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		The Global Economics Team

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How Much Help Is Needed?

For the region, there are many different ways to calculate the extent of likely support requirements, but the majority of headline estimates in the press look misleadingly high to us.  Total claims of BIS banks on all Eastern Europe are US$1.5 trillion on 3Q08 BIS data, but our banks team estimates that around US$0.5 trillion of this is locally funded, and much of the rest will be either rolled over or (in Russia’s case) covered locally.  Looking at the macro data, total foreign debt of CE3, Bulgaria, Romania, the Baltics and Ukraine is around €605 billion, of which around €208 billion is due to the banking sector, and around €182 billion is due in a year.  (We exclude Russia and Turkey as unlikely bailout candidates for the EU.)  Actual rollover rates for this debt are so far proving well above 50% everywhere but Russia.  Current account deficits have also already contracted sharply so estimates of total balance of payments funding gaps that rely on historical current account data also look too high to us.  Assuming rollover rates from 60% in Latvia and Ukraine to 80% in Estonia and Lithuania, we project a total funding gap of around €90 billion. At a pessimistic rollover rate of 50% across the region (unlikely as some private sector debt will also be rescheduled), the gap rises to €140 billion.  Some of this will be covered by local reserve rundowns (in countries with inflexible exchange rates) or by further FX adjustment, and this excludes aid already given to Latvia and Hungary.  The probable total support requirement certainly looks well below the €180 billion most recently suggested by the Hungarian government, and far from enough to pose a financial threat to EMU, in our view.  It is important, however, to analyse where such support would be focused.  Core central Europe, in this case Poland and Hungary, looks politically well placed to us (see also “Central Europe: Trip Notes”, EM Economist, March 6, 2009).  Risks rise towards the periphery.  

Options for EU Support to Central and Eastern Europe

At the EU summit on March 1, EU leaders rejected a Hungarian proposal for a €180 billion package to recapitalize the CEE banking system, and decided on an ad hoc approach. Some of the CEE countries (the Czech Republic, Poland) also objected to such an approach, as it would implicitly lump them together with riskier countries in the EU, like Hungary and the Baltics. We never expected the Hungarian proposal to go very far, but would caution against interpreting the outcome of the meeting as a sign that Western European countries will refuse help to CEE. On the contrary, we continue to think that help will be granted if and when needed, as it is ultimately in Western Europe’s interest to avoid a CEE meltdown (due to the banks’ exposure, the importance of CEE as a trading partner and for geopolitical reasons). This support could take several forms. We list them below.

i) BoP financing facility. This facility is worth €25 billion now, and was used to assist Hungary (€6.5 billion) and Latvia (€3.0 billion). It is financed by bonds issued by the European Commission and backed by the EU members.

ii) Funds channelled via EIB, EBRD. This would work in broadly the same way as the above option. The EIB can borrow on the market and lend up to €410 billion (two-and-a-half times its capital), backed by the 27 EU members. The EBRD also has shareholders that are not EU members and can be used to channel funds to non-EU members if need be (Ukraine).

iii) Anticipated disbursements of EU funds. CEE countries are heavy recipients of EU structural and cohesion funds. These funds are already set aside and are sizable (e.g., €60 billion for Poland between now and 2013, though the absorption rate is not 100%). The EU could decide to front-load the disbursements and possibly even to extend credit for the co-financing payments. Countries with poor records of use of EU funds (particularly in the Balkans) look less likely to benefit from this.

iv) ECB assistance with FX swap lines. The ECB could decide to ease FX liquidity pressures in CEE by entering into FX swap lines with the NBH, NBP and NBR. Currently, the ECB already has swap lines in Europe with the Danish Central Bank, the Riksbank, the SNB and the Norges Bank.

v) ERM2 entry (for some, not for all). The cheapest option from the EU’s point of view by far would be to grant ERM II access to those countries that have credible euro adoption plans (e.g., Poland). Of course, this would not give a boost to the economy, but should go to great lengths to stabilize the currency. However, our recent trip to the region has decreased confidence that early ERM II will go ahead any time soon (see again Central Europe: Trip Notes).

Baltics: Not Sustainable but Supportable

Clearly, the Baltic states stand out on all foreign vulnerability measures.  External debt is 130% of GDP in Latvia, with only one-third of this bank funding to subsidiaries (still likely to be rolled over), and the rest loans by non-affiliated banks and non-resident deposits (less likely to be rolled).  Debt is lower and more favourably owned in Estonia and Lithuania, but in both we think that funding gaps look large compared to reserves.  GDP contractions across the region are already even worse than we expected in the summer (see Baltics: The Euro at the End of the Tunnel, June 16, 2008).  Latvian 4Q GDP was down 10.5%Y (-23.1% on a seasonally adjusted annualized basis), with Estonia down 13.9%Y and Lithuania down 10.8%Y.  Given the challenge of readjusting unfundable current account deficits while external demand collapses, real GDP declines in the order of 15% look feasible for 2009.  Domestic demand should contract even faster.  Historically, exchange rate pegs have almost never survived such pressure, and the EUR’s relative strength in the region makes the pressure even worse.  In Latvia’s case only around 23% of exports are to Euroland and a third is with countries, from Sweden to Ukraine, that have seen major declines against the EUR.  We expect most CIS currencies to weaken further.  The CPI-deflated real effective exchange rate continues to appreciate, by 3.5% in 4Q08 alone.  Against this headwind, external rebalancing would require even larger wage cuts than the 25% currently promised across the public sector.  We continue to think that such an adjustment would be politically impossible in most countries, and the collapse of the Latvian government underlines that its success is far from guaranteed here.  While we, and our banks team, expect Scandinavian banks to continue to roll debt, we expect all three states to require new public sector external funding if the pegs are to survive. 

The EU as deus ex machina. Importantly, we believe that the EU is now effectively quite committed to the Baltic FX pegs.  While many in the US and IMF appear to have pushed for devaluation as a precondition of the Fund programme for Latvia, the EU and Nordic governments (plus the Czech Republic, Poland and Estonia) supported the Latvian government’s desire to maintain its narrow band for the lat, backing it with €3.1 billion of EU aid and €2.2 billion of bilateral commitments.  This appears to reflect genuine concern over balance sheet risks, but also a concern that risks would spread.  The IMF’s €1.7 billion commitment, though 1,200% of quota, is small in comparison.  The Riksbank’s latest announcement of a swap agreement with the Estonian Central Bank suggests that bilateral support for the region remains intact.  With its relatively large domestic banking sector (40% by assets against 15% in Lithuania and 3% in Estonia) and loose fiscal history, Latvia is clearly in the weakest position, but given the extent of intra-regional trade, it would be difficult to shield Estonia and Lithuania from devaluation in Latvia.  30% of Latvia’s exports are to Estonia and Lithuania, and devaluation in one would risk triggering household deposit withdrawals in others, in our view.  With their small size (€70 billion GDP and shrinking) and relatively good political standing, we think it likely that all three Baltic states will receive further bilateral and EU funding.  All three are likely heading into deflation fiscal deficits, and potentially government debts, and this will be the main obstacles to euro entry by 2012 if the pegs are maintained.  For all the ECB’s reluctance, both criteria have more scope for political interpretation than the inflation ceiling that has excluded the Baltics so far. 

Balkans: ‘EMU Umbrella’ Too Far Away for Comfort

Both Bulgaria’s and Romania’s external positions look vulnerable, in our view. Unlike in the Baltics, in Bulgaria the current account adjustment has not really begun yet. The country still runs a 24% of GDP current account deficit, primarily financed by loans. As elsewhere in the region, the local banking system is dominated by foreign banks (Austrian, Italian and Greek banks). With bank financing set to slow dramatically, and FDI inflows also set to drop (housing FDI is likely to dry up, for instance), funding can dwindle fairly quickly. Under flexible exchange rates, this would put pressure on currencies. The current account deficit is set to drop dramatically in 2009, to around 15% of GDP, we think, but this will not be enough to avoid a sharp loss in reserves. Note that reserves have already started to fall, though partly due to cuts in reserve requirement ratios. In Bulgaria’s set-up, FX reserves must cover the local currency component of M1: the current coverage ratio is 154%, so there is a buffer, though no room for complacency. The ‘fiscal reserve’, made up of past government fiscal surpluses and worth 15% of GDP, can also be used as an extra source of liquidity for the banking system in case of a reserve outflow. And finally, with elections just a few months away, there is zero political appetite to question the current monetary set-up in the coming months, for fear of its near-term repercussions.

We therefore think that the Bulgarian currency board is likely to remain in place this year, though further reserve outflows are likely and external support from the IMF or EU institutions may be needed. Should capital shortages continue into next year, however, the arrangement would come under increased pressure; the fiscal position is likely to deteriorate, and last year’s 3% of GDP fiscal surplus will likely disappear in 2009 and could turn into a deficit in 2010. Erosion of the fiscal buffer and further loss in FX reserves may well trigger a currency regime change in late 2009/10 and the move to a floating currency (or perhaps a one-step devaluation). Note that, unlike the Scandis in the case of the Baltics, there is no obvious external supporter of the Bulgarian peg. Also note that the lev has appreciated in real terms by 17% since January 2007, at a time when most other regional neighbours have become much more competitive. And finally, there is a lower share of FX loans for households than in any of the Baltics, so the pain from devaluation would be less (the credit portfolio is also higher quality than in the Baltics); finally, there are no realistic prospects of euro membership any time soon, we think (Bulgaria is not in ERM II), so sticking to the peg with the sole purpose of adopting the euro in the near term is not on the table (unlike for the Baltics). Unilateral euroization is not a credible option either, we feel, because of strong political opposition by the rest of the EU. ERM II entry this year looks ambitious also.

In Romania, the economy is slowing markedly (GDP growth eased to 2.9%Y in 4Q, after over 9% in the summer). The structure of the current account deficit is similar to Bulgaria, with loans covering roughly 50% of the gap.  FDI inflows, which cover the bulk of the remainder, will also dry up substantially, we think. Therefore, the current account gap should shrink, but the NBR may try to tame the ongoing slide in the currency by spending reserves.  It now seems likely that Romania will ask the IMF for assistance, most likely as part of a package that also involves the European Commission and the World Bank (or EIB/EBRD). The size of the package is likely to be around €10 billion, and will be announced in the coming weeks. The strictures of an IMF package may ultimately prove positive in a country that has run pro-cyclical fiscal policy during the boom years. A full-blown sovereign crisis, however, looks highly unlikely to us: debt levels are too low. As in Bulgaria, we feel that EMU is still several years away.

CIS – Overly Strong FX, and Less Scope for Support

Further afield, Ukraine, Kazakhstan and Russia have now seen significant FX adjustment, but continue to defend exchange rates that are, in our view, still stronger than current equilibrium values.  Ukraine’s combination of macro and political vulnerability with limited bailout prospects looks the worst in the region.  We do not think that the IMF programme is dead yet.  Compliance is far off track, but the Fund appears likely eventually to agree on disbursement of the US$1.9 billion tranche that was due on February 15, with the World Bank eventually agreeing to fund a wider deficit.  US pressure on the multilateral agencies appears strong, and the EU has not excluded further bilateral aid, though comments from the German government suggest that appetite for this is limited.  The rollover rate for medium- and long-term external debt fell sharply to 54% in January, from well above 100% every month in 2008.  However, commitments from the major foreign banks in the market suggest that most debt will be rolled (or restructured) this year, and we expect the current account to be close to balance.  We do still expect the IMF programme to run into terminal difficulty later in the year, as elections approach and the balance between growing fiscal pain and a diminishing IMF pot further discourages political compliance.  Further capital outflows, limited only by capital controls, and a move towards monetizing the fiscal deficit look likely to trigger further UAH weakness.  However, near-term sovereign debt default risks look exaggerated to us.  Total sovereign and government-guaranteed FX debt outstanding amounts to only US$18 billion, of which US$7.8 billion is to the private sector and only around a further US$1.5 billion is due this year.  FX reserves are falling fast but still stand at US$26.5 billion.  Willingness to pay is the main issue, and so far this is intact. 

Russia and Kazakhstan also look likely to see further large FX reserve losses this year, but are clearly less likely to trouble international organizations.  In Kazakhstan, President Nazarbayev’s recent commitment to the exchange rate peg suggests that it will stay for at least several more months, at a significant cost to reserves.  Shrinking the current account deficit will be difficult in any circumstances, given that exports are almost exclusively commodities.  We expect a current account deficit of around US$6 billion and a capital account outflow of around US$10 billion.  Although Unicredit has confirmed that it will continue to support ATF, overall banking sector rollover rates will remain minimal, in our view.  In the context of US$42 billion of FX reserves, including the National (oil) Fund, such an outflow remains manageable, but uncomfortable.  We continue to think that bilateral support from China and/or Russia is a viable option, given both countries’ continuing interest in securing long-term energy flows.  For Russia too, China is a potential source of support, as underlined by the recent Rosneft/Transneft deal, but the significance of such deals is smaller in the Russian context.  We continue to see downside risks for the RUB by mid-year as the political pressure of maintaining tight policy becomes harder to sustain, and continuing depreciations among trading partners erode competitiveness.  Debt restructuring will be a long and difficult process in the Russian legal context, and uncertainty about who receives state support will remain high.  We think it is important that the government has come to realise that its earlier suggestions that it would back all private FX debt stopped most corporates from being able to come to private restructuring or rollover deals – hence its attempts to raise uncertainty by closing access to VEB refinancing.  In practice, the well-connected will continue to receive support through other state-owned banks.  CBR data have total FX debt interest and principal due in 2009 at US$141 billion, some of which can be covered out of existing corporate FX balances.  Official FX reserves are US$384 billion, very comfortably enough to cover the total FX debt of the state and state-owned corporates, US$189 billion, much of which is longer term.  Default risks for these look exaggerated to us.

Turkey: IMF Funding Should Be Adequate

Turkey is also unlikely to weigh significantly on EU resources.  Here, we are actually more optimistic that IMF funding will prove adequate, though the chances of a deal being reached before March 29’s elections now looks small.  There seems to be a broad understanding and agreement on the technical aspects of the program, which is expected to last for 18-36 months and involve a credit facility of US$5-30 billion.  However, as attested by both the IMF and the Turkish government recently, there are also outstanding problems on some legislative and administrative issues that resulted in the ongoing delay in pursuing the arrangement.  Our views on these outstanding issues are as follows:

1. Autonomy for the revenue administration: In our view, this would be a difficult decision for the government as it is unlikely to be willing to lose control over the overall revenue administration body, which has a wide range of mandates.  These range from the preparation and the implementation of the state revenue and budget preparation, the carrying out of all international tax relations and tax agreements to the preparation of the laws related to the state revenues.  However, there are various autonomous bodies such as the Banking Regulation and Supervision Agency (BRSA) as well as the Central Bank of Turkey at which the legislation and implementation issues work very smoothly and successfully.  In our view, this issue might be worked out with some leniency from the IMF and some legislative assurances of smooth and near-independent functionality provided by the government.

2. Transfer of funds to local administrations (municipalities) from the central budget: In our view, this issue definitely needs to be overcome, and we agree that it would be a key issue for the maintenance of fiscal prudence in the future.  That said, given the upcoming March 29 local elections, we do not believe that the government would be willing to take action on this front.  However, we also believe that the problem is surmountable, especially after the elections take place.

3. A tax imposition for discrepancies between reported earnings and spending of economic agents: Essentially, the aim would be to lower the size of the unregistered economy by encouraging the disclosure of all assets and revenues that had been shielded from tax inspections so far.  In our view, this would also be a key issue and needs to be taken care of at some point, but we have reservations as to the viability (or practicality) of enacting such legislation this year.  We expect the economy to shrink by 0.5% in real terms in 2009 and recover modestly in 2010.  Clearly, private consumption is expected to decline noticeably, and there is a concern that passing legislation like this might discourage spending further.  In our view, the outstanding obstacle on this issue might be overcome by passing a law that would envisage a smooth transition period, for instance 12-18 months.  Therefore, in principle, we agree with the Turkish authorities’ reluctance to accept this measure at this time, but we also believe that such a move would help to cut the size of the unregistered economy in the medium term.

In summary, the probability of a deal going through before the March 29 elections seems to be getting lower each day, but we maintain our view that a standby deal will be reached at some point, preferably before Turkey gets to a point that it has to sign it.

So how much funding is needed?  Overall, we calculate Turkey’s base case net external financing gap to be US$13 billion in 2009, which might mean erosion in reserves, depreciation of the currency or both.  According to our projections, an IMF deal with a minimum loan amount of US$15-20 billion would be sufficient for Turkey to weather the ongoing credit crunch without material damage under our base case scenario.  Clearly, this assumes that global financial conditions would not deteriorate further than the current state.  In order to address the possibility of a further deterioration in global credit conditions or, the opposite, a faster-than-expected improvement in risk appetite, we also undertook a bear and a bull case scenario analysis.  Under the bear case scenario, we envisage a further decline in the current account deficit, as lower global growth would result in further weakness in commodity prices.  On the financing side, we would expect more severe weakness on the part of portfolio outflows as well as minor FDI of US$4.3 billion.  The main weakness on the financing side would be seen in private sector financing, which we assume to decline by 50%Y.  As a result of this, our bear case external financing gap reaches a significant US$30 billion, which would clearly necessitate a fully funded IMF program.  Under a bull case scenario, we reverse the picture such that the current account deficit would rise to the US$28 billion range, but the FDI and portfolio flow sides show an improvement as well.  The borrowing of Turkish corporates and banks rises 10%Y, resulting in a net rise in FX reserves of US$6 billion. Were the bull case scenario to materialize in 2009, Turkey would not need any funded IMF program at all.  In order to combine these scenarios, we attached subjective probabilities to our base case (70%), bear case (20%) and bull case (10%), which yields a combined funding gap of approximately US$15 billion.

In summary, we expect 2009 to be a clear challenge for Turkey’s external financing picture, which is likely to receive support from commodity prices, but be pressured on the financing side.  Our probability-adjusted calculations point to an overall funding need of a sum in the neighborhood of US$15 billion.  While we believe that an IMF standby arrangement entailing a credit facility of such size might be sufficient for Turkey, the market has been conditioning itself for a larger figure.  Hence, we would expect an adverse market reaction to a figure below US$15 billion, a rather neutral reaction to US$20 billion and a noticeable improvement in case the figure exceeds US$25 billion.

United States
Review and Preview
March 10, 2009

By Ted Wieseman | New York

Treasuries posted sharp long-end-led gains over the past week, as a brief respite in the supply flood before another US$63 billion in coupon issuance in the coming week allowed the market to refocus on collapsing risk markets and the grim economic situation and reverse the supply-driven losses of the prior week, when there was US$94 billion in coupon issuance.  With the US$63 billion in 3-year, 10-year and 30-year supply this Tuesday through Wednesday following the US$94 billion in 2-year, 5-year and 7-year issuance in the last week of February and US$67 billion in 3-year, 10-year and 30-year issuance in mid-February, the Treasury is cranking out enough supply in a month to make for most of what would have been a decent year not all that long ago, so we’ll see to what extent the market can sustain the past week’s bid in the face of the latest supply flood.  But with the past week’s lull in issuance, a disastrous breakdown in stocks, credit and other risk markets at least temporarily instead became the main focus, while the Bank of England’s decision to implement heavy gilt purchases raised hopes that the Fed might broaden its more targeted quantitative easing approach to also backstop the Treasury market.  The fact that mortgages finally had a very strong day only when Treasuries surged higher Thursday in response to the BoE’s announcement after having struggled badly for weeks despite heavy Fed buying must at least have given the Fed something to think about with regard to whether its targeted efforts to bring down mortgage and other borrowing rates can be successful without a corresponding program to bring down the general level of rates by getting Treasury yields lower.  Meanwhile, economic data released over the past week were somewhat mixed but continued to point to one of the worst declines in GDP ever over the 4Q08 and 1Q09 period.  The employment report was particularly awful, with the recent rate of job losses and pace of increase in the unemployment rate approaching the worst trends on record.  The ISM surveys for February were mixed directionally, but remained deeply in recessionary territory.  And construction spending has turned down too, with unprecedented speed in recent months, pointing to accelerating weakness in business capital spending and residential investment and ongoing weakness in government spending.  On the mildly positive side, a bit of upside in January real PCE and not as bad as expected February chain store sales results pointed to a small rise in 1Q consumption instead of the small further decline we previously expected after the near-record collapse in the second half of last year.  Still, even after boosting our 1Q GDP forecast to -5.2% from -5.9% but cutting our expectation for 4Q growth in the second revision to -6.7% from the -6.2% first revision, the annualized drop in output over the 4Q/1Q period should be the biggest in more than 50 years, and there is little indication of any looming improvement in the incoming data. 

For the week, benchmark Treasury coupon yields fell 8-22bp, and the curve flattened substantially.  The 2-year yield declined 10bp to 0.91%, 3-year 8bp to 1.32%, 5-year 18bp to 1.84%, 7-year 21bp to 2.49%, 10-year 21bp to 2.83% and 30-year 22bp to 3.50%.  The flight out of stocks and into cash also sent very short-end yields to rock-bottom levels, with the 4-week bill rallying 8bp to 0.08% and the 3-month 7bp to 0.19%.  Even with commodity prices generally stabilizing on net after some volatile day-to-day swings, TIPS performed poorly, with the 5-year TIPS yield up 8bp to 1.36%, 10-year down 4bp to 1.99% and 20-year down 10bp to 2.44%.  This left the benchmark 10-year inflation breakeven 17bp lower on the week at just 0.84%, a low since late January.  After yields hit their highest levels since early December at the end of the prior week, mortgages posted a good recovery.  But almost all of the upside came Thursday when Treasuries also posted almost all of their gains for the week in response to the Bank of England’s gilt purchase plan, continuing to call into question the potential effectiveness of the Fed’s strategy of trying to bring down mortgage rates only through heavy MBS purchases while not so far also buying Treasuries.  The yield on 4.5% MBS moved from 4.44% at the end of the prior week to near 4.25% Friday, a low in about a month, but still about 25bp higher than the lows seen just after the Fed began its heavy MBS buying program at the start of January.  Meanwhile, a continued worsening in conditions in interbank funding markets helped send short-end swap spreads much higher, with the benchmark 2-year spread jumping 9bp to 78bp, a high since mid-December.  3-month Libor extended its steady move higher, rising another 3bp on the week to 1.29%, a two-month high.  The spot 3-month Libor/OIS spread also saw small further upside, rising about 1bp to 103bp, but the steady, if to this point very gradual, worsening trend in Libor fueled greater pessimism about the prospects for future improvement.  The forward Libor/OIS spread to March rose about 7bp on the week to near 111bp, June 10bp to 109bp, September 8bp to 103bp, and December 6bp to 103bp.  This key gauge of bank balance sheet pressures is thus showing that investors see no prospect for improvement this year, a very pessimistic outlook for any medium-term easing in the credit crunch.  The Fed’s delayed but still quite welcome debut of the initial version of the TALF program to try to restart consumer ABS markets elicited almost no reaction from investors, a seemingly unduly pessimistic attitude about the potential for this program to help unclog bank balance sheets. 

It was another horrible weak for risk markets, with repeated daily descriptions across most market of either ‘lowest close’ since a very long time ago or ‘worst close ever’ for more recently introduced derivatives markets, with the only notable markets managing not to set new lows – though they still had terrible weeks – being investment grade credit and the highest-rated commercial mortgage derivatives.  Stocks plunged another 7% on the week for a 24% year-to-date drop, only managing a marginal gain Friday from the worst close since 1996 hit Thursday.  Financials resumed their leadership of the severe correction after industrials had briefly taken the lead, with the BKX banks stock index plunging 23% to the lowest level in its 18-year history at Friday’s close.  Credit markets also took a beating, with an intensifying breakdown in high yield being particularly alarming.  The investment grade CDX index was 29bp wider on the week late Friday at 253bp.  About the only good thing that could be said about such a week was that it didn’t set an all-time wide, which was 280bp hit November 20.  Not so for the high yield CDX index, which hit a series of all-time wides through the week.  As of Thursday’s close, it was 241bp wider on the week at 1,814bp and was trading down another half point late Friday.  Prior to the first in a run of all-time wides being hit February 27, the worst close for this gauge had been 1,546bp on November 21.  The leveraged loan LCDX index is also back in freefall, hitting an all-time wide of 2,420bp through midday Friday after a 446bp worsening on the week and then sinking further into the red in afternoon trading Friday.  Real estate derivatives markets were also hammered.  The commercial mortgage CMBX market had another in a lengthening run of disastrous weeks that left every index except the AAA index yet again at all-time wides, and even the AAA widened 65bp to 768bp.  The junior AAA widened another 61bp to 2,099bp, AA 139bp to 3,445bp, and the lower-rated indices worsened by another 157-246bp.  As close to zero as this market has already been for some time, it almost wouldn’t seem possible, but every subprime ABX index also managed to sink further to yet another round of across-the-board all-time lows at Friday’s close, with the AAA index down 1.42 points to 27.18 and AA down 0.47 points to 4.46.  As we head further into March and approach the end of the first quarter, it looks increasingly likely that financial companies are going to face, yet again, an absolutely brutal quarter of mark-to-market losses across a range of assets.

The key early round of data for February were somewhat mixed, but focus was on a gruesome employment report that showed one of the worst four-month drops in jobs ever and a near-record rise in the unemployment rate.  The ISM surveys were somewhat mixed.  Both remained deeply in recessionary territory, though directionally they were mixed.  On the positive side, consumer spending wasn’t as bad as expected.  Motor vehicle sales collapsed to a new low, but chain store sales results pointed to some further upside in non-auto retail sales on top of January’s gain that followed a horrendous holiday shopping season. 

Non-farm payrolls plunged 651,000 in February on top of downwardly revised declines, averaging 644,000 over the prior three months, making for the largest four-month drop in percentage terms since 1975.  Major job losses were widespread across industries, with big drops in manufacturing, construction, business services, retail and wholesale trade, finance and leisure.  Healthcare remained the only industry showing steady job gains.  The unemployment rate surged to 8.1% from 7.6%, a high since 1983 and one of the biggest monthly increases ever.  The average workweek held at a record low 33.3 hours, causing total hours worked to plunge 0.7%.  Average hourly earnings gained only 0.2%, so aggregate payrolls, a gauge of total wage income, fell 0.5%. 

The composite manufacturing ISM index rose marginally further in February to 35.8 from 35.6 in January and the 26-year low of 32.9 in December, contrasting with weaker results in the regional surveys.  The key orders index (33.1 versus 33.2) was little changed, while a less negative reading for production (36.3 versus 32.1) offset a deterioration to a record low for the employment gauge (26.1 versus 29.9).  Weakness in February by industry was across the board, with all 18 sectors reporting a contraction in activity after two had seen growth last month.  Meanwhile, the composite non-manufacturing ISM index fell to 41.6 in February from 42.9 in January, remaining deeply in recessionary territory though continuing to hold somewhat above the all-time low of 37.4 hit in November.  The business activity (40.2 versus 44.2), orders (40.7 versus 41.6), and supplier deliveries (48.0 versus 51.5) gauges turned lower, while the employment index (37.3 versus 34.4) rose but remained at a level consistent with continued severe job losses.  Weakness by industry was very broadly based.  Only one sector (entertainment) reported growth and 14 contraction.  Problems obtaining credit were mentioned in the report as a significant issue in some sectors. 

Early indications for February consumer spending were better than expected overall.  Motor vehicle sales continued to collapse, falling to just a 9.1 million unit annual sales pace from 9.5 million in January, the lowest reading since 1981 and second-lowest since 1974.  On the other hand, chain store sales results taken as a whole were better than expected and pointed to some upside in ex-auto retail sales to extend January’s modest bounce after the collapse in sales over the holiday season.  Coming on top of a slightly better-than-expected 0.4% gain in real consumption in January reported in the personal income report, this suggested less weakness in 1Q consumption after the collapse in 2H08.  We boosted our 1Q consumption estimate to +0.4% from -1.2%, which while marginally positive would be not be much of a bounce from the near-record 4.1% annualized decline over 3Q and 4Q. 

On the negative side for 1Q growth, however, was an abysmal construction spending report that pointed to intense weakness in business capital spending and residential investment and soft results for government spending.  Construction spending plunged 3.3% in January on top of big downward revisions to December (-2.4% versus -1.4%) and November (-3.5% versus -1.2%) – making for the worst three-month decline on record.  Major weakness was seen across all three major components in January.  Overall private residential spending fell 2.9%, but underlying details were much weaker, with the key new homebuilding component plummeting 7.5% on top of a 7.6% drop in December.  We now see residential investment plummeting 31% in 1Q, which would actually be the worst quarter of this multi-year collapse.  Private non-residential spending has finally started to roll over hard after holding up surprisingly well through much of last year.  Activity plummeted 4.3% in January on top of big downward adjustments to prior months, pointing to severe weakness in business investment in 1Q. We now see overall business investment falling at a 25% annual rate in 1Q, which coming after an expected downwardly revised 22% drop in 4Q would make for the worst two-quarter collapse on record. 

Downward revisions to construction spending in November and December along with a downward revision to December manufacturing inventories in the factory orders report suggested that 4Q GDP growth should be adjusted down even further to -6.7% (which would actually be our original forecast ahead of the first release for 4Q) from -6.2% and the advance estimate of -3.8%.  The upward revision to our consumption forecast to +0.4% from -1.2% coupled with a likely slightly smaller inventory drag after the expected downward revision to 4Q inventories was only partly offset by the weaker trajectory for capital spending, however, leading us to boost our 1Q GDP estimate to -5.2% from -5.9%.  This 6% annualized plunge in GDP we expect over the 4Q/1Q period would be the second-worst six months for growth since the Great Depression, exceeded only by a strike-driven collapse in output in 1957-58.

The economic calendar is fairly light in the coming week, with Thursday’s retail sales report the major release.  Treasury market focus will likely be more on another wave of supply, with a US$34 billion 3-year auction Tuesday, US$18 billion reopening of the 10-year Wednesday, and US$11 billion reopening of the 30-year Thursday.  Other data releases due out include the Treasury budget Wednesday and trade balance Friday:

* We expect the federal government to report a US$200 billion budget deficit in February.  Despite the lack of much of any TARP-related outlays in February, the monthly budget gap is expected to be somewhat larger than the US$175 billion deficit posted in the corresponding period a year ago.

* We look for a flat reading for overall retail sales in February and a 0.4% gain excluding autos.  February motor vehicle sales were even more dismal than in prior months, so we look for a significant decline in the auto dealer category.  However, gas stations are expected to show a sharp price-related jump this month.  More importantly, the chain store results were considerably better than feared so we look for some upside in the key discretionary categories such as general merchandise and apparel – even after accounting for some payback from the bizarre gain seen in January.  We strongly suspect that much of January’s upside surprise was related to a seasonal-adjustment quirk.  However, we have no way of knowing if this will be quickly reversed or if it reflected an offset to some downside bias in the results for previous months.  So we are assuming a partial – but not complete – reversal of the elevation seen in January.

* After hitting a five-year low last month, we expect the trade deficit to widen slightly in January to US$41 billion, with exports falling 1.0% and imports 0.1%.  After a sharp post-strike rebound last month, industry figures indicate that overseas aircraft deliveries slowed in January, accounting for much of the expected export softness, with downside in other capital goods also anticipated.  Some price-related upside in food and industrial materials should provide a positive offset. Stabilization in oil prices should also lead to a modest gain in oil imports after the huge recent pullback, while port data point to a small rebound in other goods imports after massive declines in recent prior months.

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