|
United States
Review and Preview July 15, 2008 By Ted Wieseman | New York Treasuries ended relatively narrowly mixed over the past week, with mortgages performing quite well, swap spreads tightening significantly, and agencies rallying strongly Friday as investors moved in the direction of pricing in the unlikely scenario of a nationalization of the GSEs. While financials focused turmoil in the equity market − main focus was on the GSEs, but indices of bank and brokerage stocks also plummeted again to yet another round of many year lows − provided flight-to-safety support to the market to a meaningful extent through much of the week, on Friday this was much more than offset by investors’ attempting to price in the impact on Treasury supply and potentially the U.S. sovereign credit rating if the federal government were to nationalize the GSEs and take on the trillions of dollars of obligations entailed in guaranteeing their outstanding debt and assuming the guarantees on their insured mortgages. Friday this was reflected in major weakness in Treasuries despite the intensifying market turmoil and a big widening in U.S. sovereign CDS spreads, a surge higher in agencies, further outperformance by agency MBS that built on what had already been a strong showing though Thursday, and a significant further tightening in swap spreads that extended a steady and substantial move lower since the wides since March were hit Monday. Selling Treasuries to buy agencies was a popular trade Friday. On the fundamentals, OFHEO affirmed Thursday that the GSEs remain well capitalized. Treasury Secretary Paulson also told Congress this on Thursday and on Friday said that the government’s “primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission”. Nationalizing the GSEs seems clearly to be an absolute last resort, and the GSEs capital positions do not suggest the need for any such action is anywhere near imminent or likely on that basis. Some sort of liquidity crisis if a sudden lack of confidence prevented the GSEs from accessing the debt markets on reasonable terms could possibly force government intervention even if capital remained adequate. There were no signs of any meaningful stress in GSE money market paper Friday, but the 3- and 6-month auctions on Monday and Wednesday will certainly be closely watched. The economic data calendar was very light over the past week and of little interest to investors amid the focus on the GSEs and broad financial system. But what was released was better than expected, leading us to continue sharply marking up our 2Q GDP forecast. Mostly as a result of a much better-than-expected trade report but also with support from significantly stronger-than-expected chain store sales, we boosted our 2Q GDP forecast to +2.4% from +1.7%, an increase of more than three points in the past month. But with the worsening turmoil in the financial system, which we should get a stark view of in the coming week as a slew of major financial firms report 2Q earnings, horrendous underlying consumer fundamentals that continued to get worse over the past week as oil spiked back towards a record high Friday after a brief pullback earlier in the week, and increasing signs of a global slowdown continue, in our view, to point to significant economic weakness going forward now that as of Friday the last of the meaningful tax rebate check distributions are complete. After a big sell-off Friday partly driven by investors switching out of Treasuries and into agencies and mortgages, the Treasury curve saw a good flattening move on the week on decent losses at the front end, with the 10-year solidly outperforming. The 2-year yield rose 7bp to 2.595%, the 5-year yield was flat at 3.275%, the 10-year yield fell 3bp to 3.94% and the 30-year yield was unchanged at 4.523%. To the extent the market received a flight-to-safety boost that prevented a worse performance by the benchmark coupons, it showed up much more clearly in a major rally at the very short end, with the 4-week bill’s bond equivalent yield plunging 45bp to 1.43% and the 3-month 25bp to 1.60%. Agencies traded poorly through much of the week, but rallied strongly Friday. At Wednesday’s lows, 10-year agencies were trading 30bp over LIBOR (which was still not as bad as the +40bp levels hit in March), but after a 17bp outperformance Friday ended at only +5.5bp. If the GSEs were to have a liquidity crisis, the key early warning sign would likely be in their money market debt, so there will be a lot of focus on the coming week’s 3-month and 6-month auctions on Monday and Wednesday. There were no indications of any problems Friday. Our desk saw quiet two-way trading and stable spreads in agency money market debt Friday, with 3-month paper trading 32bp through LIBOR and 6-month 26bp, both close to unchanged on the day. Agencies also continued to trade normally in repo. Meanwhile, swap spreads saw a major reversal after hitting their wides since March on Monday. For the week, the benchmark 5-year spread fell 10bp to 90bp, closing at 102bp Monday, and the benchmark 10-year spread fell 8bp to 68bp after reaching 78.5bp Monday. And agency MBS posted solid outperformance versus this significant swap spread tightening, with current coupons outperforming swaps by about 12 ticks on the week. TIPS had a terrible week, as huge underperformance when oil briefly fell sharply early in the week saw only a minor reversal when oil rebounded, with the August contract ending the week at $145.04, just marginally below the record close of $145.29 at the end of the prior week. The 5-year TIPS yield rose 13bp to 0.67%, the old 10-year 6bp to 1.43% (the new 10-year ended the week at 1.49%, very close to where it was awarded Thursday), and the 20-year 6bp to 2.03%. As a result, inflation breakevens in the intermediate sector came down a good bit from the two-year highs hit at the end of the prior week. Risk markets were mixed. The S&P 500 fell another 1.9% to end the week at a two-year low. Financials were crushed yet again. While much of the focus in the financial sector was on the sharp declines in the GSEs’ stocks, banks and brokerages also continued to get hammered to new lows. The BKX banks stock index fell another 5% to its lowest level since January 1997, and the S&P investment banks sub-index collapsed 11% to a five-year low. In contrast to this weakness in equities, credit had a solid week. In late trading Friday, the investment grade CDX index was 7bp tighter at 140bp late Friday. The high yield index was 10bp wider at 718bp through Thursday’s close, but the index was trading up slightly to recoup these minor losses on Friday. Through midday Friday, the leveraged loan LCDX index was also doing relatively well, trading 9bp tighter on the week at 414bp. On the other hand, the subprime ABX and commercial mortgage CMBX market were down on the week. All of the current ABX indices closed the week at all-time lows, with the AAA index losing 2.03 points to 43.69 and the AA 0.64 point to 10.03. The AAA CMBX index widened 9bp to 143bp, back to not far below the post-March high of 147bp hit June 27 (though still way below the March wides, which saw the prior series AAA index close as bad as 277bp). Notwithstanding the stronger-than-expected economic data that continue to roll in for 2Q, Fed rate hiking expectations in the futures market were significantly scaled back again, as investors were frightened by the worsening turmoil in the financial system and increasingly coming around to our view that the economy is in significant trouble once the spring tax rebate boost fades. The August fed funds contract gained 1.5bp to 2.025%, October 4bp to 2.135%, November 5bp to 2.23%, January 3.5bp to 2.315% and February 2.425%. Only four weeks ago the market was fully pricing in a 50bp hike in the funds target to 2.50% by the September FOMC meeting that it now sees happening only by the January meeting at the earliest. The blues (Sep 11 to Jun 12) led the gains in the eurodollar futures market, rallying 15.5bp to 16.5bp. The spot 3-month LIBOR/OIS spread continued to hold steady at a high level, ending the week unchanged at 73bp. Forward spreads widened on the week, however, as the Sep 08 eurodollar contract lost 1bp to 2.93% and Dec 08 was flat 3.13% in contrast to the dovish repricing in overlapping fed funds futures. It was a very light week for economic news, but what was released continued to surprise to the upside and drive further upward revisions to our 2Q GDP forecast. Mostly as a result of a much better-than-expected trade report, but also with a boost from significantly stronger-than-expected chain store sales results, we raised our 2Q GDP forecast to +2.4% from +1.7%. We’ve now boosted our 2Q growth estimate by more than three points in the past month. Tax rebate checks provided significantly more temporary support to consumer spending than we anticipated, though given how disastrous underlying consumer fundamentals are, we suspect this will just mean a bigger payback going forward. Capital spending appears to have been surprisingly robust in 2Q, possibly also partly as a result of the fiscal stimulus bill’s business tax incentives, which we didn’t expect to start having a notable impact until late in the year. Though signs of a global slowdown are becoming increasingly widespread, which could start to weigh on The nominal trade deficit narrowed to $59.8 billion in May from $60.5 billion in April on an as expected 0.9% gain in exports and a much smaller-than-anticipated 0.3% rise in imports. The imports surprise was attributable to shocking decline in petroleum products, as volumes plunged 10.5% and prices didn't rise as much as expected. Notable on the upside was a good gain in capital goods, a positive for domestic investment. Within the overall as expected export result, there was also a surprising substantial drop in ex aircraft capital goods exports, indicating that a notably higher share than we assumed of the upside in May ex aircraft capital goods factory shipments went towards domestic investment. The constant dollar results were much better than the nominal numbers. With real goods exports up 0.7% and real goods imports plunging 1.8%, the real goods deficit narrowed $3 billion, far better than the flat result we assumed. Even assuming a complete reversal in June, this boosted our estimate of the net exports contribution to 2Q GDP growth to a huge +1.6 percentage points from +1.1pp. This would be the biggest quarterly net exports boost since 1980. In addition, the drop in capital goods exports and rise in imports pointed to stronger investment spending. Again, even assuming a full reversal of the May capital goods export weakness in June, we boosted our forecast for 2Q business investment in equipment and software to +7% from +3% and for overall business investment to +9% from +5%. Even building in somewhat more negative inventories based on the weakness in imports, the upside implied by this report to net exports and investment significantly boosted our 2Q GDP estimate. Chain store sales in June overall also surprised significantly on the upside, as tax rebate checks appear to have provided a big boost to spending again in June. Note though that mass distributions of rebate checks were completed on Friday with $92 billion in total disbursements according to the Treasury Department. That leaves another $25 billion or so to still be sent out to late filers through year end, but future distributions will be much more spread about and smaller than the heavy weekly disbursements that began at the end of April. Incorporating the upside in June chain store sales, we boosted our ex auto retail sales forecast to +0.9% from +0.6%, which lifted our 2Q consumption estimate to +1.9% from +1.7%. Aside from what will certainly continue to be a major focus on the GSEs, the upcoming week’s calendar is very busy with key economic data and events. Fed Chairman Bernanke will present his semi-annual monetary policy testimony Tuesday and Wednesday. We don’t expect his overall message on the economy to differ much from the FOMC statement of a couple weeks ago − downside risks to growth remain from financial market turmoil, weak labor markets and surging energy prices, but risks have fallen, while upside risks to inflation have increased, with the Fed particularly focused on keeping inflation expectations contained. It hasn’t been long since FOMC members compiled the economic forecasts that will be presented in the report, but since then it has become clear that 2Q growth was stronger than seemed likely a few weeks ago, but the downside risks going forward have increased as financial-sector turmoil has increased. The key data releases in the coming week are retail sales Tuesday and CPI Wednesday. Looking ahead to the early round of key July data, the * We forecast a 0.4% rise in overall June retail sales and a 0.9% surge ex autos. The June chain store reports were much better than anticipated, with tax rebate payments appearing to provide a significant boost. So we look for solid gains in a number of discretionary categories. An obvious exception is auto dealers, where company reports showed a significant decline in unit sales. However, another price-related jump in gas station sales should help to offset some of the softness in vehicle sales. Factoring in our expectations for retail activity in June, we now see real consumption rising 1.9% in 2Q. * We look for a 1.6% surge in the overall producer price index in June and a 0.2% gain excluding food and energy. The headline wholesale price gauge is expected to post an even sharper advance than the 1.4% jump seen in May, with rising quotes for energy-related items again leading the way. Also, higher milk prices should help to spur a further gain in the food component. Otherwise, the core reading in the finished goods sector is expected to be in line with recent months, although a further escalation is likely at the earlier stages of production due, in part, to higher prices for chemicals. * A drawdown in retail inventories is expected to partially offset gains at the wholesale and manufacturing stages, leading to a modest 0.3% advance in overall business inventories in May. We look for the I/S ratio to register a slight downtick to 1.24. * We forecast a 0.8% surge in the overall consumer price index in June and a 0.2% rise excluding food and energy. Headline inflation is likely to show further acceleration driven by another sharp rise in the energy category. In fact, gasoline prices are expected to be up nearly 10% for the month. Meanwhile, the core should remain reasonably well-behaved, with a further jump in airfares and an uptick in the medical care category likely to be offset by continued softness in shelter, motor vehicles, and apparel. On a year-over-year basis, the core is expected to hold at +2.3%, but the headline should rise to +4.8%. * The resolution of a strike at a major auto parts manufacturer appears to have contributed to a very sharp rebound in motor vehicle assemblies during June. However, the employment report pointed to softness elsewhere in the factory sector. So, we look for manufacturing output to be up 0.3%, although the ex-motor vehicle result should be more like -0.3%. A weather-related jump in utility output should contribute to the gain in overall IP. * The employment report pointed to a further fall-off in residential construction workers, consistent with the ongoing consolidation required to address the bloated inventory of unsold new homes. So, we look for starts to slip another 1.5%, to a new 17-year low. We continue to look for another 25% or so drop in new construction activity over the course of the next year.
Argentina
What Farmer Strike? July 15, 2008 By Daniel Volberg & Gray Newman | New York Over the past three and a half months, Despite the recent headline drop in monthly growth rates for agricultural exports, the strike seems to have had little impact on the total size of agricultural exports. Indeed, with the exception of wheat exports, we have seen no meaningful downturn in Wheat’s drop in March-May (export volumes were off –97.5%) appears to be mostly payback after exports soared by 80% in January-February. Indeed, wheat exports in the first two months of the year (5.5 million tons) were roughly equal to exports during January to May of 2007 (5.8 million tons). The change in the timing of exports was due to new regulations which went into effect last November and required that all exports be completed within 45 days of registration, down from a previous 365-day window. That, plus the expectation that the decision to lift the ban on exports in December was a temporary reprieve resulted in much of the crop getting exported in the January-February period, before the farmers’ strike began. However, there is still a lot of wheat waiting to be exported. Using the Department of Agriculture, Livestock and Fisheries data, we estimate that total wheat exports this year should be 10.3 million tons, slightly higher than last year’s 9.5 million. That means nearly half of this year’s exports are likely waiting in storage for the authorities to reopen the export registry. In contrast to wheat, corn and soy export volumes have been largely unaffected by the farmers’ strike. Corn is harvested in February and March, and we have seen export volumes comparable to last year in the first five months of the year – 6.8 million tons in January-May 2008 compared to 6.5 million tons in the same period last year. Recall that the first round of the farmers’ strike began in the second half of March and ended in early April. We suspect that the exporters were able to buy and store the corn long enough so that the flow of exports continued uninterrupted through May. Given the decision by the farmers to lift the strike in mid-June, we suspect that the uninterrupted flow of exports is likely to continue. Using the Department of Agriculture, Livestock and Fisheries data, we estimate 2008 corn exports at 13.8 million tons – a slight decrease on last year’s 14.7 million tons – leaving just shy of half of the total projected exports for the post-May months. We expect soy to follow corn’s pattern and also be largely unaffected by the strike. Soybeans are harvested in mid-March to early May, and we are just starting to see the current crop coming to market, the bulk of which was likely harvested in April – the lull in the farmers’ strike. In fact, we have seen export volumes of soybeans largely unaffected by the striking farmers. In the first five months of this year, Currency Implications Wheat, corn and soy exports have been, and are likely to continue to be, a source of significant strengthening pressure on the Wheat exports could be a further source for significant strengthening pressure on the exchange rate down the line, potentially generating another $1 billion of inflows. In the first two months of the year, the bulk of wheat exports amounted to $1.6 billion. Compare that with $1.9 billion for all of last year. Given our estimate that there is still nearly an equal amount of wheat – 4.8 million tons – waiting to be exported, we could see near $1 billion of inflows in the remainder of the year were the authorities to reopen the export registry. The result would likely be pressure for exchange rate strengthening that, we suspect, would allow the central bank to continue building up its stock of international reserves. We suspect that the remaining wheat is likely to be exported in August-October since the authorities are likely to reopen the registry as part of an effort to resolve the conflict with the farmers. Corn exports should also continue to be a source of significant pressure for a stronger Argentine peso, potentially generating $1.5 billion of inflows. Consider that in the first five months of the year, corn exports were $1.5 billion, nearly equivalent to the $2.1 billion in the whole of last year. According to our estimates, based on the Department of Agriculture, Livestock and Fisheries data, Soy exports could add a further $8.2 billion of inflows, building strengthening pressure on the exchange rate. For soy, as for the other soft commodities, the stable volume of exports masks the true impact since the value of exports has risen dramatically as prices near doubled on a year ago. In fact, in the five months from January through May, soy exports amounted to $4.2 billion. If we assume that June volume of exports is comparable to last year, then June should have seen another $1.2 billion and in the remainder of the year the inflow could be near $8.2 billion, evenly distributed throughout the remaining months. The recent gains in the Argentine peso have come as agricultural exports − boosted by higher price and strong harvests − have withstood the threat of the farmers’ strike better than most expected. However, if the past is a guide, the agricultural exports should start to fade in October and, in turn, could reduce one of the key drivers of the recent bout of currency strength with it – out of the $10.7 billion of inflows we still expect to come, $7 billion should enter by October. Accordingly, we reaffirm our view that the Argentine peso should end the year at 3.20. Bottom Line The farmers’ strike has had limited impact on agricultural exports – a key driver for economic activity. In contrast, the greatest casualty may have been in the political arena. The administration has seen its approval rating fall from 55% in January to 19% in June according to local pollster, Poliarquia Consultores. The good news is that in the near term, we suspect that the authorities are likely to continue to see strong fiscal and trade surpluses and be able to effectively manage the currency – an economic variable that is often highly sensitive to expectations. However, until the authorities address the issue of elevated and rising inflation, we suspect that
Brazil
A Short Blanket in Tight Labor Markets July 15, 2008 By Marcelo Carvalho | San Paulo Why it Matters The central bank’s monetary policy committee (Copom) is vigilant about second-round inflation effects, including through labor markets. The monetary policymakers worry that initially localized inflation pressures can end up contaminating broader inflation dynamics, in part through second-round effects. In particular, the central bank is mindful that significant changes in relative prices, which translate in rising headline inflation, can encourage workers to seek nominal wage increases in order to restore real wages. That, in turn, could feedback into broader inflation dynamics, leading to an undesired wage-inflation spiral. Tight labor markets can aggravate the inflation picture. The central bank seems particularly concerned that tight labor markets could spur unwarranted wage pressures. It judges that the unemployment rate will continue to trend down in coming quarters, which could trigger more significant wage increases, possibly above labor productivity gains. In fact, we suspect that labor market developments will gain increasing prominence in the central bank’s analysis. Labor Markets Are Tight The current unemployment rate is also below central bank’s estimates of the ‘natural rate’, or the rate which would be consistent with stable inflation. Indeed, a recent study by central bank staff has estimated that the so-called NAIRU (Non-Accelerating Inflation Rate of Unemployment) for We expect labor markets to tighten further for a while. Our empirical work suggests a significant statistical relationship between real GDP growth and changes in the unemployment rate, with a time lag of about one quarter. On average, judging by recent years, real GDP growth in the 3.0-4.0% range would seem consistent with a stable unemployment rate. We believe that real GDP growth has already peaked, and look for significant growth deceleration going ahead. Eventually, the cumulative impact from ongoing monetary tightening will work its way through the economy to cool down labor markets too. However, given time lags, the unemployment rate looks set to still shrink further for a while, although gains from a year ago are likely to proceed at a slower pace. We believe that more significant slackening in labor markets is likely to become visible only next year. How Does Recent global empirical evidence appears to suggest a statistical relationship between unemployment and inflation – or what economists would call a global Phillips curve. A few interesting results stand out. First, while inflation has risen across the globe, it would appear to have increased more in countries where the unemployment rate has declined the most. Second, the business cycle appears to matter for monetary policy responses too. For instance, within Latin America, we expect relatively tighter policy where growth is stronger and the unemployment rate has declined the most ( What Is Happening to Wages in Average wages (per worker) have grown about 3.4% in real terms (above inflation) on average during the last twelve months through May. The number of employed workers has increased 2.2% during the same period. As a result, the pool of total real wage earnings has advanced 5.7%. Looking ahead, job creation may persist, but real wage gains per worker will depend on workers’ ability to counteract wage erosion from rising inflation. Rising inflation can undermine real wage gains, as the 2003 experience illustrates. One key difference: the economy was weak back in 2003, and even nominal wage gains slowed to a crawl back then. With a rebounding economy, nominal wages have risen steadily since then. Industrial data illustrate how nominal wage developments can depend on the business cycle. Inflation jumped high in 2003, but industrial activity was soft − as measured by hours worked in industry, for instance. It took average nominal wages about a year to jump in response to the previous spike in inflation. By contrast, industrial nominal wages gains (per worker) have accelerated since early 2007, amid rising headline inflation and increasing industrial activity. In the very latest reading, growth in industrial nominal wages per worker suddenly accelerated to 10.0% in May, from an average pace of 7.9% in the three previous months. Real wage gains seem consistent with labor productivity gains, at least so far, judging by industrial data. Real wages gains are not necessarily inflationary if they reflect productivity gains. Industrial wage advances over the last few years appear in line with productivity improvement, as measured by industrial output divided by hours worked in industry. However, at least two factors can inspire caution about labor productivity data. First, data limitations restrict the analysis to industry. But measured labor productivity gains in industry (where goods are typically tradable) may overestimate overall productivity in the overall economy, because productivity gains in the (non-tradable) services sector are often lower. Second, productivity gains can prove pro-cyclical. If so, measured productivity growth itself might fall as the broader economy takes a downturn. Separately, trade union data suggest that wage negotiations are sensitive to relative slack in labor markets. Numbers on wage negotiations from DIEESE, a union-linked research institute, show that almost 90% of collective wage negotiations last year achieved nominal wage gains above inflation cumulated in the previous twelve months. That is, the highest mark in over a decade, and it is no surprise that it coincides with the largest employment rate (or lowest unemployment rate) seen during the same period. By contrast, during the 2003 recession, only about 20% of collective wage negotiations managed to achieve nominal gains above past inflation. Bottom Line The labor market faces a ‘short blanket’ situation: if you pull it from one side, the other side is left uncovered. Rising inflation can eat into real wages, but hiking nominal wages to catch up with inflation can risk fueling an undesired wage-inflation spiral. In all, tight labor markets will likely keep the central bank worried about potential upward wage pressures in coming months. |