United States
Review and Preview
August 11, 2009

By Ted Wieseman | New York

Treasuries were crushed over the past week after the oddly strong performance the prior week, with yields spiking to their highs since the early June peaks for the year were hit as economic data surprised to the upside and provided more evidence that a solid auto-led rebound in 3Q GDP is underway.  Upside in risk markets remained somewhat muted after the enormous gains seen during most of July, but stocks and credit still set new highs for the year, and Treasuries were unable to brush off the continued strength as they did during the prior week's gains.  After the upside seen in the early run of July data, we continue to see 3Q GDP gaining 3-4%.  While this should mark the end of the recession, and we expect growth to remain positive beyond the summer, at least in 3Q, the upside appears to be quite narrowly based in autos and closely associated industries - including railroads, where traffic showed a notable improvement in July driven by increased shipments of inputs to auto production (see Freight Transportation: Rails: Traffic Hints at Near-Term Recovery by Bill Greene and Adam Longson) - though a broader flattening out in activity after the declines seen through mid-year should be supportive.  This divergence was certainly evident in the past week's numbers.  The manufacturing ISM posted its biggest monthly gain in years and moved close to the 50-breakeven level, but the non-manufacturing ISM fell back slightly further into contractionary territory.  Auto sales were way up in July (and with cash for clunkers extended should see an even bigger gain in August), but chain store sales results remained terrible.  Consumption is on pace for a significant gain in 3Q, but almost all of the upside will probably be in motor vehicles.  And the biggest contributor to the moderation in the pace of job losses in July - which based on a continued improving trend in claims should be extended in August - was a 28,000 surge in motor vehicle jobs after declines averaging 22,000 over the prior year.  All together across consumption, inventory restocking and investment, we expect the motor vehicle sector's contribution to fully account for the expected overall 3-4% gain in 3Q GDP.  A zero result for the rest of the economy would still mark a notable improvement from prior trends, and we expect to see a further gain into modestly positive territory in 4Q.  But with motor vehicle output likely to flatten out beyond the summer spike - very low inventory levels and ongoing upside in sales indicate that motor vehicle production is unlikely to reverse the enormous likely boost to 3Q, though such a big rise in production certainly is quite unlikely to be repeated - GDP growth in 4Q will probably be only about half the expected jump in 3Q. 

On the week, benchmark Treasury yields surged 19-36bp, with a poor performance by mortgages and significant associated paying and selling pressures as mortgages had moved towards levels of maximum duration convexity causing the intermediate part of the curve to underperform.  The 2-year yield rose 19bp to 1.31%, 3-year 25bp to 1.85%, 5-year 30bp to 2.83%, 7-year 33bp to 3.49%, 10-year 36bp to 3.85%, and 30-year 29bp to 4.60%.  Even with a rebound in the dollar helping to restrain gains in commodity prices, with a pullback Friday leaving September oil only up about US$1 a barrel on the week, and the Treasury warning of increased future supply, TIPS far outperformed.  News reports indicated that the Treasury's decision was prompted by a desire of the Chinese government to increase TIPS investments but only if the Treasury remained committed to sustaining liquidity in the sector, which led investors to believe that the increased supply would be more than soaked up by the rising demand from China.  The 5-year TIPS yield rose 14bp to 1.31%, 10-year 17bp to 1.84%, and 20-year (which the Treasury indicated will be replaced by 30-year issuance soon) 12bp to 2.32%.  This left the benchmark 10-year spread up 19bp on the week at 2.01%, a closing level that has only been exceeded once in the past year when nominal yields hit their highs on June 10.  The Treasury's dislike for TIPS prior to the agreement with China to boost supply came from TIPS inflation breakevens' persistent underestimation of actual inflation for a number of years, which made TIPS an excessively expensive form of issuance.  A 2% 10-year inflation breakeven is completely reasonable, however, and there's no particular reason to believe that selling TIPS at current spreads to nominals will be a bad deal for taxpayers. 

Mortgages had a terrible week, with yields blowing out of the top end of the range mostly seen since mid-June after having moved beyond the lower end of the range at the end of the prior week.  That rally the prior week left the MBS market unsustainably rich versus Treasuries.  This was partially corrected by an underperformance versus the latest week's Treasury rout, but mortgages hardly look cheap at current spreads.  For the week, current coupon MBS yields spiked almost 50bp from below 4.4% to above 4.8%, a high since the first part of June after yields had mostly been in a 4.4-4.6% range for about seven weeks.  During that period of fairly stable MBS market conditions, 30-year mortgage rates were consistently close to 5.25%, 50bp higher than the record-low levels close to 4.75% seen from late March to late May, but at least improved from higher rates seen for a couple weeks during the worst of the mortgage market sell-off that started near the end of May.  But unless MBS yields quickly reverse course, 30-year rates being offered to consumers will likely move through 5.5% in short order.  The pressure on mortgages put major paying pressure on swaps and caused the belly of the Treasury curve to perform poorly, as mortgage yields had reached a point where convexity was quite high, requiring significant offsetting adjustments by portfolio managers as the sell-off in rates rapidly extended the duration of MBS holdings.  The benchmark 10-year swap spread jumped 9bp to 33bp, a high since the worst of the prior MBS market turmoil in early June, while the benchmark 5-year spread surged 11bp to 36bp after having hit a six-year low at the end of the prior week.  Mortgage-related pressures far outweighed the narrowing impetus to swap spreads from what has now probably reached just about full normalization in interbank markets.  3-month LIBOR continued gradually to move to new record lows each day, dropping 2bp on the week to 0.46%, which caused the 3-month LIBOR/OIS spread to dip 1bp to 27bp.  This is somewhat above levels around 10bp that were the norm before August 2007, but it seems doubtful that there will be much further improvement from here in the post-crisis world of permanently higher risk and term premia.  Indeed, forwards indicate that we've probably moved to near the lows for now, with the forward LIBOR/fed funds spread for mid-September pointing to a small increase to around 29bp and then some further upside priced looking into 2010 before a return back towards current the current spread in 2011. 

 

The healing in the financial sector reflected in the normalization in interbank lending rates was also seen in a very strong week for financial stocks, which paced a solid rally for the overall equity market.  The S&P 500 gained 2.3% on the week to another high for the year.  The BKX banks stock index surged 12% to move into positive territory for the year at Friday's close for the first time since January 2.  The 2.5% year-to-date gain in the BKX still substantially trails the S&P's 12% rally, but the gap has been narrowed a lot over the past two weeks as overall stock gains have slowed to +3% while bank stocks have spiked 22%.  Strength in financials also helped credit have another strong week.  In late trading Friday, the investment grade CDX index was another 5bp tighter on the week at 105bp, which would be the best close since May 2008 after an enormous year-to-date move from the 197bp close on December 31.  Lower-quality credit was stronger as well but with a big divergence between high yield and leveraged loans.  The HY CDX index was only 3bp tighter on the week at 751bp at Thursday's close and the index was only slightly extending this small upside Friday with about a 3/8 of a point rally.  On the other hand, the LCDX index had a terrific week, tightening 88bp through midday Friday to 612bp.  This built on a substantial outperformance by LCDX over HY CDX since the recent wides were hit June 22, when the former closed at 1,075bp and the latter at 1,059bp.  The commercial mortgage CMBX market had a huge week, surging to moving to another round of new highs for the year.  The AAA index surged almost 4 points to 83.41, but performance among lower-rated indices was comparatively even a lot stronger, with the junior AAA spiking 6 points to 49.11, AA over 3 points to 49.86, and A 2 points to 23.30.  Since the end of 2Q, the AAA index has now risen 14%, while the junior AAA has surged 57%, AA 62%, and A 49%.  Our CMBS analysts believe that increasing optimism about the PPIP program has contributed to the huge rally in the lower-rated indices, which has gone well beyond a more modestly positive response to legacy CMBS TALF, for which only AAA rated securities qualify. 

The July employment report was the least negative since last September when the financial system froze up after the collapse of Lehman Brothers.  Non-farm payrolls fell 247,000 in July, the smallest drop since last August.  The biggest upside contributor was the smallest decline in manufacturing (-52,000) since last July, with auto sector jobs posting a rare gain and one of the biggest on record as assemblies surged.  The pace of decline in finance (-13,000) and business services (-38,000) also slowed notably.  Other details of the report were positive.  The unemployment rate fell to 9.4% from 9.5%, as job losses in the household survey also slowed and the labor force participation rate fell.  The average workweek rose a tenth to 33.1, which left aggregate hours worked flat, the best outcome since last August.  A significant rise in manufacturing hours worked that was mostly a result of a surge in the auto sector accounted for most of the improvement.  This supported expectations for the biggest gain in manufacturing production in July in many years.  Average hourly earnings gained 0.2%, which with hours worked flat also led to a 0.2% rise in aggregate weekly payrolls, a proxy for total wage and salary income.  This was the best result for aggregate payrolls since last summer and pointed to a similarly improved outcome for the personal income report for July.  With jobless claims continuing to show notable further improvement in the second half of July after the survey period for this employment report, job losses appear likely to further slow as we move into August. 

The auto-led nature of the beginning of the economic recovery was well illustrated by the divergence in the ISM surveys.  The composite manufacturing ISM index surged 4 points in July to 48.9, the biggest monthly gain in four years to the least negative reading since last August before the economy collapsed in September.  Underlying details were notably stronger than the relatively solid headline reading, with the key orders (55.3 versus 49.2) and production (57.9 versus 52.5) gauges moving well into growth territory above the 50-breakeven line.  Even the employment index (45.6 versus 40.7) was way up, though still pointing to contraction.  On the negative side, though, the industry breakdown showed only 6 of 18 industry groups reporting growth in July.  On the other hand, the composite non-manufacturing ISM index dipped a half-point in July to 46.4.  Underlying details were weaker, with a jump in the supplier deliveries index mostly offsetting significant drops in the business activity (46.1 versus 49.8) and employment (41.5 versus 43.4) gauges and a small drop in orders (48.1 versus 48.6).  On the other hand, weakness was more narrowly based by industry, with seven sectors reporting growth, up from six in June, and 10 contraction, down from 11.  Sectors remaining negative in July included miscellaneous services, government, finance, wholesale trade, transportation and construction. 

This divergence in industry trends was also evident in consumer spending.  Motor vehicle sales surged 16% in July to an 11.2 million unit annual rate, the best outcome since September though still a very weak selling rate from a longer-term perspective.  The increased money allocated for cash for clunkers Friday should drive a further big gain in August.  On the other hand, chain store sales remained dismal in July.  Overall retail sales are still likely to post a big gain to start 3Q and put it on pace for a gain in consumption in line with the expected 3-4% rise in GDP, but ex auto sales look to have been close to flat last month. 

There's another busy calendar in the upcoming week.  Focus in the first part of the week will be on the refunding auctions - US$37 billion 3-year Tuesday, US$23 billion 10-year Wednesday and US$15 billion 30-year Thursday - which overlaps with the FOMC announcement on Wednesday.  Having bought US$243 billion of Treasuries since purchases began in late March, the Fed is on pace potentially to finish the planned US$300 billion of buying before the FOMC meets again in September, so some statement on future plans seems necessary.  With the recession probably already over, the Fed is approaching the point when it will likely start winding down quantitative easing, though the enormous slack that has built up in the economy and that appears unlikely to be much reduced over the next year with GDP growth only expected to run near potential should keep rate hikes from being necessary for some time as underlying inflation remains under pressure.  In our view, the best course for the Fed would be to affirm both the total amount of Treasury, MBS and agency buying announced back in March and also the year-end plan for completing all buying, but to announce a shift in the mix of planned purchases.  Mortgages have reached fairly rich levels versus Treasuries with major help from Fed buying, so the level of Treasury yields will likely be a more important determinant of mortgage rates going forward than mortgage/Treasury spreads.  As a result, we think that the Fed should shift some of its planned 4Q buying of mortgages and agencies into Treasuries, which would allow buying of all three sectors to continue through year-end instead of the current plan to stop Treasury buying in September but continue heavy purchases of mortgages and agencies through 4Q.  Most key data releases are late in the week after the FOMC and most of the refunding.  Retail sales on Thursday and CPI on Friday will certainly be key focuses, but the industrial production report on Friday should be the week's most notable release as it will reflect most directly what appears to have been a very robust for the manufacturing sector in July thanks to a huge recovery in auto assemblies.  Other data releases due out include productivity Tuesday and trade and the Treasury budget Wednesday:

* We forecast a 6.0% surge in 2Q productivity and a 5.5% plunge in unit labor costs.  The GDP report showed a 1.7% decline in the measure of output that is relevant for the calculation of productivity.  However, hours plummeted nearly 8% during the quarter.  So it looks like productivity skyrocketed in 2Q, helping to drive unit labor costs much lower.  On the flip side, downward revisions to GDP over the past few years point to significantly lower productivity growth over this period.

* We look for the trade deficit to widen by US$2 billion in June to US$28 billion after hitting a 10-year low in May, with exports up 0.7% and imports 2.0%.  On the export side, industry figures and factory shipments data point to small upside in capital goods, and rising prices should provide a boost to industrial materials.  On the import side, a huge rise in prices combined with an expected stabilization in volumes after a major decline last month should drive a big gain in petroleum products, more than offsetting port data that continue to point to weakness in other goods.  Note that our forecast is slightly better than BEA assumed in preparing the advance estimate of 2Q GDP.

* We expect the budget deficit to jump to US$181 billion in July, about US$80 billion wider than in the same period a year earlier.  Some of the swing (about US$25 billion) is related to a calendar shift, but the bulk of the deterioration is attributable to economic factors and policy changes.  For example, unemployment benefit payments appear to have risen by nearly US$10 billion because of both higher unemployment and the extension of benefit payments.  Also, tax withholdings continue to run well below last year's pace, reflecting both the sluggish economy and the impact of the Make Work Pay stimulus program.  The budget deficit for the first 10 months of the fiscal year appears to have been close to US$1.3 trillion, and we expect a deficit of a shade below US$1.5 trillion (or about 10.2% of GDP) for the fiscal year as a whole.

* We look for a 1.3% surge in overall retail sales in July but only a 0.1% gain ex autos.  The spike in vehicle sales tied to the cash-for-clunkers program should more than offset a modest price-related pullback in the gas station component resulting in a sharp rise in headline retail sales for the month of July.  The chain store results pointed to some softness in the general merchandise category on a monthly sequential basis although there is considerable uncertainty tied to this sector now that Wal-Mart no longer reports.  Also, company reports suggest that the restaurant sector was weak again in July.  On the bright side, apparel outlets should show a pick-up. 

* A pullback in gasoline prices is expected to contribute to a flat reading for the headline CPI in July following a sharp 0.7% jump in June.  Meanwhile, the core is expected to moderate to +0.1%, as the recent upside surprises in apparel and motor vehicles should be at least partially unwound (although the impact of cash for clunkers was probably evident too late in the month to be picked up in the CPI survey).  Also, the key shelter category should show further moderation, reflecting weak rental markets across much of the nation.

* Based on the manufacturing hours data and a 45% surge in auto assemblies, we look for industrial production to rise 0.7% in July.  The anticipated gain would be even larger were it not for a sizeable negative contribution from utility output tied to unseasonably cool temperatures.  The key manufacturing category is expected to be up a whopping 1.4% - the best since the mid-1990s if you exclude two brief hurricane-related rebounds in 1999 and 2005.  Finally, manufacturing ex-motor vehicles output is expected to be -0.3% - still down but the best result since May 2008 (excluding the gyrations related to last fall's Boeing strike).

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