Latin America and the Dollar: More Than Meets the Eye
June 02, 2009
By Daniel Volberg & Luis Arcentales | New York
After three quarters of strengthening, the recent weakening in the USD has once again sparked questions about the future dollar outlook, and questions about the dollar's sustainability are gaining ground. Late last year and in early 2009, as financial and economic dislocations intensified, fear drove many investors to seek safe haven in the dollar, but increasingly the tables have turned. Our currency strategy team - Sophia Drossos, Emma Lawson, Ron Leven and Yilin Nie - have revised their dollar outlook towards more weakness: they now forecast the dollar to weaken against the euro to 1.45 year-end and to 1.60 by end-2010, versus their previous forecasts of 1.40 and 1.50, respectively (see "G10: Lower Tail Risks, but Muted Tail Winds", FX Pulse, May 14, 2009). In fact, they are now increasingly concerned about outright sustainability of the dollar (see "USD: Hope for the Best, Prepare for the Worst", FX Pulse, May 28, 2009).
What would a weaker dollar mean for Latin America? We argue that, short of an outright dollar crisis, Latam watchers may want to focus away from the broad dollar performance and shift their attention to the strength of the eventual global recovery and especially its effect on commodity prices. We are further concerned that, on both counts, the recent market gains across much of the region may have run ahead of the fundamentals.
Historical Agnosticism
First, history alone does not provide much help in determining what dollar strength means for growth in Latin America. In the post-Bretton Woods era, we have seen periods in which a strengthening dollar appeared to have accompanied stronger growth in Latin America - most notably in the second half of the 1990s - but we have also experienced periods where the dollar and Latin American economic growth have moved in opposite directions. During the past six years, for example, a weaker dollar has accompanied better growth in Latin America. Meanwhile, in the early 1990s a sudden rebound in activity in Latin America was associated with a largely flat dollar. The data from the 1980s are equally mixed.
Second, the historical relationship between movements in the dollar and the movements in Latin American currencies is not much better. Whether one looks at the dollar's move from the optic of the Fed's broad or major currency index, there seems to be little clear pattern of how Latin currencies will necessarily respond. We've built a Latin American real effective exchange rate index with trepidation: it runs the risk of double-counting the impact of trade within the region. But it provides a useful proxy for the region's currencies. And it shows that, in the past 25 years, Latin currencies have gained ground with a strengthening dollar (the second half of the 1990s), gained ground while the dollar has weakened (2002-08) and have also strengthened when the dollar was largely stable (early 1990s). The sudden bouts of Latin currency depreciation have taken place as the dollar was gaining ground (1982), as the dollar was largely stable (1994) and as the dollar had peaked (2002).
Our agnosticism derived from a review of history stands in sharp contrast, of course, to the currency movements in the region in recent weeks. Around the region - from Brazil to Mexico - since mid-March, we have seen the biggest rally in over a year. This forceful rally has increasingly turned up the pressure for us to justify our cautious outlook for the region. While the moves in the past two months may be explained in part by evidence that the pace of the economic deterioration in the region may be moderating, we see reason for caution ahead. This brings us to our third point.
The Growth Link
What holds up to the test of time is the strong association between strong currencies and robust growth in Latin America and the link between this growth and positive terms of trade. In each of the countries and in our imperfect Latin American real effective exchange rate index, better growth in real GDP accompanies a stronger currency. Even after putting aside for the moment the issue of causality - does a strong currency boost domestic demand or does strong domestic demand attract inflows, pressuring the currency to strengthen - robust growth in Latin America and strong currencies have coincided for decades, largely uninterrupted. And positive terms of trade have long been associated with strong currencies and robust growth in the region.
Therein lies the rub: it is not the dollar's move per se that will likely drive Latin growth or currencies, but instead what should concern Latin watchers is what is driving the dollar's move. To the extent that dollar weakness is prompted by concerns about the sustainability of US macro policies (fiscal deficit and debt sustainability, inflation risks and the surge in issuance) and, given the importance of the US to the global economy - at market exchange rates, the US consumer accounts for 40% of world private consumption - we are concerned that global growth recovery may prove subdued, and growth and currencies in Latin America will accordingly suffer. After all, look at the last time we had a US and global slump in 2001 and 2002. In 2001, real GDP growth in Latin America slumped to 0.3% among the seven largest economies in the region or just over one-tenth of its five-year average. In 2002, Latin American real GDP growth slipped further, to just 0.1% - again roughly one-tenth of the new lower five-year average (which then incorporated the latest weakness). And Latin currencies also slipped.
Whether one looks at what has, in recent years, been a darling of emerging market investors, Brazil, or its neighbor, Argentina, we find that external factors explain the bulk of the improvement in growth rates in recent years. In both cases, the bulk of the difference between real GDP growth in 1H08 versus growth in 2003, when the era of abundance began, can be explained by unusually favorable external factors (see "Latin America: Growing Disconnect, Growing Risk", EM Economist, March 7, 2008). Remove those factors and we are afraid that the region sees slower growth. The progress the region has made on its ‘balance sheet' (which should limit currency weakness) is much greater than the progress made on its ‘income sheet' (which ultimately is likely to be seen through lower growth). Meanwhile, the link of Mexico - which is in the midst of the deepest recession since the Tequila Crisis over a decade ago - to the US economy remains very much alive (see "Mexico: Not Your Same Old Jobs Cycle", EM Economist, May 18, 2009).
Latin America's dependence on world growth guides us to remain relatively cautious on the prospects for a robust economic recovery in the region, given that a quick turnaround for the global economy seems unlikely: our US economics team expects a multi-year adjustment as the US consumers rebuild their balance sheets (see Deleveraging the American Consumer, May 27, 2009). As US consumers - who super-charged the global economy in the past few years - lift their savings rate from 1.3% of disposable income over the past five years to 5.4% on average this year and next, this should present Latin America, and indeed emerging markets more broadly, with a formidable challenge (see "Latin America: Globally Challenged", EM Economist, April 3, 2009). We are concerned that the sharp recovery in Latin currencies that we have witnessed in recent weeks may be challenged in the weeks ahead once hopes for a strong recovery fail to gain traction.
Bottom Line
The recent dollar slide may be near the top of investor concerns, but for Latin America, the implications are far from straightforward. Rather than the dollar's swings per se, what has historically mattered for Latin America is the strong association between strong currencies and robust growth and the link between this growth and positive terms of trade. To the extent that the dollar slide is prompted by concerns about the sustainability of US macro policies, and given the importance of the US to the global economy, the eventual global growth recovery may prove subdued. In turn, this may pose a challenge to the prospects for a robust economic recovery and further currency gains in Latin America.
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Nordic Glimmers of Hope
June 02, 2009
By Elga Bartsch | London
Sweden Has Been Hit Very Hard by the Global Recession...
There is no doubt that the Swedish economy was hit hard by the financial crisis and the global recession. The largest Nordic economy contracted by a downwardly revised 5.0%Q in 4Q08, the steepest decline seen across Europe. A further, more moderate decline of 0.9%Q followed in 1Q09. The main drivers of the slump were a sharp fall in export demand, a contraction in consumer spending and a big negative growth contribution of inventories. Incoming data in the current quarter suggest, however, that economic activity is starting to stabilise in the industrial sector. A gradual stabilisation in activity over the summer and a return to positive growth momentum towards year-end would leave 2009 GDP down 5.1% compared with last year. Previously, we had been looking for a contraction of only 3.6%. Consensus estimates, which are currently looking for a decline of 4.0%, are also likely to come down. For Sweden, this would mark the sharpest contraction since 1940, when the Swedish economy contracted by a bit more than 9%. It also makes Sweden one of the hardest hit economies in Western Europe.
...but it Has a Very Robust Recovery Story Lying Ahead
Clearly, this slump in activity is likely to have negative repercussions on key variables such as unemployment, insolvencies and corporate profits, which tend to lag the business cycle. But, it is important to recognise that activity in the hard-hit industrial sector in Sweden might be close to bottoming out. This suggests that much of the bad news might be behind us. We believe that Sweden is probably the most robust recovery story in Europe. Of course, the very open Swedish economy, where international trade in goods and services accounts for 97% of GDP (compared with only 43% in the euro area and 56% in the UK) would not be insulated if the global recovery faltered. But, in terms of the domestic factors driving the recovery, Sweden seems to be in better shape than most other European countries, for four reasons:
• First, macro stimulus in Sweden is very sizeable with the Riksbank intending to keep the repo rate at 0.5% until early 2011 and the government implementing discretionary fiscal stimulus of more than 3% over 2009/2010. In addition, the Riksbank could engage in active quantitative easing by buying bonds, if it deemed such additional measures necessary.
• Second, contrary to the euro area, which faces the headwinds of a stronger euro, the weaker SEK should help to reignite export demand. This should help Swedish industry, which accounts for nearly a quarter of the economy and thus takes a considerably larger share of the economy than in the UK or US (two other countries benefitting from a more competitive exchange rate).
• Third, so far the banking system seems to have weathered the storm better than in other places. Ongoing strength in loan growth suggests that a potential credit crunch is still far off.
• Fourth, balance sheets appear reasonably healthy, with only moderate household debt levels and rather low government debt levels. Only non-financial corporates in Sweden seem to be more highly geared. A long-standing current account surplus indicates that Sweden historically has a savings surplus, exporting its excess savings abroad. We discuss each of these factors in detail below.
Factor #1: The Size of the Macro Stimulus
Swedish authorities have put considerable policy stimulus into place. Starting with monetary policy, the Riksbank cut the repo rate by a total of 425bp since last October to a new historical low of 0.5%. In its April Monetary Policy Report Update, the Riksbank forecasts to leave interest rates at this rock-bottom level until early 2011. While this is a forecast, not a policy commitment, it allows the Riksbank to influence financial market expectations and, together with its inflation target, to anchor longer-term interest rates at relatively low levels. The impact also shows in the Swedish money market curve, which compares favourably to the ones in EMU, the UK and the US.
In addition to cutting interest rates, the Riksbank has also extended its lending operations to the banking system drastically since the start of the financial turmoil. In addition to this passive form of quantitative easing (QE), it stands ready to act and engage in active QE, if needed. According to Riksbank Governor Ingves, the Riksbank could, for instance, purchase government bonds and, possibly, also mortgage debt. We are not convinced that such outright purchases will be necessary at this stage though. Before embarking on such unchartered territory, the bank could still decide to lengthen the maturity of its lending operations, which at the moment do not go beyond six months. As far as outright purchases of government bonds are concerned, we doubt that with an already relatively narrow government bond market, a somewhat shorter yield curve and very large national pension funds, buying government bonds is the best strategy. Hence, we would deem purchases of mortgage debt more appropriate.
Next to the monetary policy stimulus, the overall fiscal stimulus provided in Sweden is probably among the largest in Europe due to a combination of large discretionary measures and elevated automatic stabilisers built into the generous Swedish welfare system. The Swedish government has approved about 3% of GDP in terms of discretionary measures over this year and next. Along with the measures presented in the 2009 Budget Bill and afterwards, the government is allocating a total of SEK 45 billion in 2009 and SEK 60 billion in 2010 to combat the crisis. Of the discretionary measures, two-thirds are tax cuts while another third is spending increases. The measures are equally spread out over 2009/10, thus reducing the risk of a levelling off in growth during the course of next year.
As a country with high marginal tax rates and generous benefits, it also has larger-than-normal automatic fiscal stabilisers at work. These stabilisers will likely bring the total fiscal policy support in the largest Nordic economy over 2009/10 to close to 9% of GDP, on our estimates. Given the healthy starting point of public finances, the fiscal policy measures are more likely to be effective than in countries where fiscal sustainability is being called into question. Concerns about an unsustainable fiscal policy path would potentially undermine confidence of the private sector and reduce the spending propensity of both households and companies.
Factor #2: Weaker SEK Should Reignite Export Demand
Contrary to its competitors in Germany, which have seen a stronger currency undermining their price competitiveness and profit margins, Swedish manufacturers are benefitting from a weaker SEK. Since last May, the SEK has fallen by almost 20% against the EUR and by more than 20% on a trade-weighted basis. On our estimates, the weaker currency alone could add 7% to export demand over the medium term. At present, the potential of a recovery in export demand is still dented by the slump in global industrial activity, we think. This is because, contrary to exchange rate movements, which affect export demand only with time-lag, overseas industrial activity has an immediate impact on export demand.
But, with a tentative turnaround in industrial activity starting to show in manufacturing surveys in many parts of the world now, it is only a matter of time until Swedish exporters will feel a welcome lift from their weaker currency. The overall impact on GDP will likely be a powerful one as Sweden is a highly export-oriented economy where international trade of goods and services accounts for 97% of GDP (compared with 43.3% in EMU and 56% in the UK). Exports of goods and services alone account for more than half of Swedish GDP (52.4%), compared to 22.3% in EMU and 26.3% in the UK. But, it is not just that international trade is playing a big role in the Swedish economy - the manufacturing sector, at 24% of value-added, is also larger than in many other European countries.
Factor #3: Banks Seem to Weather the Crisis
Contrary to many other countries, there are only very limited signs in Sweden of a marked slowdown in bank lending, either in response to the international financial turmoil or the deep economic recession. In addition, the Swedish financial rescue package is rather sizeable in international comparisons - largely as a precautionary measure for potential repercussions from the turmoil in the Baltics. The IMF estimates the total financial rescue package to come to 70% of Swedish GDP. As such, it is outdone only by the Irish (263%) and the US (74%) rescue packages (see State of Public Finances: Outlook and Medium-Term Policies after the 2008 Crisis, IMF, 2009). More than half of the package are guarantees (accounting for 47% of GDP), followed by central bank liquidity facilities (making up a further 15% of GDP), while asset purchases and treasury lending come to 5% of GDP and recapitalisations to a further 2%. .
Factor #4: Healthy Balance Sheets and Public Finances
Private sector balance sheets appear reasonably healthy in Sweden, with only moderate household debt levels by European standards and low government debt levels compared with peers in the region. According to Eurostat, Swedish households currently owe about 70% of GDP, compared with more than 130% in Denmark, 111% in the UK and 82% in Spain. Only non-financial corporates in Sweden seem to be somewhat more highly geared than their counterparts in the rest of Europe.
Looking at the asset side of the private sector balance sheets indicates that house prices in Sweden have not yet started to fall, even though the pace of increases has clearly slowed down. As a result, a major decline in housing wealth hasn't yet hit household balance sheets. Such a hit, however, has been experienced in some of the pension funds. As a country with long-standing current account surplus, Sweden has historically run a savings surplus, exporting part of its excess savings abroad. We expect this savings surplus - and along with it the current account surplus - to drop as a result of Swedish GDP growth being recalibrated towards domestic demand.
Factor #5: Experienced in Dealing with Financial Turmoil
Last but not least, Sweden has experience in handling a severe financial crisis and has emerged strongly from the turmoil of the Nordic banking crisis of the early 1990s. Such a positive experience will likely have a positive impact on the so-called ‘animal spirits' of consumers and corporates. In addition, we believe that the positive outcome of how the crisis in the early 1990s was handled will likely encourage policy makers to take bold actions, if needed.
Risks to the Recovery in Sweden
A number of risks exist to our call that Sweden will likely see a robust recovery:
First, not all cyclical effects have run their course yet; negative knock-on effects from the sharp drop in GDP, such as rising unemployment, falling profits and climbing involvencies, are still to come. The Riksbank itself, for instance, forecasts unemployment to rise from around 6% at the moment to more than 10%.
Second, Swedish banks are closely tied to Central and Eastern Europe, where exposure to CEE is around 23% of GDP, but only 11% of bank assets. The risks are very much concentrated in the Baltics, where Swedish banks account for 57-79% of cross-border lending.
Third, another big three-year wage round, which is on the agenda for early 2010, will be key in determining income and employment dynamics in the years ahead.
Finally, after an extended period of deregulation, privatisation and liberalisation, the political pendulum could swing back towards the traditional ‘Folksheim' welfare state, causing a marked drop in potential output and a considerable rise in the equilibrium unemployment rate.
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Review and Preview
June 02, 2009
By Ted Wieseman | New York
A rollercoaster week ended with a mixed performance by Treasuries after the prior week's drubbing, with small gains at the short and long ends but sizable losses by the 5-year as mortgages came under pressure. Treasury trading continues to be dominated by supply trends, as the market was hammered through early Thursday afternoon's 7-year auction, extending a collapse that began the prior Thursday morning with the announcement of this week's latest flood of US$101 billion in coupon issuance, before strongly rebounding Thursday afternoon and into Friday once the auctions were done. Month-end portfolio adjustments also added to a strong Friday rally that closed out a very volatile week. More notable than the mixed performance by Treasuries - which given recent history seems quite likely to turn back into broader weakness after Thursday's next supply announcement of the 3-year, 10-year and 30-year auctions that will take place the week of June 8 - was that the huge, mostly supply-driven backup in Treasury yields over the past couple of months (that at least temporarily peaked midday Thursday) finally reached the point where it was too much for previously stable mortgages to bear, with the MBS market plummeting and hugely underperforming Wednesday after the extent of compression between Treasury and mortgage rates had simply become unsustainable. With a lot of help from a more aggressive Fed, mortgages also managed to recover solidly starting late Thursday and extend the rebound much more substantially Friday. Still, even after the strong late week recovery, current coupon MBS yields have surged more than 40bp in the past week-and-a-half, decisively breaking out of their stable prior range even with Friday's renewed outperformance versus Treasuries. At the worst of the mortgage market troubles, 30-year consumer mortgage rates had been surging towards 5.5% from the stable, record-low levels very close to 4.75% that they had held close to for two months. Even if the late week MBS rebound pushes rates back down towards 5.25% or so, this substantial rise in mortgage rates would clearly present a substantial threat to the recent stabilization in home sales that was reflected in the past week's new and existing home sales reports for April.
From a market perspective, the consistent trend of recent months has been big Treasury market sell-offs during supply periods followed by some improvement - though only partial - during the intervening issuance lulls, a sort of one step forward/two steps back pattern that has seen yields move to new highs in usually alternating weeks, back off a bit, then move back to new highs again. The federal government's budget deficit and borrowing needs are so large at this point that it's becoming increasingly possible that the fiscal stimulus may not be stimulating the economy but is instead starting to hurt growth through the impact on interest rates and the powerful offset this pressure on rates is having on the Fed's attempts at targeted quantitative easing, possibly making this a rare occasion when the normally perverse Hoover/Rubin prescription of trying to stimulate the economy by tightening fiscal policy could actually be the right approach. This recent Treasury market back-and-forth pattern appeared to be right on track again following the big market rebound after the collapse that peaked with the 7-year auction that wrapped up the latest supply deluge Thursday. Still, it remains to be seen if this trend can continue into the coming week, given the break lower in the mortgage market, which even after Friday's solid rebound has left MBS yields far above their prior stable range and probably still left the market with looming needs to shed some duration somewhere in the interest rate markets to adjust to the extended duration of MBS that has resulted from the sell-off. While supply remains the dominant driver of the Treasury market, and this shift in the mortgage market could still present additional near-term market challenges even after the late-week rebound, some attention in the coming week may shift towards more fundamental news, as we get the run of key initial data releases for May, the employment report, the two ISM surveys and early signs for retail sales from motor vehicle and chain store results.
On the week, benchmark Treasury yields ended mixed as big losses through early Thursday afternoon's 7-year auction (except at the front end, which has continued to hold little changed for some time now) were partially or fully reversed Thursday afternoon and Friday. The old 2-year yield fell 1bp to 0.88%, the 3-year yield rose 3bp to 1.41%, the old 5-year yield rose 12bp to 2.33%, the old 7-year yield rose 9bp to 3.04%, the 10-year yield rose 2bp to 3.47% and the 30-year yield declined 5bp to 4.34%. With commodity prices continuing to move to new highs, with focus on another US$5 a barrel rally in oil to another high for the year above US$66, and the dollar remaining under pressure, TIPS were able to significantly extend their huge outperformance of the prior week. The 5-year TIPS yield fell 8bp to 0.93%, 10-year 6bp to 1.62% and 20-year 8bp to 2.25%. Even against the huge back-and-forth swings in Treasuries during the week, even bigger gyrations in mortgages - especially coming after two months of very low volatility with yields not moving too far from 4% since the Fed's stepped up buying announcement in March - took center stage in interest rate markets the past week. By Tuesday's close, the persistent recent weakness in Treasuries, combined with the stability in mortgages, had driven mortgage/Treasury spreads to extremes. This mortgage outperformance had been a persistent trend for two months, but suddenly for some reason, the dam broke Wednesday and mortgages were crushed, far underperforming what was already a severe sell-off in Treasuries. This underperformance extended into Thursday, but then swung back swiftly the other way on Friday. Still, for the week, it ended up being a terrible run for the MBS market that broke yields decisively above their tight two-month-long range. At the close in the middle of the prior week before the latest bout of Treasury weakness started, current coupon MBS yields closed at 3.93%, around the middle of their established range. At Thursday's close, this had surged all the way up to 4.67%, sending consumer mortgage rates to 5.5% or higher. With Friday's strong recovery building on a late-day bounce Thursday, it was down to around 4.30%, nicely recovering from the worst levels, but still a good way far above the prior range and likely to be consistent with 30-year consumer rates above 5%, up from recent record-low levels consistently around 4.75% when the MBS market was pinned its prior narrow range centered on yields a bit below 4%.
It's been a while since interest rate markets have driven risk markets instead of the other way around, but that was the case for a good part of the past week, with Wednesday's Treasury and mortgage market severe corrections substantially pressuring stocks (but much less so credit, which has done relatively better recently) and Thursday and Friday's rate drops helping a rebound. For the week, the S&P 500 gained nearly 4% to make it back to only about 1% below the recent high hit May 8. Credit performance was better. In late trading Friday, the investment grade CDX index was 8bp tighter on the week at 139bp, moving through the prior recent tight close on May 8 of 143bp to the best (roll-adjusted) level since September. High yield had a good week, but has not done quite this well on a longer-term view, with the HY CDX index 23bp tighter at 1,080bp at Thursday's close (compared with the recent best level of 1,008bp on May 8) and gaining about another 7/8 of a point as of Friday afternoon. The leveraged loan LCDX index's performance was in line with HY CDX, with an 80bp tightening on the week to 1,045bp as of midday Friday, pushing it just better than its prior recent tight hit also May 8. On a much more negative note, the commercial mortgage CMBX market took a big hit after the prior week's strong gains that followed the Fed's announcement that the TALF in July would accept legacy CMBS, the first legacy assets to be included in this program. The legacy CMBS will have to be rated AAA across the board to be eligible for TALF financing, however, and this universe of securities is about to get a lot smaller after S&P announced early in the week that up to 90% of AAA rated CMBS issued in 2007 (the last year there was CMBS issuance of any significance) would likely be downgraded, with not quite as widespread but still likely broadly based downgrades coming for prior year's issuance. As a result of this soon to be rapidly shrunken amount of legacy CMBS eligible for TALF financing, the big CMBX rally that followed the TALF announcement was unwound, with the AAA index off nearly 6 points on the week to 72.08, right back to about where it was two weeks ago before a brief run-up to a high close of 81.29 on May 20 after the Fed's TALF announcement. Meanwhile, the AAA subprime ABX index appeared to take a bit of a knock-on hit from the CMBX downside, falling more than a point to 26.80. The broader trend in this index, however, has been that after an almost continuous, gradual improvement in the month after the April 8 low of 23.10 was hit, it's been chopping around a bit but on net holding little changed now for about three weeks.
In economic news, the plunge in GDP in 1Q was revised to a slightly less severe -5.7% from -6.1%. Coming on top of the 6.3% decline in 4Q, this still represented the worst six-month contraction in the economy in 50 years. The upside in 1Q relative to the advance estimate reflected a smaller, though still huge, drag from inventories (-2.3pp versus -2.8pp). This was a bit higher than we anticipated, leading us on a preliminary basis to trim our 2Q GDP forecast to -2.7% from -2.5%. We will update this estimate after the full details of the revision are released along with Monday's personal income report. Upside in inventories offset a downward revision to consumption to +1.5% from +2.2%, a weak rebound following the near-record 4% plunge in 2H08. Consumption is on track to resume declining in 2Q at about a 1.5% annual rate. Business investment (-37%) continued to show a record decline in 1Q and residential investment (-39%) the worst drop since 1980. Both of these components are expected to be down sharply again in 2Q, but not to this extent.
On business investment in particular, durable goods orders gained 1.9% in April following a downwardly revised drop of similar size in March (-2.1% versus -0.8%). The April gain was boosted by upside in motor vehicles, fabricated metals and some miscellaneous defense items. Important underlying details were much weaker, however. Non-defense capital goods ex-aircraft orders, the key core gauge, fell 1.5% in April on top of a sharply downwardly revised drop in March (-1.4% versus +0.4%). Weakness in April was led by computers, while the March revision reflected much weaker results for machinery. Core capital goods shipments also remained very weak, falling 2.1% in April for a 34% annualized plunge so far this year, pointing to continued major weakness in business capital spending. We see equipment and software investment falling another 22% in 2Q and overall investment 17%.
On the residential side, home sales continue to show signs of stabilization, though this may be threatened by the ongoing back-up in mortgage rates. New home sales were little changed near a record low in April, ticking up 0.3% to a 352,000 unit annual rate. With single-family housing starts also near a record low, the stability in sales recently allowed the number of unsold new homes to fall another 4.2%. There has been an improvement in the months' supply of unsold new homes to 10.1 from the record 12.4 hit in January, but this remains way above more normal levels of around six months. Meanwhile, existing home sales have also been roughly steady in recent months after a 3% gain in April to a 4.68 million unit annual rate. A very high share of existing home sales has been of foreclosed properties, however, which continue to flood the market - the Mortgage Bankers Association reported yet another quarter of record rates of mortgage delinquencies and foreclosures in 1Q - and keep prices under pressure and inventories elevated.
The upcoming week has the potential to be a better one for the Treasury market with no new issuance to worry about until Thursday's announcement of the following week's auctions - we look for a US$35 billion 3-year, US$18 billion reopening of the 10-year and US$11 billion reopening of the long bond, which would all be unchanged sizes - and on the other side of the supply equation two rounds of Fed Treasury buying plus probably a round of agency buying on Friday and ongoing daily (and potentially stepped up) MBS buying. While MBS buying could be increasing, Treasury buying has actually been scaled back a bit for the next couple of weeks, with only two operations each of the next two weeks after the pace had been raised to three a week for the two weeks before this latest holiday-shortened period. The key early round of economic numbers for May will be released through the week, with focus on what will likely be another weak employment report for May. Prior to that we will get the manufacturing ISM survey Monday, non-manufacturing ISM Wednesday, early indications for retail sales from auto sales results Tuesday and monthly chain store reports from most major companies (but unfortunately as of this month not Wal-Mart anymore) on Thursday. Other data releases due out include personal income and spending and construction spending Monday, factory orders Wednesday and revised productivity Thursday:
* We look for 0.2% declines in both personal income and spending in April. The labor market report pointed to another outright decline in personal income, while the retail sales figures imply a similar dip on the spending side. Still, the personal savings rate should tick up a bit due to the impact of a slight reduction in tax withholding associated with the Making Work Pay provision of the fiscal stimulus legislation that was enacted in February. Our translation of the CPI data suggests that the headline PCE price index should come in at +0.05%, with the core at +0.24% (which would push the year-on-year rate up a tick to +1.9%).
* The regional surveys that have been released to this point continue to show that manufacturing conditions are deteriorating at a slower rate. So, we look for a 2-point rise in the ISM in May to 42.0, with upticks in the production and inventories categories driving much of the anticipated gain. The price index is also expected to move up about 4 points to 36.0 - still an extremely depressed level from a longer-run perspective but well up from the cycle low of 18.0 that was hit in December.
* We forecast a 1.8% plunge in April construction spending. The housing starts data point to continued slippage in the residential sector. Also, we look for a pullback in the non-residential category this month following the surprising gain seen in March. Finally, it's probably still too early to see any meaningful upside in the public component tied to fiscal stimulus spending.
* Motor vehicle sales in May appear to be tracking close to April's 9.3 million unit selling rate, and we look for only a marginal further drop to 9.2 million. Industry reports suggest that Chrysler has managed to temper much of the negative impact on buyer psychology that might have been associated with the company's recent bankruptcy filing by introducing very aggressive incentive deals. However, fleet activity - across the industry - represents an important wildcard this month. Finally, the recent rise in gasoline prices should help to tilt this month's sales toward cars and away from SUVs.
* We expect overall factory orders to rise 1.5%. The advance report pointed to a sharp gain in the durables component, which, together with a likely price-related rise in bookings for energy-related items, should lead to solid rise in overall factory orders. Meanwhile, shipments are expected to be little changed, with inventories down 0.9% - a bit smaller drop than seen in recent months.
* The upward revision to 1Q GDP points to a similar adjustment to productivity growth to +1.4% from the originally reported figure of +0.8. Meanwhile, an upward revision to compensation is expected to offset some of the impact of higher productivity, limiting the likely downward adjustment on unit labor costs to only 0.2pp (from +3.3% to +3.1%). Both productivity and costs are rising at about a 2% pace on a year-on-year basis.
* We look for a further 500,000 plunge in May non-farm payrolls. The recent sharp divergence in the initial and continuing claims series creates considerable uncertainty regarding the state of the labor market. We suspect that the pace of job loss has started to moderate on an underlying basis - but signs of any moderation remain quite tentative at this point. So, we look for another sizable decline in employment, with further significant job losses in categories such as manufacturing, construction, temp help and retail trade. Most importantly, the expected payroll drop would be even larger were it not for an anticipated 75,000 of additional census-related hiring by the federal government. Of course, this follows 63,000 such hires in April. These workers are performing address checks in preparation for the 2010 census and most should disappear from the payroll tally in the next month or so. However, census-related hiring will begin to gear up again later this year. Indeed, the government estimates that as many as 1.5 million workers will be needed to conduct the 2010 census - far more than were hired for the 1990 or 2000 tallies. Finally, an expected pullback in the labor force participation rate, following a surprising uptick in April, should help to limit the rise of the unemployment rate in May to only a couple more tenths to 9.1% after a run of much bigger sequential rises stretching back to late last year.
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