Mexico
The Fiscal Straightjacket
July 14, 2009

By Luis Arcentales & Daniel Volberg | New York

The outcome of July's mid-term election has once again raised the prospect for political gridlock in Mexico.  Voters handed an important defeat to the ruling party, which failed to hold on to its 206-seat plurality in the 500-seat lower house of congress.  Over the past three years, the administration had successfully pushed through a series of proposals in congress, including overdue changes to the public pension system and more recently to the oil sector.  Now, with the ruling party losing meaningful ground in congress as well as at the state governor level, many Mexico watchers argue that the opposition finds itself in an enviable position to effectively block any further effort by the administration to advance a structural reform agenda - ranging from changes to the labor and tax codes to efforts to enhance competition - which seeks to boost the country's competitiveness and potential growth.

But topping the list of possible reform proposals that could fall victim to the new political dynamic may be a set of fiscal changes aimed at lifting non-oil tax revenues - which last year stood at just 10.0% of GDP, an extremely low figure by global and even regional standards - and thus reducing the public sector's dependence on volatile oil receipts.  Indeed, the authorities have expressed their intention to push for a fiscal reform coinciding with the 2010 budget negotiations, which are set to start in early September. With the election result - in which the ruling party's share in the lower house dipped below one-third of the seats, the minimum required to sustain a veto - the prospects for tax reform may have become more challenging.  Thus, in our view, an important question to ask is whether, absent reforms, Mexico's current fiscal path leads to unsustainable deficits ahead?  So how urgent and significant is Mexico's fiscal predicament?  Our projections suggest that, absent a reform that boosts non-oil tax receipts, policymakers will have little choice but to meaningfully curb the rapid expansion in expenditures that have become the norm in recent years.

Old Concerns, New Urgency

Concerns about the sustainability of Mexico's fiscal path are not new (see "Mexico: No Oil, No Problem?" EM Economist, February 27, 2009).  The main fear is derived from the steady drop in oil output, which has fallen since its peak year (2004) by over one-fifth to just 2.65mbpd in the first five months of 2009.  Combined with surging gasoline imports and rapidly falling crude exports, Mexico is progressively deriving fewer fiscal benefits from any increase in oil prices (see "Mexico: Oiling the Fiscal Coffers", EM Economist, June 6, 2008).  Indeed, rating agencies have made cautious comments about Mexico's credit rating and, on May 11, S&P shifted Mexico's credit outlook to negative - citing fiscal vulnerabilities derived from "budgetary dependence on oil revenues ... and a low non-oil tax base" - confirming market fears about a potential rating downgrade. 

The difference today is that the depth of the ongoing recession has turned many of Mexico's medium-term impediments into more immediate threats.  With the economy set to contract by 7.0% this year, the government has found itself with limited maneuvering room to provide needed fiscal stimulus, bringing attention to the country's underlying fiscal vulnerability.  Indeed, the fiscal authorities have resorted to a series of measures this year to plug in the expected budget shortfall, ranging from a M$95 billion one-off FX-translation transfer from the central bank to M$35 billion in expenditure cuts announced at the end of May to a timely oil-hedging strategy (see "Mexico: Fiscal Hedging Grace", EM Economist, November 14, 2008).  In addition, the government was sitting on savings worth near 1.8pp of GDP at the end of 1Q which, though welcome, may in our view be insufficient to provide much of a cushion beyond 2011 or even earlier. 

Absent progressively higher crude prices or a turnaround in output, Mexico's oil revenues may be on a steadily deteriorating trend, when measured as a share of GDP.  In the past we had argued against what we thought were overblown market concerns about the immediate risk from lower crude quotes to the fiscal accounts, which likely reflected a widespread misunderstanding of the interplay between crude prices and the combination of exchange rate weakness and controlled domestic fuel prices, which act as an automatic stabilizer (see Mexico: No Oil, No Problem?).  Indeed, though undesirable from a standpoint of economic activity, the authorities could accelerate the pace at which fuel prices are increased starting 2010.  This year, however, domestic gasoline prices are frozen and the price of diesel is increasing only slightly as part of the stimulus package at a cost of roughly 0.4pp of GDP.  Over the medium term, however, falling oil output and exports - combined with rising imports of gasoline due to insufficient domestic refining capacity - are set to translate into erosion in the GDP share of oil-related revenues, in turn putting pressure on the fiscal accounts. 

Quantifying the Fiscal Challenge

To better understand the magnitude of the challenge, we make a medium-term projection of Mexico's fiscal accounts.  We focus on projections for both fiscal revenues and fiscal expenditures. Our fiscal revenue projections leave little room for comfort.  We proceed by breaking fiscal revenues into two components: oil receipts and non-oil revenues.  We then project both components of fiscal revenues out to 2015 to coincide with the mid-point of the next presidential term, since it gives a convenient estimate, in our view, of the potential pressures that the next administration is likely to face in sustaining social spending and public investment if the country remains on its current path.  Our revenue projections are made under two different scenarios: a low growth scenario with real GDP growth of 1.5% - near the average growth of the Mexican economy during the ‘lost decade' of 1980-89 (1.6%) - or a trend growth scenario with GDP growth of 3.0% - close to the average annual growth of the past decade (2.9%).  We further assume that oil prices remain constant near US$60 per barrel throughout the forecast horizon and that Mexico's oil output continues to decline by 0.3pp of GDP a year. We find that the results under either scenario are not encouraging.

We find that pressure from oil-related receipts makes for a challenging outlook for total fiscal revenues.  On the oil front, we find that after representing 8.0pp of GDP in the past five years, revenues could dip by around two full percentage points by 2015 on average, depending on the GDP growth scenario.  Under our two scenarios for GDP growth, non-oil revenues increase over time by just enough to offset the deterioration in oil receipts; in fact, our model yields fairly stagnant total budgetary revenues, which barely increase by 0.1pp of GDP on average per year over our forecast horizon.  Similar work conducted recently by the IMF as part of Mexico's article IV consultation yielded an even more challenging outlook for total budgetary revenues. 

With total revenues relatively stable over time, policymakers face a difficult balance ahead.  Absent a successful tax reform - the IETU tax introduced in 2008 has not yielded the revenue stream projected by the finance ministry - the rapid expansion in expenditures of recent years would have to be curbed, in our view.  This forced fiscal contraction may be economically undesirable, given our expectation that Mexico may see only a subpar recovery ahead (see "Latin America: Speeding up the Cycle, but Recovery Subdued," EM Economist, June 19, 2009).  Importantly, inherent rigidities in the budget translate into potential risks to the aggressive efforts by the authorities to boost infrastructure and social spending, if this forced adjustment were to take place.

To estimate the potential fiscal pressures in coming years, and complement our revenue projections, we created three scenarios for expenditures.  In the first, we use the average real growth in realized expenditures in the past five years (+7.2%).  For the second, we assume half of the aforementioned growth pace and, in the third, zero real growth. 

We find that, absent tax reform, a major spending adjustment would be required to avoid meaningful medium-term fiscal deterioration. Going ahead, policymakers face a set of difficult choices, which would require hiking taxes, broadening the tax base - which the VAT on food and medicine would achieve - and/or expenditure cuts.  For example, were the authorities to cut the rapid rise in expenditures seen in recent years to match just inflation, Mexico's fiscal accounts would revert to a sustainable path, according to our calculations.  This result is true even in our bearish growth scenario, which incorporates annual GDP growth of just 1.5%, and it is certainly the case if the economy grows at twice that pace.   But the margin to maneuver seems limited: with outlays growing at a real rate of just 3.6% - half the actual pace of expenditure growth in the past five years - the fiscal shortfall would approach 6% of GDP in our low-GDP growth scenario, while stabilizing at around 3.5% of GDP if the economy grows by 3% on average.  In what we suspect is the most likely outcome - one of subpar GDP growth and expenditure growth above inflation - avoiding fiscal deterioration would require efforts that may be politically challenging following the results from the early July mid-term election.  Thus, insofar as policymakers are unable to constrain expenditure growth, we suspect that Mexico watchers are right in expressing the urgent need for a new tax reform.

Bottom Line

Mexico faces a difficult fiscal balancing act.  Our work suggests that, on its current path, Mexico's fiscal accounts may be heading towards unsustainable deficits as oil output continues to decline.  We are concerned that avoiding fiscal deterioration would require efforts that may be politically challenging following the results from the early July mid-term election.  Thus, insofar as policymakers are unable to constrain expenditure growth, we suspect that the chorus of Mexico watchers expressing the urgent need for a new tax reform will continue to grow louder.

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United States
Review and Preview
July 14, 2009

By Ted Wieseman | New York

Treasuries posted big gains led by the intermediate part of the curve over the past week, extending the prior week's post-employment report surge to send yields to their lows since mid-May after what's been a major rally from the market lows hit after the early June release of the stronger-than-expected May employment report.  The latest week's rally was a particularly strong performance, coming in the face of a previously unprecedented but now soon-to-be regular run of four straight coupon auctions, as the recent notably gloomier sentiment on the economic outlook that accelerated substantially after the weak employment report continued despite not a lot of new data over the past week.  This shift in sentiment weighted on equity, credit and commodity markets through much of the week, providing additional support for Treasuries that was also reflected in strong demand at the auctions, particularly at an unusually well bid 10-year reopening.  Mortgages were able to generally to keep pace with and thus help fuel the Treasury rally, with yields on current coupon MBS falling to new lows Friday near 4.3% since the late May breakdown, down from levels briefly above 5% at the worst of the mortgage market rout a month ago.  The sustained recent improvement, which has seen MBS yields moving further below 4.5% since the post-employment report rally on July 2, along with further major improvement in interbank rates and spreads as pressures on bank balance sheets apparently continue to ease, helped drive a substantial narrowing in swap spreads over the past week and drove the overall Treasury market rally and outperformance by the belly of the curve.  Results from the week's light economic calendar were somewhat mixed.  Chain store sales were terrible and supported expectations that June retail sales will be down aside from a price-related jump in gas station sales and that real consumption in June and for 2Q as a whole will turn negative again after the prior slight improvement.  The jobless claims report was mixed, but investors placed more emphasis on a surge to another record high in continuing claims than a plunge in initial claims that appeared to be just the result of seasonal adjustment problems.  And labor market weakness and rising gasoline prices drove a major pullback in the University of Michigan's consumer confidence poll in the first part of July after it had far outperformed a significant drop in the Conference Board survey in June.  On the positive side, though, the trade report was much better than expected and pointed to an enormous add to 2Q growth from net exports, far bigger than we previously expected, as well as a slightly smaller plunge in investment.  Also incorporating industry data showing another plunge in truck inventories in June, however, we only boosted our 2Q GDP forecast to -1.1% from -1.5%.  But a much more positive mix of final sales versus inventories within that estimate points to substantial, if likely only temporary, potential upside to our 3Q GDP estimate of +1.0% if auto inventories merely flatten out after what looks to have been a huge decline in 2Q. 

For the week, benchmark Treasury coupon yields plunged another 9-25bp, led by the intermediate part of the curve, extending the 11-28bp rally of the prior week that was also belly-led.  The 2-year yield fell 9bp to 0.90%, 5-year 21bp to 2.21%, 7-year 25bp to 2.88%, 10-year 21bp to 3.29%, and 30-year 12bp to 4.20%.  These were lows since mid-May after rallies ranging from 51bp for the 2-year to 72bp for the 5-year since the highs for the year were hit in the days after the release of the May employment report - the somewhat better-than-expected results of which certainly appear to have been a major head fake - on June 5.  With such a big rally in nominals and major weakness in commodity prices - August tumbled almost US$7 a barrel to below US$60, a low since mid-May (lots of things were hitting new highs or lows since mid-May on Friday) - TIPS performed terribly on a relative basis and breakevens continued moving substantially lower.  The 5-year TIPS yield was flat at 1.13% and the 20-year rose 9bp to 2.29%.  A decent auction apparently helped the 10-year sector perform comparatively well, with the new issue ending at 1.78%, about a 9bp improvement from the old issue's close of 1.84% the prior week including a small yield pick-up into the new issue.  This still lowered the benchmark 10-year inflation breakeven another 14bp to 1.51%, a low since mid-May and down from a high close of 2.10% on June 10. 

Mortgages had a good week, largely tracking the strong Treasuries rally and sending current coupon yields down towards 4.3% after initially breaking 4.5% after the employment report.  If sustained, this upside could see 30-year mortgage rates moderate down towards 5% going forward - which would be back not too far from the record lows around 4.75% rates were consistently around from late March through late May when the MBS market was very stable at yields around 4% - after having moderated down from levels above 5.5% a month ago at the worst of the MBS market turmoil to just below 5.25% in the latest week.  The lagged impact of the prior back-up in rates could still cause some near-term weakness in housing market activity after the prior period of stability, but a more sustained and pronounced renewed down-leg in sales looks to have probably been averted for now.  Of note, the MBA's mortgage applications index showed a bit of renewed upside the past week after having been in freefall for several weeks.  The general market rally added support from strength in mortgages and resulting duration extension needs as the decline in rates lowers MBS market duration, and continued improvement in interbank rates helped to drive a notable further narrowing in swap spreads over the past week.  The benchmark 10-year spread fell another 3.5bp to 17.75bp and is moving back closer to the record low of 8bp hit in mid-May after having moved up towards 45bp a month ago.  Despite the major improvement in interbank markets, recent improvement in shorter spreads has been more muted, but a 2bp narrowing to 39bp still left the benchmark 2-year spread near the lows seen since the financial turmoil began a couple of months ago.  3-month Libor is back to setting record lows on a daily basis, with a further 5bp drop over the past week to 0.51%, lowering the 3-month Libor/OIS spread to 31bp, another new low since early 2008.  Expectations for Libor/fed funds spreads going forward also continued moving to new lows.  Aside from some modest upside priced in for year-end pressures in December, forward Libor/OIS spreads are priced to be near current relatively low spot levels - which in the post-crisis world may be around the new normal instead of the prior 10bp or so - over the next year.  So at least this key gauge of bank balance sheet stress continues to suggest notable easing in financial market strains. 

The renewed gloominess about the economic outlook that continued to fuel the Treasury market rally also continued to weigh heavily on equity and credit markets.  The S&P fell another 2% on the week for a 5% drop since the employment report.  After a long period of being persistently the high-beta sector, financials have performed about in line with the overall market weakness recently and cyclical sectors have been more frequently leading market weakness, with the commodity price plunge recently obviously pressuring energy and materials stocks.  Friday's stock close was the worst since May 1 and left the S&P 500 down 3% for the year.  Credit has struggled recently as well certainly, but is holding up somewhat better than this so far.  In late trading Friday, the investment grade CDX index was trading 8bp wider at 145bp, matching the prior recent wide closes hit June 22 and 23, but in contrast to stocks still a good bit better than the May 1 close of 164bp.  The high yield index was 30bp wider on the week at 999bp through Thursday and, even with about another half-point loss, Thursday was on pace to hold in moderately better than the recent wide of 1,059bp hit June 22 or the May 1 close of 1,120bp.  Note, though, that with the pace of defaults accelerating, we've now already reached version 7 of the current series 12 HY CDX index that only began trading in late March.  Leveraged loans continued their recently similar performance to high yield, with the LCDX index 38bp wider through midday Friday at 952bp, maintaining roughly similar net improvement as the HY CDX compared to June 22 wide or prior day of the prior stock low on May 1.  Against this downside in stocks and credit, performance by commercial real estate and subprime was quite robust.  Underlying fundamentals in these areas don't seem to be improving much (though subprime default rates are showing some signs of possibly moderating), but the sentiment shift engendered by recent moves by financial institutions to repackage real estate assets and add credit enhancements to maintain AAA slices seems to be continuing to have positive impact.  The AAA CMBX index gained 0.65 point on the week to 73.94, just off the peak of 74.00 hit June 2 in the aftermath of the rally that began after the first of these CMBS restructurings was announced in mid-June (when the index was trading near 68).  The junior AAA CMBX index also had a good week, gaining 0.58 points to 33.48, similarly just below the peaks of the recent rally, though lower-rated indices were more mixed.  The subprime ABX market has generally been a lot less volatile for a while than the CMBX market, and this continued, but the AAA ABX index did tack on a marginal gain to 25.83, near its best level in a month.

The trade deficit narrowed to a near 10-year low of US$26.0 billion in May from US$28.8 billion in April, with exports rebounding 1.6% after a 33% annualized plunge over the prior nine months, but imports falling another 0.6% to extend a 43% collapse over the prior nine months.  Export upside was driven by industrial materials.  This was partly price-related but, surprisingly, mostly a result of higher volumes.  Meanwhile, on the import side petroleum products posted a surprising decline as a major drop in volumes more than offset the substantial rise in prices.  The real trade deficit fell even more than the nominal gap, pointing to a very large positive contribution to 2Q GDP growth from net exports.  We now see trade adding 1.9pp to 2Q GDP growth instead of 0.5pp.  Arithmetically, this is clearly a major positive, but the real import/export breakdown we see giving this outcome - imports plunging 20% and exports 11% - is hardly showing strength, though at least the surprising jump in exports in May was a notable, at least, temporary change from the prior trend.  On top of the much more positive outlook for net exports, the mix of capital goods exports and imports (a marginal rise in exports that was in line with expectations but an unexpected small gain in imports) was slightly positive for investment relative to our prior assumptions, leading us to boost our forecast for 2Q equipment and software investment to -21% from -22% and overall business investment to -10% from -11%. 

Largely offsetting the substantial boost to our 2Q GDP forecast from the trade report, however, was a much more negative outlook for motor vehicle inventories.  Industry figures indicated that unit truck inventories posted another drop in a run of enormous declines in June that was far bigger than we expected.  Combined seasonally adjusted car and truck inventories now look as if they may have plummeted nearly 20% over the course of 2Q.  Incorporating this result (plus a slight additional negative from a larger-than-expected drop in wholesale inventories in May), we cut our estimate of the inventory contribution to 2Q growth to -1.7pp from -0.5pp, offsetting much of the upside from the net exports boost (and slightly smaller-than-expected negative from investment) to only result in our 2Q GDP forecast going up to -1.1% from -1.5%.  Note, however, that the mix we see in 2Q is now much stronger between final sales and inventories, and this has potentially substantial positive implications for 3Q.  In particular, if motor vehicle inventories merely flatten out in 3Q after the huge apparent drop in 2Q, the boost to 3Q growth would be quite large; though, of course, this would be only temporary barring a sustained pick-up in auto sales, which we do not expect beyond a modest temporary near-term lift from the ‘cash for clunkers' plan (which may turn out to be underwhelming unless more is done to raise public awareness and understanding of this program before it kicks off later in the month).

The economic calendar is busy in the upcoming week after the light flow of numbers over the past week, with Tuesday's retail sales report the most notable report.  The first round of regional manufacturing surveys for July will be released (Empire State Wednesday and Philly Fed Thursday), setting early expectations for the next ISM report, but the survey period for the employment report is late this month, so we'll have to wait another week before claims figures cover the survey week (and they probably won't be of much use anyway with auto seasonal adjustment problems likely to continue through the month).  The Fed will release the minutes of the June FOMC meeting on Wednesday, which will likely be most notable for providing the FOMC's updated economic forecasts ahead of Chairman Bernanke's semi-annual monetary policy testimony on July 21.  Other data releases due out include the Treasury budget Monday, PPI and business inventories Tuesday, CPI and IP Wednesday, and housing starts Friday:

* We expect the federal government to report a US$75 billion budget deficit in June.  June is generally a surplus month due to heavy inflows of corporate taxes and estimated payments by individuals.  However, we look for a sizeable deficit this time around.  The red ink reflects a number of factors including  a calendar shift (US$22 billion), significant slippage in June tax payments by both corporations and individuals (US$43 billion), capital injections to the agencies (US$24 billion) and higher outlays for unemployment benefits and other entitlements (about US$25 billion).  The June results would be even worse were it not for the expected impact of TARP repayment by a number of firms.  The June repayments amounted to US$69 billion, which should translate into a negative budget outlay of about US$23 billion, using net present value accounting.  However, there is some uncertainty involved here because it is possible that the Treasury will not recognize the repayments in the official budget numbers on a timely basis.  Finally, applying our June estimate, it looks like the budget deficit totaled about US$1.1 trillion over the first nine months of F2009.

* A price-related surge in gas station sales is expected to lead to a sizeable advance in retail sales in June, and we forecast a 0.6% rise in overall sales and a 0.7% gain excluding autos.  However, sales excluding autos and gas are expected to be down 0.2%, reflecting the headwinds of job loss, wealth declines, constrained credit availability and high energy prices that continue to bear down on the consumer.  Indeed, chain store reports pointed to a bad month for apparel retailers.  Also, unseasonably cool temperatures across some parts of the country are expected to have helped restrain sales of air conditions and fans. 

* We look for a sharp 1.8% jump in the headline producer price index in June tied to one of the sharpest advances in wholesale gasoline prices on record.  Quotes for natural gas are also expected to rise following a lengthy string of monthly declines. Otherwise, outside of a modest rise in food category, prices appear to have remained well behaved in June - right in line with the trend seen in recent months - and we expect the core PPI to be flat.  And, of course, the elevation in this month's headline reading is likely to prove temporary, given the recent pullback in quotes for spot energy prices.

* We forecast a 1.1% decline in May business inventories, as the figures for the manufacturing and wholesale sectors point to another sharp drop in overall business stockpiles.  Meanwhile, the I/S ratio should tick down to 1.42.  However, this ratio is still quite elevated relative to the long-run trend, which implies continued sluggishness in production for the foreseeable future.

* We look for a 0.7% surge in the consumer price index in June but a 0.1% rise excluding food and energy.  A sharp jump in prices at the gas pump is expected to lead to a significant run-up in the headline CPI this month. However, quotes for most other items - such as apparel and motor vehicles - should show some further softness.  Moreover, the key shelter category is expected to show continued signs of underlying moderation, reflecting weak rental market conditions across most of the country.  So, even with a bit of upside in service categories such as education and medical care - together with another advance in used cars - the core is expected to just barely round down to +0.1% (after having just barely rounded up to +0.2% in May).  This should help to push the core rate down to +1.7%Y in June.  Finally, the impact of the sharp rise in the headline reading for June should be limited, given the subsequent pullback in energy prices.

* We expect industrial production to plunge another 1.1% in June.  The employment report showed another sharp decline in hours worked within the manufacturing sector.  Moreover, vehicle assemblies appear to have posted another sizeable drop.  Meanwhile, although temperatures were below normal in the Northeast, they were well above normal in the South.  So electricity demand for the nation as a whole appears to have registered little change during the month.  This all appears to add up to a decline in overall IP that matches the May result, with the key manufacturing category expected to be down 1.3%.

* We look for June housing starts to rise to a 540,000 unit annual rate.  Homebuilder sentiment has improved a bit in recent months.  So even though the labor market report showed a sharp drop in residential construction jobs, we look for a slight (+1.5%) uptick in June starts.  Our estimate reflects continued expected modest upside momentum in the single-family category, together with a flattening out in the multi-family sector following on the heels of some wild gyrations in recent months.

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United States
Rising Saving Rate Does Not Signal Renewed Consumer Retrenchment
July 14, 2009

By Richard Berner | New York

Does the jump in the personal saving rate over the past year signal renewed consumer retrenchment, with the ‘paradox of thrift' poised to weaken the economy further?  The paradox refers to Lord Keynes' famous observation that increasing saving individually may be a good thing, but if in a recession all consumers try to save more in unison, it will pull down spending, output and incomes, prolonging the recession.  That's still a cyclical risk, because the perfect storm for consumers isn't over.  But we think renewed retrenchment is highly unlikely; in fact, we see a short-term bounce in spending ahead, courtesy of ‘cash-for-clunkers' vehicle purchase incentives (see Does the Economy Need More Stimulus? July 7, 2009).  And a recovering economy should promote a modest acceleration in spending next year.

But the spending acceleration in 2010 and beyond is likely to be mild, as we believe that a sea change in consumer behavior is underway, one involving a slow return to thrift.  Aggressive deleveraging of household balance sheets and a slow stabilization of household wealth over the next few years mean that spending should grow more slowly than income.  As a result, the personal saving rate seems likely to rise to 7-10% during this period (see Deleveraging the American Consumer, May 27, 2009).

This longer-term increase in personal saving is clearly a good thing, but its timing is not perfect.  It won't be large enough or soon enough to finance huge US budget deficits.  And weakness in US consumer spending is not likely to be offset by a major pick-up in consumption abroad soon enough to help rebalance the global economy.

Looking through the one-time factors.  Short-term movements in the saving rate measured in the National Income and Product Accounts (NIPAs) may be a poor guide to consumer behavior; the data can be noisy, and are subject to potentially large revisions.  The past 18 months are a case in point: The influence of the recession on income and spending and several changes in taxes and transfers in response to the downturn have produced a bumpy path for the saving rate.  But when adjusted and smoothed for a few of those policy changes, the recent rise in the saving rate does seem consistent with our story that a deleveraging consumer is in the midst of a sea change in behavior.  For example, the 2008 tax rebates lifted the saving rate over 4% in May of that year, but adjusting for those rebates (using Bureau of Economic Analysis estimates of their magnitude and holding other things equal), the saving rate dipped below zero as consumers defended their lifestyles.  That changed last summer as sliding home prices and an intensifying credit crunch triggered retrenchment beyond the slowing in income.  In the first five months of 2009, apart from the effects of one-off Social Security/SSI checks, the measured personal saving rate jumped 150bp.  Adjusted for these one-time checks, the tax refunds and lower final settlements from 2008, and tax cuts and transfers from the 2009 stimulus package, the saving rate has been roughly stable this year at about 4%.  In the next few months, the measured saving rate will almost certainly slip back towards 4% temporarily as spending picks up and some one-time factors vanish.

To assess underlying changes in consumer behavior apart from one-time factors, we typically use models that capture feedback from the economy.  Models are inherently imprecise, and lags from causal factors are hard to gauge.  Yet the best of these suggest that the loss of nearly US$14 trillion in household wealth since it peaked two years ago may have increased the saving rate by 3-4 percentage points over the past year to about 4% - roughly in line with our adjusted saving rate.  This is a key reason why the tax cuts haven't fully been spent.  Consumer deleveraging seems to be on track, although it's still early days.  The household debt service ratio - household payments of interest and principal on debt in relation to disposable income - has declined by 75bp to 13.5% in 1Q from its peak two years ago, and consumer credit continues to plunge.  In May, such credit fell 1.8% from a year ago, equaling the record decline in the 1991 recession.

But the deleveraging process has a long way to go, depending on the path of the economy, home prices and interest rates.  We estimate that debt service in relation to disposable income may fall another 200bp to 11.5% by early 2011 in our baseline deleveraging scenario.  That is consistent with a 25-30 percentage point decline in household debt-to-income ratios of 80-100%.  Consumers will slowly make the adjustment to a new normal environment only as they become resigned to the need to rebuild balance sheets and save more.  While some of the increased thrift is clearly voluntary, rising foreclosures that extinguish loans are also painfully at work.  The pace of credit losses and the feedback to the economy will likely help to dictate the outcome (see Credit Losses, Deleveraging and Risks to the Outlook, May 4, 2009).

The impact of deleveraging on the consumer is deepened by cyclical risks: Jobs and income continue to shrink.  The weak June employment report won't be the last one, as the increase in continuing claims for unemployment insurance attests, although there are some signs that the pace may be abating.  For example, private job opening rates rose in May, and our business conditions index showed an uptick in hiring plans (see Business Conditions: Back to Reality, July 10, 2009).  Home prices are still falling, however, and the recent end to the foreclosure moratorium initiated in February may further increase the inventory of vacant homes (although California began a 90-day moratorium on June 14).  Credit availability, although improving, is still low.  Auto finance companies in May raised average loan-to-value ratios back into the 90% range as they gained access to credit.  In mortgage credit, however, downpayments appear to be stuck at much higher levels than three or four years ago, reflecting the expectation of further downside risk to home prices.  The run-up in energy prices has abated sharply, but it had already sapped discretionary income by about US$50 billion this spring.  The mortgage refinancing window could reopen if rates decline further, but the hoped-for contribution to spending power during the last round was smaller than expected.

Treasury yields range-bound for now.  Against this backdrop, we and our interest rate strategy colleague Jim Caron see Treasuries range-bound between 3% and 3.75% for now, but moving back to 4% or more by year-end.  Additional weakness in the economy and an associated retreat from risky assets could push Treasury yields lower, especially as inflation fears have abated, but the 70bp rally in 10-year yields and 50bp decline in inflation breakevens probably substantially discount such a scenario.  Prospective fiscal policy changes are also likely to figure in the mix.  Renewed weakness in the economy would keep alive the new debate over the need for additional fiscal stimulus, while improvement should quash it.  An increasing chance of new fiscal stimulus likely would put a floor under yields if they get back near 3%.

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