Currencies
AXJ: The Energy Shock to Asia
July 04, 2008

By Stephen Jen & Luca Bindelli | London

Summary and Conclusions

Since May 1, we have not turned ‘cautious’ on Asia; rather, we have been outright bearish, at least about the next few months.  The energy shock is likely to have serious consequences for Asia.  Even China – the country that seems invincible to shocks – may start to exhibit negative reactions to this oil/energy shock.  Asian assets, including most Asian currencies, should underperform the weak dollar. 

Focus on the Energy Shock

There are a number of powerful macroeconomic cross-currents that are relevant for investors.  The US is struggling with three blows: (i) the housing recession; (ii) the credit crunch; and (iii) the oil/energy shock.  The dynamics of these three shocks, including the policy responses to them, will be important to all investors.  Of the three shocks, the third – oil/energy – is likely to prove most damaging for the EM economies, especially Asia. 

The energy shock may be due to a variety of reasons.  We have suggested elsewhere some hypotheses.  Some of the possible drivers of the oil/energy shock may be related to the US housing recession and the credit crunch.  However, it is important that investors, when thinking about the outlook for the Asian currencies, properly rank the relative importance (and relevance) of these three shocks. 

Further, it is important to appreciate that the oil/energy shock is the ‘newest’ of the three shocks.   Even though oil prices have risen steadily since 2002 (Brent was US$20 a barrel at end-2001), the recent surge from around US$70 a barrel at the onset of the credit crisis in August 2007 surprised most investors and analysts.  The talk of stagflation and the complications that central bankers face all stem from the oil/energy shock, in our view.  Had oil remained in the US$80-100 a barrel range, we doubt that there would be nearly as much angst about inflation as there is now.  

The key aim of our note is to urge investors to be focused on the oil/energy shock when thinking about AXJ and other EM assets, and not be distracted by other issues, such as the US credit crunch and the housing correction, even though these latter shocks will also pose a negative demand shock for Asia.

Asia, Especially China, Is Super Energy-Reliant

This fact should be familiar to most investors.  However, we would like to remind readers of some basic statistics.  Excluding energy exporters, China is the heaviest user of energy on the measure of the energy usage per unit of GDP output for selected countries.  Other Asian countries such as Korea and Singapore are also heavily reliant on energy.  Japan and the EU25, on the other hand, are significantly more energy-efficient – more than twice as efficient as China, according to this measure. 

While many investors and analysts are concerned about inflation containment and the effects of monetary reactions, higher price levels of energy, not just inflation, will hurt Asia.  In other words, even if oil/energy prices stabilise now, this will be a very significant shock to Asia, especially China.

Energy Subsidies Are Still Large in EM

So far, the impact of the global energy shock on EM economies has not been fully revealed, partly because it takes time for these effects to show up in macro data, and partly because of energy subsidies that have muffled the price shock in the first place.   While China and several other Asian countries have recently adjusted their domestic fuel prices, they are still substantially below international prices. In China, gasoline is about 40% below international prices, and diesel is about 50%.

Roughly 70% of China’s energy demand is filled by coal.  While coal prices in China are ‘market-determined’, there are quotas on coal exports, shielding the Chinese coal market from international demand-supply pressures.  Further, and more importantly, power plants in China have not been permitted to raise electricity prices, despite the fact that the main input – coal – has tripled in price in the past year. 

Coal prices have risen with crude oil prices, but electricity prices have remained unchanged in recent months.  This is a major subsidy to China’s industries, and it is not clear how much longer power plants can absorb the higher costs of coal and the associated losses.   

Our Thoughts

We believe that the energy shock will have serious long-term consequences for Asia, especially China:

1.         Impact will reveal itself gradually over time.  The energy price increases we have witnessed will likely have a meaningful structural impact on many economies, but especially Asian countries, and especially China.  Energy subsidies of all types are distorting the price mechanism and allocation of different types of energy inputs in these economies, and it will take time for the distortions to be unwound.  One pressure point in China now is the coal-fired power plants.  China’s rise occurred in an environment of low energy costs during the decade ending in 2005.  Higher energy costs will be a game-changer, in our view. 

2.         The Asian export model will be stress-tested.  High shipping costs will tax the Asian trade model, and encourage trade regionalisation (benefiting the NAFTA members and East European countries), at the expense of trade globalisation. 

3.         Margin compression in China will be material.   Some businesses and factories in Asia were most likely not built with the current levels of energy in mind.  To the extent that the market energy prices make these entities financially not viable, there will likely be ‘non-linear’ effects on economic activities in these countries when energy subsidies are gradually removed. 

4.         Asian currencies will weaken.  Most Asian currencies will likely reflect these negative pressures arising from the energy shock.  Margin compression, loss of monetary credibility, outflows of foreign securities investment and slower growth will all weigh on the currencies.  

Bottom Line

We believe that the energy shock poses a significant challenge for Asia, and many other EM economies.   The outsized energy price increases will be a ‘game-changer’ for Asia, in our view.  While there is some scope for remedial policy action to ‘amortise’ this shock, AXJ currencies will likely weaken against the dollar, and assets should underperform in the period ahead.

Currencies
Dollar Smiling Against EM, Still Frowning Against EUR
July 04, 2008

By Stephen Jen | London

Summary and Conclusions

We are updating our currency forecasts.  We continue to believe that the dollar will stage a tentative and asynchronous recovery.  Though it is possible that the dollar will weaken further against the EUR in the near term, given the monetary paths of the Fed and the ECB in the coming weeks, the dollar has already begun to reassert itself against many EM currencies.  This latter trend will continue, in our view.  We see a peak in EUR/USD later this year, followed by USD strength.

Powerful and complex macroeconomic cross-currents will continue to dictate the trends in currency markets.   While uncertainties linger, we believe that 2H could mark some important inflection points for various macro variables that matter for currencies.  In the short run, the USD will likely remain on its back foot against some of the G10 currencies – contrary to our expectations at the start of the year.  However, we believe that the significant undervaluation of the USD will limit the extent of any USD sell-off, and economic weakness outside the US will likely permit some rally in the USD.  With the vicious circle between oil and the dollar posing a particularly corrosive threat to the global economy, the risk of joint interventions in the currency markets continues to rise, in our view. 

For non-G10 currencies, however, inflation and the policy responses to dealing with inflation will likely dictate the trajectories of currencies.   Our view is that the USD will continue to appreciate against most EM currencies.  The exceptions are those that experience positive terms of trade (ToT) shocks, such as the GCC currencies and the RUB. 

Against our previous forecasts of 1.40 and 105, we now see EUR/USD and USD/JPY at 1.53 and 97 by end-2008.  We are pushing out our USD recovery into 2009, with end-2009 targets of 1.40 and 110, respectively.  Importantly, we see the USD outperforming most of the AXJ currencies in 2H this year – a trend that has already begun, as AXJ struggle with the oil price rise. 

The ‘Storyline’ for the Global Economy: Version 2.0

It is important to underscore how the basic ‘storyline’ for the global economy has changed in the last six months.  Six months ago, the debate was whether the rest of the world (RoW) would re-couple with a faltering US or de-couple from it.  It is by now obvious that the world has, by and large, de-coupled from the US, as the RoW has so far performed exceptionally well, despite a subdued US economy.  We believe that a key reason why the RoW has been able to de-couple from the US is because monetary policies have been coupled, i.e., the Fed’s hyper-proactive policies have been exported to many parts of the world through inflexible currency regimes.  In a way, the de facto dollar zone (or ‘Bretton Woods II’) was in operation, and the Fed’s easing arguably has had a bigger stimulatory effect on the RoW than on the US economy itself.   In other words, the RoW will slow because of excessive inflation, not because of faltering US consumption undermining the RoW’s exports. 

‘Monetary coupling’ is one key part of the story, but there is also the fact that, for the first time since 1970, the global economy has been growing above its long-term (25-year) trend of 3.8% for the fifth year in a row, and almost all forecasts have the global economy growing above this trend in 2009.  With such an extended period of above-trend global growth, why should global inflation not be an issue?  

Moreover, investors need to appreciate that with ‘monetary coupling’, and therefore a too easy monetary stance in the world, plus sustained above-trend growth, the world’s ‘core’ inflation has remained reasonably well-behaved and it is the energy and food price inflation that has surprised on the upside.   In other words, the real question should be why isn’t general (non-fuel non-food) inflation even higher than it is.  Part of the answer may be related to supply-side issues in the energy sector.  The other possibility is that this is a one-off adjustment in the relative price of resources, just as relative wages and return on capital needed to adjust in the past few years due to globalisation.  

In any case, inflation of this particular type – propelled by oil prices – should be somewhat negative for developed countries, but extremely negative for developing countries.   In fact, we believe that EM will likely be the next dominos to fall, weighed down by this oil issue and ineffectual policy responses to deal with it.  Thereafter, Germany could finally falter, as demand from EM weakens.  Eventually, the RoW will ‘re-couple’ with the weak US, but how the world gets to that end state will be very different from what many may have had in mind: faltering US consumption hurting export demand of the RoW.  This rather circuitous path for the global economy also helps to explain why the dominos have fallen in super slow-motion, relative to general expectations.  

Highlights of Our Forecast Changes

In our last round of forecasts, we argued that the dollar would stay on its back foot for a bit longer before reasserting itself, and that JPY was an opportunistic buy.   Since March, EUR/USD has remained in the 1.53-1.60 range, while USD/JPY plummeted to 96 on the Monday (March 17) after the bail-out of Bear Sterns.  Further, we declared that we were on ‘intervention watch’, and were looking and waiting for the monetary trajectories of the Fed and the ECB to be more in sync before declaring that the conditions were ripe for joint intervention.  Finally, we argued that commodity currencies should perform well.  

Here are some key features of our new forecasts:

1.         The dollar could undershoot further against the EUR, but this would be a buying opportunity for the USD.  The relative strength of the Euroland economy thus far this year has admittedly surprised us.  The ECB raising the refi rate to 4.25% today, after being on hold for 14 months, is an important statement about its attitude towards inflation.  However, with Denmark now in technical recession and European manufacturers aggressively scaling down production plans, downside risks to Euroland growth are (finally) mounting and becoming more evident.  In our view, this is the beginning of the end of the ECB’s tightening campaign that began in the summer of 2005 (with the refi rate at 2.00%).  With growth faltering, the ECB is likely to shift the focus of its communications with the market from the current inflation rate to what inflation might be one to two years out.  In other words, the ECB (and other inflation-targeting central banks), when confronted with stagflationary conditions, will likely incorporate weakening domestic demand into its inflation expectations over the medium term.  At the same time, Chairman Bernanke is unlikely to repeat the mistake made in 2003/04 when the Fed kept the FFR low (at 1.00%) for a full year and did not start to normalise rates until there were concrete signs of an economic recovery.  In other words, we believe that the Fed could begin its rate normalisation campaign well before we see clear signs of an economic recovery.  In short, we believe that EUR/USD has a better-than-even chance of setting a new all-time high in the coming weeks, but a potential divergence in the monetary paths, in favour of the USD, should occur some time in 2H, allowing EUR/USD to mark its peak. 

2.         USD/JPY to probe marginally and temporarily lower.   JPY should benefit from risk-aversion; this is well-known.  If risk-reduction intensifies, we could clearly see a rally in the JPY.  We show 97 in our end-4Q forecast to illustrate this bearish environment in the coming weeks.  We don’t see a new low in USD/JPY because we don’t expect general risk-aversion to exceed the heights reached during the Bear Sterns bail-out on March 16, 2008: that was when USD/JPY traded to 96.  At the same time, we believe that capital outflows from Japan will continue to be a powerful and reliable structural trend.  As a result, USD/JPY cannot stay low for too long, even if it trades lower temporarily.  110 is a more stable level for USD/JPY than 95.

3.         USD weakness to provoke joint intervention?   In our view, the policy paths of the Fed and the ECB are more aligned than at any time since the financial crisis began.  When the ‘switching point’ we described above takes place between the Fed and the ECB (the Fed starts to tighten while the ECB adopts an easing bias), the primary pre-condition for joint intervention will be satisfied.   We believe that the risk of interventions could rise sharply in the coming weeks, as the USD weakens further, and as the Euroland economy decelerates.  The vicious circle between the dollar and oil is extremely damaging for the global economy and the global financial markets.  Outright currency interventions would mark the multi-year top in EUR/USD, in our view.  We remain on intervention watch. 

4.         EM – especially many AXJ – currencies to suffer.  This is perhaps the biggest call we have, that energy and food ‘inflation’ will prove to be very detrimental to many EM economies, especially those in Asia.  We put the word ‘inflation’ in quotes because the permanent elevation in the price levels of food and energy will be very negative for Asia, even if energy price inflation stabilises.  Asia’s trade model has been built largely in an environment of open international trade and low energy prices.  It is unclear if trade will remain as free, and clearly the margins of every company involved in the Asian export model will be compressed by higher shipping costs, higher wages and stronger currencies.  We now see most AXJ currencies trending lower against the dollar for the remainder of this year.  While many AXJ currencies should recover in 2009, we believe that INR, KRW and VND will underperform, while CNY, TWD and SGD should outperform.  We also expect Latam currencies to start to weaken against the dollar.  

Bottom Line

We continue to expect the dollar’s ascent to be hesitant and asynchronous, buffeted by macro cross-currents.   The dollar has begun, and will likely continue, to reassert itself against most EM currencies.  While the dollar may remain somewhat vulnerable against the EUR in the near term, we continue to believe that the USD is grossly under-valued and should perform better over the longer term.  

Appendix: Additional Thoughts

There are other related issues to keep in mind: 

1.         Commodity prices.   This has been a difficult asset class for macroeconomists to get right.  But if the global economy does slow more than most now expect (to decelerate below the long-term trend of 3.8%), led by the US or one or more large EM economies, many commodity prices, in theory, should be more contained, if not decline outright.  This will have the logical implications for commodity-exporting currencies. 

2.         Inflation-targeting (IT) central banks are struggling with inflation.   There are 18 central banks in EM that have explicit IT regimes.  At present, only Brazil has inflation in the targeted range.  At the same time, of all the eight developed market central banks with IT, only Canada has inflation within its targeted range.  While non-IT central banks are also struggling to contain inflation, given the greater perceived rigidity of the IT regime, it will be important – and probably more challenging – for the IT central banks to properly communicate with the market about how they will deal with the inflationary pressures.  We believe that the net outcome will be that several EM economies’ IT regimes may fail this stress-test. 

3.         If the dollar zone is so bad, why is the Euro-zone so good?  The consensus view is that it is a bad idea for the GCC economies, China and other Asian countries to maintain either fixed or sticky exchange rates vis-à-vis the dollar.  At the same time, the consensus view is in support of monetary unions, such as the Euro-zone, the GCC monetary union and an eventual Asian monetary union.  These two opinions are inconsistent.  In our view, there should be a critical consideration of the concept of monetary unions.  How the Fed’s monetary policy is inappropriate for the other members of the BWII regime is the same as how the ECB’s policy is increasingly inconsistent with what many EMU members need.  One-size-fits-none is increasingly a risk for the Euro-zone, as growth divergence intensifies.  In the pre-EMU/ERM days, macroeconomic pressures would reveal themselves through asset prices, mostly exchange rates (such as what has happened to EUR/GBP in recent months).  But with the EMU, pressures will reveal themselves in more subtle and corrosive ways through the real economies, with consequences for asset prices. 

4.         Global policy rates may indeed be too low.   In real terms, the US, non-US OECD and the EM economies have their policy interest rates at their lowest points in more than two decades.

Global
The Transatlantic Inflation Puzzle
July 04, 2008

By Joachim Fels & Elga Bartsch | London

Central banks’ mea culpa.  The drivers behind rising global inflation pressures are fairly well understood.  As we have explained in this publication before, a very lax global monetary policy stance – especially in the US and in many emerging market countries that tie their currencies to the dollar – is at the root of the problem.  This has driven up food and energy prices first, but other prices are likely to follow higher, especially as most central banks around the world are unlikely to tighten policy sharply anytime soon.  We find it interesting that the BIS, a club of central banks, in its Annual Report released this week shares our assessment that global inflation largely reflects the easy money and credit conditions that prevailed for many years.  “Yes, we are to blame” is what central bankers appear to be saying in this report.

Puzzle #1: Why is inflation in the US not much higher than in the euro area?  While it is not surprising that inflation is rising everywhere, it does appears puzzling that inflation in the US is only slightly higher and has actually increased less rapidly over the past year than in the euro area, despite a major depreciation of the dollar against the euro.  Since June 2007, the euro has risen from US$1.36 to US$1.57.  Over the same period, annual US CPI inflation rose by 1.5 percentage points from 2.7% to 4.2% (May 2008, the latest available) while euro area HICP inflation rose by 1.8 percentage points from 1.9% to 3.7%, and has increased further to 4.0% on the preliminary June estimate. 

Different cyclical positions play a role.   One likely explanation for this puzzle is the different positions in the economic cycle, with the US slowdown having started earlier than the slowdown in the euro area.  The US unemployment rate has now risen by more than a percentage point to 5.5% from its cycle low of 4.4% in March 2007, while the unemployment rate in the euro area has continued to fall until recently (to 7.2% in May).  Thus, ‘slack’ in the labour market has increased in the US but has declined in the euro area, which is also reflected in slowing wage increases in the US and accelerating wage rises in the euro area.  In addition, a pick-up in productivity growth in the US has weighed down on unit labour cost growth recently, while a slowing of productivity has contributed to rising unit labour cost growth in the euro area.  Thus, domestic inflation pressures appear to be lower in the US for now, offsetting some of the impact of rising import prices due to a weak dollar on total inflation.

Owner-equivalent rent also helps.  Another factor that helps to explain the more muted rise in total US inflation than in the euro area is the impact of a weak US housing market on rent increases.  As Dick Berner points out, owner-equivalent rent, which accounts for nearly one-quarter of the overall CPI, slowed to 2.6% in May from a peak of 4.3% in December 2006 (see Global Inflation, Economic Slack and Monetary Policy, June 30, 2008).  Note that the HICP inflation measure excludes the costs of owner-occupied housing, so no such effect exists in the euro area.  A measure of US services inflation excluding rents shows a sharp acceleration over the past year or so, while services inflation in the euro area has hovered broadly sideways over the same period.

Puzzle #2: Why are market expectations of longer-term inflation in the US and euro area identical?  However, the different positions in the cycle and the inclusion or exclusion of owner-occupied housing costs are unable to explain another transatlantic inflation puzzle.  Despite the Fed’s and the ECB’s divergent policy paths – aggressive Fed easing since last August versus unchanged ECB rates so far and a likely rate rise tomorrow – market expectations of longer-term inflation trends in the US and the euro area are virtually identical.  Judged by break-even inflation rates calculated from inflation-linked bonds, markets expect inflation to average 2.6-2.7% over the next five years and around 2.5% over the next ten years in both the US and the euro area.  These implied expectations contrast sharply with the popular mantra that the Fed, due to its dual mandate, is more lenient towards inflation than the ECB, which is generally seen as a tough institution focusing on its primary mandate (price stability).

More favourable micro factors at work in the US.   While the divergent monetary policy stances and strategies would suggest higher long-term inflation risks in the US than in the euro area, we propose an explanation based on micro or supply-side factors for why US inflation pressures may be tamer than in the euro area on a lasting basis.  The fact that the US is much further advanced than the euro area in liberalising and deregulating its product and labour markets could be the missing link, we think. The micro factors and market structures will also play an important role – in addition to the business cycle, the monetary policy stance, etc. – in determining both the ability of companies to pass on higher commodity prices and the ability of workers to demand compensation for it in the form of higher wages. The piecemeal supply-side reforms and still-incomplete single market in the euro area could potentially make core inflation more prone to spill-overs from the commodity price shock, in our view.

Micro factors affect price-setting and hence inflation persistence.   The ECB’s own work on firm-level data has among other things found a much greater degree of price stickiness in the retail sector in the euro area than in the US. While in the euro area, typically consumer prices are only adjusted every four to five quarters, in the US price changes at the retail level are happening twice as often, i.e., every two quarters. Price stickiness cuts both ways. On the one hand, it can reflect a low inflation environment and stable inflation expectations. On the other hand, it can reflect structural rigidities in the retail industry. While the reasons for the transatlantic difference are not entirely clear, the difference can at least be partially attributed to differences in the degree of product market competition, we think. We would highlight that European retailers also haven’t been able to repeat the productivity spurt seen in this sector in the US in the late 1990s.

Greater inflation risks, tougher central bank.  There are several consequences of the greater price stickiness in the euro area. First, the slower frequencies with which prices on average get adjusted could mean that European retailers are sitting on pent-up price increases that still need to be rolled out to customers. Second, euro area inflation will likely not respond to changes in costs and/or output to the same extent as in the US. In a recent note, our colleague Carlos Caceres has shown that a 1 percentage point shortfall in GDP growth only shaves off 0.2 percentage points from core inflation (see The Long Shadow of the Energy/Food Spike, May 19, 2008). Third, the spill-over from headline into core inflation might be higher in Europe. This is what a first visual inspection of the co-movements in headline and core inflation on both sides of the Atlantic would suggest. Hence, it could well be that a large part of the divergent policy path on both sides of the Atlantic is warranted in light of the different structures of the respective economies, which imply that the risks of protracted inflation overshoot are somewhat more elevated in Europe.

Fed and ECB paths may continue to diverge for longer.   If our argument about more favourable micro or supply-side factors in the US than in the euro area is right, this would have clear-cut implications for monetary policy on both sides of the Atlantic.  Compared to the Fed, the ECB is fighting an uphill battle against inflation, suggesting a need for higher real interest rates than in the US.  The Fed, by contrast, may be justified in keeping interest rates low for longer as favourable micro factors should help to limit the knock-on effects of higher food and energy prices on core inflation.  Thus, markets may be right in assuming that the longer-term inflation outlook in the US is not much different from that in the euro area, despite different monetary policy stances and strategies.

Higher inflation both in Europe and the US.  To conclude, we emphasise that we have made an argument about the relative inflation outlook in the euro area versus the US, not about the absolute level of inflation in both economies.  On the latter, we continue to think that lax global monetary policies will lead to persistent inflation pressures virtually everywhere over the next several years, and we believe that market expectations of longer-term inflation are too low.  Yet, in this note, we throw some doubts on a view we frequently encounter from investors that euro area inflation should be significantly lower than US inflation over the next several years.  Micro factors suggest otherwise.

United States
Review and Preview
July 04, 2008

By Ted Wieseman | New York

After a series of major swings over the prior five weeks, the Treasury market calmed down over the past holiday-shortened week – even as turmoil intensified in many other markets – posting good front-end gains and holding little changed at the long end to send the curve to its steepest levels in a month.  Though the employment report was right in line with economists’ estimates, the market had gone into the unusual employment Thursday fearing a weaker outcome, and most of the week’s other data were also better than expected, with the non-manufacturing ISM, where the negative impact of surging costs was pronounced, the major negative outlier.  On the positive side, the manufacturing ISM unexpectedly rose back into growth territory for the first time in five months, motor vehicle sales were terrible but not nearly as disastrous as widespread industry fears, and construction spending was again better than expected thanks to continued surprising resilience in business construction spending in spite of the drastic tightening in commercial real estate lending conditions.  The upside in construction spending, with a partial offset from a lower-than-expected rise in inventories in the factory orders report, led us to boost our 2Q GDP forecast marginally further to +1.7% from +1.6%.  This is way up from our estimate a month ago of -0.7%.  So it seems clear that the economy has escaped recession for now.  But investors are increasingly looking through the near-term resilience and starting to come around to our view that the economy is going to be in big trouble later this year when the temporary boost from tax rebate checks fades.  Consumers will then be faced with the combination of falling wealth, a sharp reduction in credit availability and major weakness in real income from surging inflation on top of continued pressure on nominal wages from the weak labor market.  At the same time, risk markets are melting down, and the mess in the financial sector shows no signs of improvement as the credit crunch rolls on.  And industrial stocks have started to get clobbered along with financials as incoming overseas data increasingly draw into question the sustainability of global decoupling from the US downturn, potentially threatening the only significant underlying source of support for the US economy over the past year, booming net exports.  So notwithstanding the week’s overall better-than-expected – or at least not-as-bad-as-feared – economic news, rising investor fears of future weakness led to Fed rate-hiking expectations being scaled back significantly further to the point that futures now favor only one 25bp rate hike through year-end and two through the January FOMC meeting, down from the at least three hikes by year-end and at least four by January that had been priced in three weeks ago.

On the week, benchmark coupon yields fell 1-12bp, and the curve hit its steepest levels since before the major sell-off during the week of June 13.  The 2-year yield fell 12bp to 2.525%, the 5-year 10bp to 3.27%, the 10-year 2bp to 3.97%, and the 30-year 1bp to 4.53%.  With support from oil’s move to a series of record highs, with the August contract having risen US$4 a barrel to US$144 at the time of the early bond market close, TIPS had a very strong week that sent benchmark 5-year and 10-year inflation breakevens to two-year highs.  The 5-year TIPS yield fell 17bp to 0.55% and the 10-year 8bp to 1.37%.  The run-up in the 5-year inflation breakeven has well exceeded the rise in the 10-year, however, so the 5-year/5-year forward has actually fallen over the past couple of months, though it was up a bit in the latest week.  Risk markets weren’t the only areas seeing significant softness as Treasuries rallied, as spread product in interest rate space also performed poorly.  The benchmark 10-year swap spread rose 5bp on the week to 76bp and the 5-year 7bp to 100bp.  And MBS had a terrible week, substantially underperforming this weakness in swaps. 

Equity and credit markets extended their terrible showing in June into the first few days of July, supporting Treasuries through the week.  The S&P 500 was down 1.2% on the week after managing just a marginal rebound Thursday after closing at a two-year low Wednesday.  Bank stocks continued to get crushed, with the BKX index falling another 3.3% to another more than 11-year low, as investors looked ahead to what could be some ugly earnings news in coming weeks, with the continued pressure on bank capital and balance sheets clearly a major problem for the economy.  Credit also continued sinking.  The investment grade CDX index widened another 5bp on the week to 148bp, the worst level seen by the current series 10 index since it debuted in late March and up from a low of 86bp hit May 2, though this was still a good bit better than the worst close hit by the prior series 9 index of 191bp on March 14.  The high yield index was 25bp wider on the week at 698bp through Wednesday’s close, and the index was down another three-eighths of a point midday Thursday.  This was also the weakest the series 10 high yield index has traded and way up from the best level, also hit May 2, of 524bp.  Other markets did better, with commercial mortgages a major outperformer.  The AAA CMBX index tightened 13bp to 134bp, the AJ 32bp to 403bp, and the AA 50bp to 608bp.  The subprime ABX market mostly traded softer on the week, but the losses were marginal compared to the collapse seen in June, with the AAA index only dipping 0.17 points to 45.72 and the AA falling 0.22 points to 10.67.

Fed rate-hiking expectations were scaled back quite a bit, with only one rate hike now priced as likely by year-end.  The August fed funds contract gained 1.5bp to 2.04%, October 2bp to 2.175%, November 3.5bp to 2.28%, January 6bp to 2.35%, and February 8.5bp to 2.485%.  Three weeks ago, the January contract closed at its worst level of 2.855% as the market was on the verge of pricing in 25bp rate hikes at the August, September, October and December FOMC meetings.  So there’s been a major rethinking of the likely Fed path even as incoming data over this period has actually been better than expected, as investors increasingly worry about downside risks going forward.

Non-farm payrolls fell 62,000 in June, and May (-62,000) and April (-67,000) were revised down.  The unemployment rate held steady at 5.5% after the huge spike last month.  Heavy job losses continued in manufacturing (-33,000) even with a boost from the end of an auto parts strike and construction (-43,000), though job losses in the other recent major source of weakness, retail trade (-8,000), moderated.  Job cuts in financial services (-10,000) accelerated, business services (-51,000) fell sharply again, and the one previous area of notable strength, healthcare (+14,000), saw its smallest gain in four years.  The average workweek held steady at a near-record low 33.7 hours, causing aggregate hours worked to fall 0.1%.  Combined with a 0.3% gain in average hourly earnings – which lowered the year-on-year pace to +3.4%, a two-and-a-half-year low – aggregate weekly payrolls, a proxy for total wage and salary income, rose 0.3%, but this will be substantially negative after adjusting for a likely surge in inflation in June.

The two ISM surveys were mixed, with manufacturing showing surprising upside as exports for now continue to be a key source of resilience, though the composition of the rise in the overall index was not particularly strong, but non-manufacturing being hit hard by surging prices.  The manufacturing ISM composite index rose to 50.2 in June from 49.6 in May, entering growth territory for the first time since January.  The orders index (49.6 versus 49.7) was flat at a slightly negative level, with strength in exports (58.5 versus 59.5) continuing to provide major support, production held little changed (51.5 versus 51.2) at a moderately expansionary reading, and employment (43.7 versus 45.5) sinking to a five-year low.  Instead, upside in the composite index was driven by gains in inventories (51.2 versus 48.0) and supplier delivery times (55.1 versus 53.7), the latter possibly reflecting some impact of the Midwest floods.  The prices paid index gained another 4.5 points to 91.5, a high since 1979, with a wide range of energy items, metals and chemicals reported up in price.  Meanwhile, the non-manufacturing ISM composite index plunged 3.5 points in June to 48.2, returning to contractionary territory after two months of growth.  The business activity (49.9 versus 53.6), orders (48.6 versus 53.6) and employment (43.8 versus 48.7) gauges were all way down, but a stable reading for supplier deliveries (50.5 versus 51.0), an index of questionable value in this survey in our view, prevented an even bigger drop.  The sector breakdown deteriorated badly, with eight industries reporting growth in June and eight contraction, compared with 13 and four in May.  The prices paid index surged 7.5 points to 84.5, an all-time high in the survey’s 11-year history.  Comments from survey participants in the report all focused on the negative impact of surging costs on their businesses.

Motor vehicle sales results were terrible in June in any sort of absolute sense, but they weren’t nearly as bad as industry fears.  Sales fell to 13.6 million units annualized from 14.3 million in May.  While this was a 15-year low, it was a good bit better than widespread industry fears of a decline into the 12s.  And the mix in June was relatively positive compared to recent trends, as the drop in overall sales of domestically produced vehicles to 9.9 million, a low since 1991, from 10.4 million was mostly a result of a decline in car sales to 4.9 million from 5.3 million.  After having plunged 23% in the three months through May, sales of domestically produced trucks stabilized, dipping to 5.0 million from 5.1 million.  We’ll get more key early information on June consumer spending this Thursday with the release of monthly sales results from most of the major retail companies.

Capping a month of major upward revisions, we boosted our 2Q GDP forecast a bit further in the latest week to +1.7% from +1.6% as we finalize our full monthly forecast update for Monday.  In last month’s report, we forecasted a 0.7% decline in 2Q GDP, one of the biggest monthly swings we can remember.  The slight additional upside in the latest week came from construction spending, with a partial offset from a smaller gain in May factory inventories than we expected.  Construction spending declined a modest 0.4% in May, and there were significant upward revisions to the prior couple months.  Residential spending declined 1.6% overall, boosted by a gain in the unreliable improvements component.  The key new homebuilding categories plunged another 2.8%, putting 2Q residential investment spending on pace for another sharp decline, but a good bit less than the 25% drops in 1Q08 and 4Q07.  We see residential investment in 2Q running near -17%.  On the positive side, private non-residential spending continued to show very surprising strength, gaining 0.2% for a fifth straight advance.  The severe tightening in commercial real estate lending and deteriorating corporate profits will likely lead to future weakness in this area, but for now business investment in structures appears to have been quite robust in 2Q; we estimate a 10% gain.  Government spending gained 0.4%, reversing a small decline the prior month.  Strains on state and local government budgets will also likely lead to some softness in this area going forward.

The calendar is pretty quiet in the coming week.  The most notable economic news will be the chain store reports on Thursday, which will give an early indication of whether the tax rebate check-juiced jump in May retail sales was sustained into June.  There will be supply on Thursday in a new 10-year TIPS auction.  We look for an unchanged US$8 billion size, as the debt managers seem to have settled into an US$8 billion new/US$6 billion reopening pattern for TIPS.  Given increases in nominal sizes recently, there is certainly the risk of a bigger issue, but with actual inflation running way ahead of inflation breakevens at this point, TIPS are not a cost-effective financing choice for the Treasury.  Other data releases due out include the trade balance and the Treasury budget on Friday:

* We look for the trade deficit to widen sharply in May to US$64 billion, mostly as a result of higher oil prices.  In fact, the real trade gap is expected to be little changed.  Exports are expected to rise 0.9%, largely as result of price-related upside in industrial materials.  Industry data and factory shipments figures point to little change in capital goods exports following a substantial rise last month.  Meanwhile, we expect imports to jump 2.1%, led by a price-driven surge in petroleum products to a record-high.  A pick-up in inbound shipments at the key West Coast ports also points to modest upside in imports of other goods.

* We expect the federal government to report a US$47 billion budget surplus in June, US$20 billion wider than in the same period a year ago.  However, much of the swing is attributable to the anticipated receipt of spectrum auction proceeds.  Also, a calendar shift pushed some regular monthly payments forward into May.  Indeed, these special factors will more than offset the distribution of about US$25 billion in stimulus rebate payments.