paper market, where our desk continued to observe through the week a shift back towards a predominance of very short-term over term financing along with a worsening of spreads versus LIBOR. On the other hand, at least there wasn’t the mad rush into the safety of very short dated Treasuries seen during August’s money market and ABCP problems, though there was modest richening, with the 4-week Treasury bill’s bond equivalent yield falling 7bp on the week to 3.70% and the overnight repo rate for Treasury general collateral averaging 4.14% Friday, down from 4.19% at the end of the prior week.

The past week’s economic calendar was very light, with a couple of housing market releases the most notable reports. Housing starts rebounded 3.0% in October to a 1.229 million unit annual rate after September’s 11.4% plunge but only because the volatile multi-family component surged 44.4% after having collapsed 35.9% last month. Single-family starts continued sinking, plunging 7.3% to 884,000, a low since September 1991 and down 52% from the January 2006 peak. We expect that single-family starts will move towards the low of 604,000 hit in the 1990-91 recession before the housing downturn troughs, given the bloated inventory situation that continues to worsen as sales remain under pressure and rising mortgage foreclosures are putting more homes on the market. We still see 4Q GDP tracking at +0.6%, with a 25% plunge in residential investment – which would be a new cycle worst – subtracting more than a full percentage point from growth. We see that extreme rate of decline in residential investment extending into 1Q. A continued grim outlook from the National Association of Homebuilders was in line with this pessimistic view. The NAHB’s composite housing market index was unchanged at a record low (since this index started in 1985) of 19 in November. The assessment of current sales was unchanged at a record-low 18, expectations for future sales fell a point to a new low of 25, while traffic of prospective buyers rose two points to a still dismal 17. Note that all these indices are on a 50-breakeven scale similar to the ISM. The NAHB attributed these miserable results to “continuing mortgage market problems, a substantial inventory overhang, and ongoing concerns about the effects of negative media coverage”. The report also noted that many builders “are reporting that their special sales incentives are having limited success in terms of getting buyers in the door”.

The economic calendar is quite busy in the coming week, though the releases are generally of secondary importance ahead of the key early round of November data due out in the following week. On that front, we will update our current November ISM forecast of 50.5 (versus 50.9 in October) based on the results of the remaining regional surveys and our preliminary +50,000 estimate for November non-farm payrolls based on this week’s claims report. On the supply calendar, Treasury will announce 2-year and 5-year notes on Monday for auction Wednesday and Thursday. We look for unchanged sizes of US$20 billion and US$13 billion, respectively. We look for these sizes to be upped in February.

There are a few Fed speakers in the coming week along with the release of the Beige Book prepared for the December 11 FOMC meeting on Wednesday. Chairman Bernanke will be speaking Thursday evening, but it will be after receiving an award, so it doesn’t seem likely that he will say anything potentially market-moving. Vice Chairman Kohn speaks Wednesday morning. No topic has been announced, but the forum – the Council of Foreign Relations – appears more appropriate to signal any about-face by the Fed on cutting rates at the upcoming meeting. Indeed, with the Fed entering its pre-FOMC meeting quiet period the first week of December, this looks like the most likely public forum to signal such a flip-flop. And that is clearly what it would represent relative to the October 31 FOMC statement that plainly attempted to steer the market away from expecting a December rate cut, a consistent reiteration of that message from Fed speakers in the weeks since, and the expanded economic forecasts released with the minutes from the October meeting on Tuesday, which were relatively optimistic on the medium-term outlook and consistent with the up to now Fed rhetoric suggesting that the rate cutting might be over. As of October 31, Fed officials were estimating real GDP growth this year of +2.4-2.5% (on a 4Q/4Q basis), implying +1.5% growth in 4Q, in our view a relatively optimistic take on the likely fallout in the current quarter of the credit crunch and energy price surge. The Fed’s forecast for 2008 was similarly relatively upbeat. The central tendency estimate was a wide 1.8-2.5%, but even the lower end of the range was above our +1.7% estimate and this outlook certainly appeared to be much more optimistic than the market’s apparent expectation of a recession implied by current Fed pricing in futures markets. The mid-point of the 2008 central tendency at +2.2% growth for next year suggested that on average the FOMC saw a relatively mild further fallout from the credit crunch in 1Q and a quick return to the +2.5% trend growth rate that it now sees, as implied by the +2.5-2.6% estimate for GDP growth in 2010. In describing the near-term view, the minutes said that “Subpar economic growth” was “projected in the near term” but was “not anticipated to persist”, with the economy expected to “pick up as the adjustment in the housing markets ran its course, financial markets gradually resumed more normal functioning, and as the monetary policy easing at the September and October FOMC meetings provided support to aggregate demand”. Clearly, this is not an outlook that obviously calls for additional rate cuts. If Vice Chairman Kohn is to signal otherwise on Wednesday, he will likely have to tie it to a significantly lowered economic outlook over just the past three weeks and attribute this revision to the weakness in financial markets, since the incoming data have not provided any basis at this point for such an adjustment. Indeed, by far the most notable economic release since the Fed’s forecasts were formulated at the end of October has been the surprisingly robust October employment report.

Data releases due out include Conference Board consumer confidence Tuesday, durable goods and existing home sales Wednesday, revised GDP and new home sales Thursday, and personal income and spending and construction spending Friday:

* We look for a nearly six-point drop in Conference Board’s measure of consumer confidence to a two-year low of 90. The other major surveys moved lower in early November, and jobless claims are pointing to some deterioration in labor market conditions, the focus of the Conference Board survey.

* We expect durable goods orders to be flat in October. Company reports point to a modest decline in the volatile aircraft category. We expect this to be offset by a partial rebound in the defense grouping, which was unusually depressed in September. Meanwhile, even though the ISM orders gauge has been trending steadily lower in recent months, it remains in positive territory. Moreover, export activity is providing support for some big-ticket machinery and tech items. So, we look for the key core category – non-defense capital goods excluding aircraft – to register a modest 0.2% advance.

* We forecast October existing home sales of 5.10 million units annualized. The pending home sales index flattened out in September.

Moreover, the huge drop-off in September resales may have overstated the extent of the weakness. So we look for a temporary uptick of about 1% in the October sales pace.

* We expect third quarter GDP growth to be revised up to +4.9%.

Significantly higher inventory accumulation, a narrower trade deficit, and stronger construction spending should offset slower consumption growth to lead to a full percentage point upward revision to the already robust advance estimate of 3Q growth. Indeed, 3Q now appears to have posted one of the strongest growth rates of the entire six-year expansion.

* We forecast October new home sales of 750,000 units annualized. The latest NAHB survey showed ongoing deterioration in sentiment. So, after heavy discounting helped to spur an uptick in the September sales pace, we look for about a 2.5% drop in October.

* We look for a 0.4% rise in October personal income and 0.3% gain in spending. The employment report pointed to a modest rise in income that would match the gain seen in each of the prior two months. Meanwhile, the retail sales figures implied a slightly smaller rise in spending during October together with a downward revision to August. Finally, our translation of the CPI data suggests that the core PCE price index should rise by 0.21%, lifting the year-on-year pace to +1.9% from +1.8%.

* We forecast a 0.6% decline in October construction spending. Another sizeable decline in the residential sector, together with some flattening out in the non-residential and public categories, following on the heels of unsustainably large gains in September, should lead to a decent decline in overall construction spending.

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United States
Testing Time for the Fed
November 26, 2007

By Richard Berner | in Tokyo

It’s August déjà vu.  Fed officials again confront deteriorating credit markets, dwindling money-market liquidity and consequent downside risks to US economic growth, possibly requiring them to ease by more than the 25 bp we currently expect.  The pressures are also evident in offshore markets, and represent a challenge for other central banks.  The risks today may be smaller than three months ago; after all, US policymakers have eased the funds rate by 75 bp and cut the discount rate by 125 bp in the past two months, and those actions have yet to affect economic activity. 

But tell that to bond investors: Reflecting renewed market turmoil and fears of recession, by our reckoning, markets now are fully priced for a Fed easing move in December, and up to four more moves by later in 2008 (for details, see Treasury Market Commentary, Ted Wieseman, November 23, 2007).  Yet Fed officials have not publicly changed their view from the October FOMC meeting that “the stance of monetary policy roughly balanced the upside risks to inflation and the downside risks to growth.”  With less than three weeks until the December 11 FOMC meeting, the disconnect between market pricing and Fed rhetoric has rarely been so apparent.  How will it be resolved? 

In my view, officials likely will respond in two ways, both of which may reduce this tension.  First, they probably will aggressively provide liquidity to mitigate money-market pressures.  Second, they will likely choose to refine their rhetoric.  Two refinements would help clarify their views prior to the December 11 FOMC meeting: They could acknowledge the changes in market conditions and comment on their relevance for economic activity.  And they could discuss the triggers that might shift the balance of risks in either direction.  Details follow.

There’s no mistaking the deterioration in credit and other risky asset markets since the October FOMC meeting; these constitute tighter financial conditions.  Measured by indexes of credit default swaps, credit spreads have widened significantly.  The 5-year HiVol CDX index (which includes a mix of rated names) has widened by 54 bp to 215 bp relative to Libor, and the broader investment-grade index increased by 20 bp to 80 bp.  Prices of subprime mortgage securities measured by the ABX indexes have collapsed: Quotes on the current series AAA and AA indexes have plunged by 30% and 57%, respectively, in the past five weeks.  The carnage spilled over into the commercial mortgage market; spreads widened on senior CMBX indexes by 54-127 bp in just the past three weeks.  Judging by surveys of small businesses and our own analysts’ canvass, on balance credit availability did not improve much in the wake of the Fed’s last easing move.  And measured by the S&P 500 index, stock prices have fallen by 7% since that action.  It’s difficult to gauge how that restraint will affect the economy, but lenders and investors seem to be growing ever more circumspect as recession worries mount. 

Rising pressures in money markets threaten to tighten financial conditions still further.  Libor-overnight index swap (OIS) and benchmark swap spreads have widened since October 31, and Libor and swap rates are the pricing benchmarks for most loans and cost-of funds.  Three-month Libor has moved to 81bp above OIS for the same maturity, or 15 bp below the August highs (Libor-OIS spreads help assess the extent to which onshore funding pressures exist offshore as well).  The widening of two-year swap spreads to an eight-year high of 96 bp speaks to a renewed flight to quality.  Correspondingly, liquidity is ebbing on funding desks, and in the commercial paper market, issuance has shifted back to overnight and shorter maturities. 

Finally, such pressures are not limited to US markets – far from it.  A Libor composite for the G10 markets compiled by our FX strategy team rose to 56 bp at the end of last week.  That is the highest level since just before the first Fed ease on September 18.  In the UK, 3-month sterling Libor rates have risen by about 23 bp in the past three weeks to more than 75 bp over the Bank of England’s policy rate.  And Euribor 3-month rates are starting to catch up, with rates now 70 bp over the ECB’s refi rate. 

Absent policy actions, in my view, the divergence between benchmark money market and policy rates will continue to broaden in coming weeks and months.  That’s because there are two sets of forces at work on spreads: First, temporary year-end pressures are reflecting precautionary demands for liquidity and “window dressing.”  Second, more lasting strains result from the reintermediation of the banking system and the shedding of riskier assets.  Unlike the past, when financial markets could cushion the banks or vice-versa, this time they are deleveraging and shrinking together, representing a constraint on the supply of credit.  And I think these latter forces likely will continue to play out past the turn of the year (see “Funding Pressures: More Fundamental than Turn of Year,” Global Economic Forum, November 19, 2007). 

To mitigate this tightening of financial conditions, Fed officials may seek two remedies.  First, they likely will aggressively provide liquidity to mitigate money market pressures.  Aggressive in this case may not involve size as much as maturity: Pressures that last at least through year end may require that they use term repurchase agreements that last past the turn of the year.  Indeed, my colleague Sophia Drossos, who worked on the Fed’s Open Market Desk, reminded me that the Desk can execute repos with maturities up to 65 business days.  In the past, when year-end funding pressures were more evident, the Desk would 'layer in' such reserve additions well ahead of the turn of the year.  Should circumstances require it, aggressive action could also include another reduction in the discount rate without easing monetary policy.  A third line of defense might involve using more unconventional tools, such as selling liquidity options as was done seven years ago during the century date change.  However, while the Fed has used such options in the past, and officials have indicated that they are willing to contemplate their use today, getting past the contemplation stage seems unlikely; most policymakers don’t want to risk being “unconventionally wrong” (for a discussion, see “Unconventional Policy Options: Footnotes in the Fed’s Playbook,” Global Economic Forum, August 17, 2007).  Turning back to the more conventional arsenal, the Fed of course can always ease monetary policy further and reduce the funds rate.  But if the immediate issue is dwindling liquidity, despite the pressure from the markets, monetary ease right now might be a cure that creates problems down the road.

Which brings me to the second remedy: Greater clarity.  The disconnect between Fed rhetoric and market thinking is intensifying this spread widening, and is especially ironic for a Fed that has just gone to great lengths to enhance and improve its communications with the public.  But the Fed and markets apparently have different views on two distinct issues.  First is the consistency between the Fed’s new forecasts for growth and inflation and the market’s perceptions about financial conditions.  The Fed’s projections are conditional on “appropriate monetary policy,” but market participants view the Fed’s forecasts as optimistic unless policy eases considerably further to offset financial market tightening.  Judging by the description in the minutes from the October 30-31 meeting, the Fed apparently thought at the time that those financial-market pressures were already ebbing. 

The second issue involves different perceptions of the balance of growth and inflation risks.  The Fed’s description of its forecast for growth is larded with downside risks.  But officials are also concerned about inflation and implicitly seem willing to tolerate a relatively weak economy to bring inflation down over the next couple of years, partly because they think potential growth has fallen to 2½%.  Thus, while there is considerable uncertainty around that point estimate, officials believe that it may take an uncomfortably long period of below-trend growth to create the slack needed to reduce inflation, especially as energy prices have risen and the dollar has declined appreciably.  In contrast, market participants don’t much fear inflation, judging by inflation breakevens.  While headline inflation likely rose to 4% in November, five-year inflation breakevens stand at just 2.3%. 

Thus, as I see it, the Fed can clear the air and clarify their views in two respects. First, officials could communicate clearly their awareness of today’s market conditions and opine on their relevance for economic activity.  Second, while they have outlined their objectives and perception of the economy’s potential in their new forecast, they could also delineate the triggers that might shift the balance of risks in either direction.  That will give a clear sense of the tactical risks prior to the December 11 FOMC meeting. 

Other central banks face similar issues.  My colleague David Miles points out that the Bank of England continues to lend to the banking system at a penal rate (100 bp over the policy rate), and following the Northern Rock experience no single institution wants to bid to borrow from the Bank even against a wide range of collateral (including mortgages).  He argues that if 3-month Libor gets to 100 bp over the policy rate, the Bank may have to change its procedures to mitigate those pressures. 

In contrast, the European Central Bank has responded quickly to alleviate pressures arising in continental European money markets.  Citing “re-emerging tensions” in money markets, ECB officials announced late last week that they would add enough extra liquidity this week to mitigate funding strains.  Importantly, the ECB said that they would continue to add liquidity until at least the end of the year, and “to the extent that money markets remain subject to tension, we will stay there as long as necessary.”  That statement provides a backstop for market participants worried about liquidity drying up.  And the ECB’s prompt actions to reduce funding pressures may buy them time to weigh their options for monetary policy.

For investors, these developments reinforce my conviction that yield curves will continue to steepen, however the disconnect between market fears and Fed rhetoric is resolved.  If the Fed indicates a renewed willingness to ease, long-term yields may rise from current levels as policymakers reflate.  And if the Fed sticks to its guns, that may flatten the curve temporarily.  But the market could then price in a greater chance of recession, moving short-term yields still lower.  Given that the Fed isn’t finished easing, using periods of flattening to reload is still the right bet.

Risks abound for markets and for policymakers.  The current level of longer-term yields is inconsistent with our economic outlook and thus likely will back up.  Indeed any selloff could be abrupt.  For their part, Fed officials risk a loss of credibility unless they clarify the risks around their forecasts and how they might respond to them well in advance of December 11 FOMC meeting.  Their challenge is to maintain the integrity and credibility of the policy process they have just enhanced while retaining the flexibility to respond appropriately to rapidly changing financial conditions. 

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