Germany
Mending Europe's Largest Economy
September 29, 2009

By Elga Bartsch | London

A Clear Win for the Centre-Right

Contrary to various polls, which in recent days had shown a rise in support for left-leaning parties, Sunday's general election brought a clear win for the centre-right coalition between Chancellor Merkel's Christian Democrats (CDU), their Bavarian sister party (CSU) and the free-market Free Democrats (FDP).  For the first time in 11 years, Germany will again be governed by a so-called black-yellow coalition.  The win for the centre-right is mainly due to a very strong showing for the Free Democrats, which reached their best result in post-war history in this election.  Meanwhile, the CDU/CSU lost a little voter support compared to the previous election, but were able to gain a number of extra (so-called overhang) mandates.  The Social Democrats, by contrast, suffered a major loss in voter support compared to the 2005 general election.  Both the Left Party and the Greens gained support, as expected.  With 334 seats out of 625 of the new German Bundestag, the black-yellow coalition has a strong political mandate and, by German standards, a relatively broad majority in the lower house of parliament, the Bundestag.  After the electorate opted for the status quo four years ago (see German Economics - A Clear "Neither Nor", September 19, 2005), it now seems that the German people want to see some change.

No Stumbling Blocks in the Upper House - at Least for Now

The position of the centre-right coalition is somewhat weaker in the upper house of parliament, the Bundesrat, representing the governments of the regional states.  In the Bundesrat, the centre-right is currently the largest group, but it lacks an outright majority of the votes.  So far, the black-yellow coalition does not have to contend with the opposition parties, the SPD, Left and Greens having a blocking majority as was the case towards the end of the Kohl era.  The ability to push legislation through the upper house rests on the fact that those states, where only one coalition party is part of the federal government, are neutral in any debate and abstain from voting.  How the majority in the upper house develops going forward depends also on the outcome of coalition talks in several regional states, which went to the polls from late August.  Four states - Thuringia, Saarland, Brandenburg and Schleswig-Holstein - still need to agree on a coalition.  In all cases, there are several possibilities.  Typically, a choice is between a Grand Coalition between the SPD and the CDU (which after the change in government at the national level is probably less enticing and has already been ruled out in Schleswig-Holstein) and a left-leaning coalition between the Social Democrats, the Left Party and the Greens.  As a third alternative, a so-called Jamaica coalition between the CDU, the Free Democrats and the Greens is being discussed, e.g., in Saarland.  Only Schleswig-Holstein, where the votes are still being counted as we write, might just have been able to turn the corner towards a CDU/FDP coalition.  Finally, the largest German state, North-Rhine Westphalia, will go to the polls in a regional election next summer. 

Good News for Medium-Term Growth and Near-Term Sentiment

As such, the election outcome probably does not warrant a change in our German macro forecasts.  We continue to expect the sharp contraction in GDP of 5% this year to be followed by GDP growth around the long-term trend of 1.5% next year.  But, on balance, the change in government makes us more positive about Germany's medium-term growth prospects, and we might have to revisit our forecasts once the coalition agreement takes shape and the timeline for the income tax cuts promised in the election campaigns becomes clear.  In the near term, however, the change in government will likely boost investor and business sentiment in Germany as a CDU/FDP coalition is perceived to be more market-friendly and we would expect some visible gains in the next ZEW investor sentiment and the Ifo business climate surveys.  Eventually, it should, however, also boost investment spending and hence job growth in Europe's largest economy.

Tremendous Policy Challenges Lie Ahead

In light of these positive factors, it is vital not to lose sight of the challenges that still lie ahead.  The recession has likely done considerable damage to the economy, much of which still has to manifest itself - among other things in the labour market - in fiscal balances and possibly in bank lending.  Notwithstanding the vigorous initial bounce-back, the recovery eventually will likely be a tepid one, we think.  As a result, unemployment is set to rise further.  In addition, the timid recovery implies that the cyclical improvement in public finances will remain smaller than it usually would in an upswing and, like many other governments, the new German government is likely to look at various options, including privatisations (see European Economics & Strategy: Poor State of Government Finances & Implications for Equities, September 1, 2009).  As both parties have promised significant tax cuts in their election campaigns, creating the budgetary room for such manoeuvres will be challenging. 

Would the Real Angela Merkel Please Stand Up?

During her first national election campaign four years ago, Angela Merkel pushed for a pro-market election platform.  However, after this bold reform platform nearly lost Mrs. Merkel the 2005 election and forced her into an uncomfortable Grand Coalition with the Social Democrats, she altered her tone.  One of the key questions that political pundits have been debating ever since is whether this shift largely reflected the necessity of keeping the Grand Coalition together or whether it also reflected a change in her personal convictions.  Having the opportunity to team up with the Free Democrats, who share a large part of her original radical reform platform, we should find out soon.  Our sense is, though, that having to manoeuvre Germany through the deepest recession in post-war history and through major financial market turmoil might also have changed her own perspective.  The only question is by how much.  In general, the political spectrum has shifted towards the left in Germany.  Over the last four years, Chancellor Merkel's Grand Coalition reversed some of the hard-fought-for labour market reforms implemented by the Red-Green Schroeder government (e.g., by introducing minimum wages in several sectors, by extending unemployment benefits for older workers, and by bulking up short-shift subsidies sharply).  In addition, top income taxes were hiked (instead of lowered as the CDU/CSU election platform had envisaged) with the introduction of a so-called ‘Reichensteuer', which introduced a new top income tax bracket at 45% to appease the Social Democrats, who had to swallow a three-point VAT hike, which especially hit those on lower incomes and hence with higher spending propensities. 

Mending Europe's Largest Economy

The tasks facing the new German government are tremendous.  It has to manage the exit from the massive fiscal stimulus and financial rescue packages carefully.  It has to ensure that the post-crisis economy is a more resilient and more balanced one.  It has to address the long-standing issue of an ageing German society where generational inequality is on the rise and where younger generations are now burdened with an even higher debt level.  Importantly, it has to facilitate the necessary structural change needed to combat climate change and to stay competitive in a rapidly changing global economic landscape.  As a very open economy, it has to resist protectionist pressures at home and abroad.  At the heart of many of these issues is whether the still highly regulated German labour market is flexible enough to generate enough new jobs to make up for the job losses in declining industries.  As we discussed the election platforms in detail and highlighted potential investment implications at the individual stock level in a recent report (see German Elections: Not a Done Deal Yet, September 8, 2009), we only highlight some key points below.

Election Platforms Go in the Right Direction, but Not Far Enough

Regarding taxes, both parties have committed to income tax cuts in the run-up to the election and will now be under pressure to deliver on this key election promise.  In addition, the Free Democrats aim to remove some of the restrictions introduced as part of the 2008 corporate tax reform, notably the new limits introduced on the tax-deductibility of interest payments, on carrying losses forward after a take-over and on offshoring, thus reducing the effective corporate tax burden.  Both aim to raise the tax credit for families and to lower the lowest tax band from the current 14% to 12% or even 10%. 

In light of the newly introduced debt brake, under which the German constitution limits federal government borrowing to 0.35% of GDP by 2016 and governs state borrowing completely from 2020 onwards, the new government has its work cut out if it wants to reduce the budget deficit and cut taxes at the same time.  This will likely mean some serious spending cuts.  Some of these cuts could come in the area of social benefits.  Some could come in healthcare, where the FDP is proposing a basic private insurance, with subsidies for those who cannot meet the costs.  However, the CDU/CSU is essentially aiming to maintain the status quo, having abandoned its more radical healthcare reform ideas.  Some of the savings could come in the area of pension benefits, where the CDU/CSU is committed to the planned gradual increase in the pension age to 67.  The FDP is even proposing to do away with the fixed pension age altogether and to allow individuals to decide when they want to retire based on actuarially fair discount factors.  While the proposals of the Free Democrats on pension reform are far reaching, it remains to be seen whether, if it could indeed be implemented, it would be sufficient to address the pension time bomb caused by an ageing society with generous entitlements to pension benefits, healthcare and long-term care. 

With regard to labour market policies, one of the key questions is whether the new sector-specific minimum wages that have been introduced by the Grand Coalition can be watered down or even completely dismantled. The latter looks unlikely, given that the CDU/CSU still seems to support sector-specific minimum wages.  But as the FDP is seeking to abolish them altogether, this will likely be a topic of debate in the coalition talks.  Further, the FDP is very much in favour of allowing companies to negotiate tailor-made deals with their workforce.  In our view, the ability of individual companies and their workers (represented by trade unions) to hammer out company-specific agreements on working hours and pay was instrumental in the successful corporate restructuring process (see German Economics: Macro Reforms Meet Micro Restructuring, August 25, 2005).  It would thus be important not only to turn back the clock on minimum wages, which more than anything else act as a barrier to competition, but also to allow for more flexibility in company-specific negotiations.

Both parties are committed to building new power stations (notably modern coal plants) and to capturing and storing carbon dioxide (CO2).  Running existing nuclear power stations longer is acceptable to the CDU/CSU and the FDP, even though they would probably shy away from building new nuclear power stations.

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Brazil
Brazil: Growth Rebounds
September 29, 2009

By Marcelo Carvalho | Sao Paolo

As policy stimulus gets more traction, Brazil's economy is rebounding. With domestic credit expansion underway and job creation back to pre-crisis standards, Brazil's growth outlook is improving. We are revising our forecast, and now look for real GDP growth of 4.8% in 2010, from our previous forecast of 3.5%. In turn, faster growth means that the central bank will likely start hiking rates sooner rather than later - our forecast now advances the timing of the first rate hike to 2Q10, if not earlier, as opposed to 2H10 in our previous forecast. With an earlier start, we believe that monetary tightening will bring end-2010 policy rates to 11.0% (from 10.0% in our previous forecast), from the current 8.75% mark.

Policy Gets More Traction

Monetary easing gets traction. The historical relationship between real interest rates and real GDP growth in Brazil temporarily broke down late last year, when the global shock hit Brazil with an impact equivalent to a rate hike of several percentage points. But as global healing advances, domestic monetary easing is now getting more traction, in an environment where Brazil's nominal and real interest rates have fallen to unprecedented lows.

Fiscal policy provides support, including through quasi-fiscal stimulus. While Brazil's current fiscal strategy can raise concerns (see "Brazil: Fiscal Challenges", EM Economist, August 28, 2009), expansionary fiscal policies have provided support for the cyclical recovery.  Most attention seems to focus on the headline fiscal stimulus through tax breaks and increased spending, but we suspect that quasi-fiscal stimulus via credit expansion by public sector banks may have been at least as important, if not more. In fact, the fiscal stimulus through standard fiscal measures is estimated at about 1% of GDP, but credit extension by public sector banks has been the equivalent of 3pp of GDP so far this year.

Credit and Labor Markets Are Improving

Indeed, the credit channel is expanding. We suspect that the domestic credit channel can become a key theme for the domestic growth story in 2010 (see "Brazil: The Credit Channel", EM Economist, August 3, 2009). Although still relatively low by developed world standards, total domestic credit in Brazil has climbed to a record high of 45.0% of GDP as of July 2009. This is up from 41.3% at the end of 2008, or a share of GDP in the mid-20s earlier in the decade.

Public sector banks have done the heavy lifting so far this year in extending domestic credit, including through the national development bank (BNDES). Total domestic credit has grown 20.8%Y as of July, with growth in lending by private sector banks slowing to 10.5%Y while lending by public sector banks jumped to 40.3%Y. As a result, the share of public sector banks in total domestic credit has increased to 40% of the total as of July, from a share of 36% at the end of 2008.

The credit outlook is improving. Looking ahead, public sector banks seem unlikely to sharply cut back their lending appetite next year. As for the private sector, there is a growing local perception that lending by private sector banks can gain speed into 2010 if they seek to catch up. After all, private sector banks in Brazil are well capitalized, interest rates are low, and delinquency rates appear to be peaking as local conditions improve. In addition, a large planned IPO by a financial institution in the local market has the potential to significantly further expand capital ammunition for domestic lending.

Another area where policy traction has become visible is the labor market, which is showing remarkable strength. Net formal job creation has accelerated back to pre-crisis standards, jumping to 242,126 in August. This was the best monthly headline figure so far in 2009 by far, and even better than the 239,124 reading in August 2008. This is the first time that net formal job creation is better than a year ago, since September last year, when the global crisis started to hit net formal jobs in Brazil. Seasonally adjusted, in our computations, net job creation exceeded 200,000 in August, almost double the July pace and much better than the monthly average pace of less than 10,000 during 2Q.

Job gains are widely spread across sectors, but the turnaround is most striking in industry. Historically, services typically generate most new formal jobs in the economy, followed by industry and the construction sector. During the sharp downturn late last year, job gains weakened across all sectors. Jobs in services proved relatively resilient, but net job creation in hard-hit industry suffered the most and stayed the longest in negative terrain, by far. Besides ongoing expansion in services and construction, recent numbers show a rebound in net job creation in industry, now firmly back to positive territory.

Accordingly, the headline unemployment rate is trending down. The unemployment rate had been trending lower over the last several years, from a peak in 2003 all the way to record-lows during 2008. The unemployment rate jumped around the turn of the year, but now seems to have resumed its downward trend. In our seasonal adjustment, the unemployment rate declined to an average of 8.0% during the three months through August, from a recent peak of 8.6% in January.

Employment is picking up. The declining trend in the unemployment rate has taken place against the backdrop of an increasing labor force.  In other words, the declining trend in the unemployment rate reflects growing employment, as opposed to just a decline in the participation rate because discouraged workers leave the job market altogether.  In fact, total employment grew 0.6%Y on average in the three months through August, while the labor force grew 0.8%Y in the same period. Employment trends did suffer at the turn of the year but have picked up lately, with an inflection point during 2Q.

Wage earnings are rising. Besides recovering employment, real wages are going up too. Wage earnings per worker are up 2.9%Y on average during the three months through August, in real terms - that is, above inflation. Combined with rising employment, the resulting total real wage mass is up 3.5%Y during the three months through August - again above inflation. Local press stories also support the notion of recovering domestic labor markets, given recent news of worker strikes in banks, the postal system and even in the previously hard-hit automobile sector. In all, improving labor market conditions should provide support for local consumer sentiment and domestic consumption.

Upgrading Our Forecasts

Brazil's economy has rebounded briskly from a sharp but brief downturn. Real GDP growth recovered in 2Q09, expanding at a sequential, seasonally adjusted pace of 1.9%Q - that means an annualized rate of 7.8%, even though the year-on-year comparison was still negative, at -1.2%Y. After two quarters of negative sequential growth, the quarter-on-quarter comparison is now back to positive terrain. Private sector consumption has led the way, besides a significant sequential rebound in exports from a previous slump. Investment remains soft - it was flat in sequential terms in 2Q, after two quarters of sharp sequential contraction, further worsening the year-on-year comparison.

Expansion continues now in 2H09. Looking ahead, partial monthly data suggest that sequential real GDP growth looks set to be positive again in 3Q. Judging from a sharp rebound in business confidence in recent months, real GDP growth recovery looks likely to prove robust going ahead, based on past correlations.

Our revised forecast sees strong expansion ahead. We now look for average real GDP growth at zero in 2009 (from -0.5% before) and 4.8% in 2010 (from 3.5% before). Among GDP components, domestic demand will likely lead the way. Net exports have typically been a drag on growth over the last few years, and should post a positive contribution to growth this year, but will likely become a drag on growth again next year as imports pick up. Within domestic demand, private sector consumption should drive the recovery, spurred by expanding domestic credit and supportive labor market conditions. For its part, investment may take a while to fully recover, although rising capacity utilization should eventually encourage investment too.

Policy Outlook: Fiscal Expansion, Monetary Tightening

Fiscal policy will likely remain expansionary. Although tax breaks are scheduled to be unwound by end-2009 (on white-line goods and automobiles, for instance), the recent acceleration in fiscal spending is unlikely to lose much steam ahead of the general elections in October 2010. Likewise, quasi-fiscal stimulus through the credit channels is unlikely to be taken back - on the contrary, the BNDES appears eager to strengthen its lending muscle. In turn, fiscal policy has implications for monetary policy: the looser fiscal policy is, the relatively tighter monetary policy has to be, for any given overall policy stance.

Monetary tightening is coming. As the economy recovers and the output gap shrinks, the central bank sooner or later will need to start unwinding at least part of the monetary stimulus it has put in place this year. Monetary policy in Brazil now faces the interaction of two concurrent factors - one is structural, the other is cyclical. First, structurally, Brazil's ‘neutral' or ‘equilibrium' real interest rate has probably trended down over the years as Brazil becomes a better place - after all, Brazil has deservedly obtained investment grade status by all major rating agencies. Second, however, the central bank has cut rates aggressively this year in light of cyclical considerations. So, while the ‘neutral' rate should now be lower than in the past, we believe that actual real interest rates have now fallen even below that declining ‘neutral' level - and appropriately so, given the sharp cyclical growth downturn around the turn of the year. Going ahead, as cyclical conditions normalize, the central bank should eventually start to take back at least some of its cyclical monetary stimulus (see "Brazil: Are Lower Real Rates Here to Stay?" EM Economist, July 2, 2009).

The central bank will start hiking rates before mid-2010, in our new forecast. We had previously assumed that the monetary policy committee would start the hiking cycle in 2H10. But a rapidly closing output gap will likely speed up the process. We now assume that the central bank starts hiking rates at some point during 2Q10, maybe around April, if not earlier. The stronger the growth rebound is, the sooner monetary policy normalization would start. We assume that the political calendar will not prevent the central bank from taking decisions based on technical considerations. With an earlier start to the hiking cycle, we now see policy interest rates at end-2010 at 11.0%, from 10.0% in our previous forecast. The current policy rate is 8.75%.

Be ready for swift policy action. The authorities do not seem to be in a rush to hike - at the moment. But keep in mind that monetary policy in Brazil can change course in a relatively short period of time, if history is any guide. In fact, for what it is worth, since the start of the current inflation-targeting regime back in 1999, Brazil's central bank never left policy rates unchanged for more than six months in a row. That being said, the central bank is likely to start telegraphing its message to the markets before it actually starts hiking rates, and it might begin the tightening cycle with relatively smaller rate hikes before it decides later on whether or not to augment the hiking pace. 

Watch inflation expectations. Actual inflation will likely remain benign over the next several months, running below the 4.5% official target. But inflation expectations will probably start drifting higher over the course of next year. We suspect that market consensus expectations for 12-month-ahead CPI inflation could be rising above the 4.5% target center by mid-2010. The concern therefore is not about actual inflation for 2010 itself - instead, the worry is about inflation expectations for 2011.

The latest central bank inflation report sends a first warning sign. In its recent quarterly inflation report, published on September 25, the central bank sees inflation rising above the 4.5% target in early 2011, under standard assumptions. It has revised up its own projection for CPI inflation to 4.6%Y during the first two quarters of 2011, up from its previous projections of 4.1%Y for 1Q11 and 4.0%Y for 2Q11. Given the (lengthening) time lags between monetary policy and its impact on inflation, a forward-looking, proactive central bank would likely seek some policy normalization sooner rather than later. In turn, rate hikes will eventually slow down the economy, but time lags mean that the cumulative impact on growth will likely become most visible going into 2011.

The current account deficit will widen as domestic demand heats up, but capital inflows will likely pick up too. Imports should increase with rising domestic demand, and outward remittances of profits and dividends will likely climb too. As a result, the current account deficit is set to widen next year, from about 1% of GDP in 2009 to beyond 2% in 2010. Luckily, the capital account outlook seems favorable, as capital inflows pick up - barring an unexpected sharp deterioration in global conditions. In particular, FDI prospects look promising (see "Brazil: What Is the FDI Outlook?" EM Economist, September 25, 2009). In all, the combination of faster growth, higher rates and stronger capital inflows lead us to fine-tune our currency forecast - we now assume the Brazilian real finishing 2009 at R$/US$1.80 (from 1.90 before) and 2010 at 1.70 (from 1.80 before).

What are the risks to the outlook? On the external front, global uncertainties remain. Our global economics team argues that global recession has purged much of the imbalances, so the main downside risk to global growth is now a premature global policy reversal (see "‘Up' Without ‘Swing'", Global Forecast Snapshots, September 10, 2009). Indeed, global exit strategies are a delicate balancing act. If the global economy slides into a double dip, there is little doubt Brazil would suffer. One key transmission channel for Brazil is commodity prices and linkages with China (see "Brazil: What Is the China Link?" EM Economist, July 31, 2009).  But our global team also warns of upside risks: We cannot rule out a blow-out scenario in 2010-11 as we may still be underestimating the combined impact of unprecedented stimulus and a sharp rally in risk markets. On the domestic front, policy slippage remains a key risk in an election year, but is not in our base case scenario.

Bottom Line

As fiscal and monetary policy stimulus gets more traction, Brazil's economy is rebounding. Amid domestic credit expansion and fast job creation, Brazil's growth outlook is improving. We now look for real GDP growth of 4.8% in 2010, from 3.5% before. In turn, faster growth will force the central bank to start hiking rates sooner rather than later - our forecast now sees the first rate hike in 2Q10, if not earlier. 

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United States
Review and Preview
September 29, 2009

By Ted Wieseman | New York

A mild pullback in stocks, continued super-dovish Fed policy, softness in a couple of the limited number of economic data releases, and a strong wrap-up to the latest supply flood at the 7-year auction supported good 7-year-led Treasury market gains over the past week.  The market was trading a bit softer on the week ahead of Wednesday's FOMC announcement, as investors had apparently been fearful of a hawkish shift in rhetoric or possibly the announcement of some initial steps to drain the increasingly massive supply of bank reserves - excess reserves are likely to top US$1 trillion soon, around 1,000 times normal, as the retirement of the US$165 billion of outstanding SFP bills begins Thursday - after the New York Fed consulted with dealers ahead of the meeting on implementation of reverse repos.  In the event, however, the Fed continued to say that rates would remain near zero for a long time and didn't say anything else about winding down quantitative easing aside from an earlier-than-expected decision to extend and slow MBS and agency purchases while affirming the prior total purchase amounts of US$1.25 trillion and "up to" US$200 billion, respectively.  This continued dovishness helped the market post good gains in the second half of the week, with the upside supported by a recently rare run of three straight down days for stocks, a quite well received 7-year auction after more mixed results at the prior 2-year and 5-year sales, and some softness in the existing home sales and durable goods reports.  A surprising drop in capital goods shipments and larger-than-expected decline in inventories in the latter led us to reduce our 3Q GDP forecast to +3.2% from +3.7%.  Meanwhile, the huge rebound in home sales off the early year lows paused in August, with existing home sales down a bit and new home sales up only slightly after a run of major increases.  The rebound in the sales pace has been big enough, however, that inventories again plunged even with the softer sales.  Supply of unsold homes could be back towards more normal levels by year-end if sales are sustained, which would likely allow the recent stabilization in home prices to continue.  After some brief disappointment with the Fed's early tapering of MBS buying and some concerns about private demand after Vanguard shifted the benchmark index of a number of its bond funds to a version that excluded Fed MBS holdings, the MBS market had a strong week that sent yields to new lows since May, which should certainly provide some support to housing demand as the expiration of the first-time buyers' credit looms.  In addition to the home inventory figures, more positive results were seen in some higher-frequency data - jobless claims were again much better than expected, confirming a renewed improving trend, consumer confidence in the Michigan survey hit its best level since early 2008 as a large proportion of respondents reported having recently heard positive news about the labor market, and the Kansas City Fed's manufacturing survey showed a big improvement that supported expectations for another positive ISM report.

On the week, benchmark Treasury yields fell 5-15bp, led by 7s and 10s, as mortgage yields and swap spreads along much of the curve moved to new recent lows.  The old 2-year yield fell 5bp to 0.94%, 3-year 9bp to 1.47%, old 5-year 12bp to 2.34%, old 7-year 15bp to 2.95%, 10-year 15bp to 3.33% and 30-year 14bp to 4.09%.  This was a new low since May for the 30-year as the Fed's continued on-hold policy prompted continued moves out the curve to pick up yield and carry.  TIPS lagged, but relative performance was pretty strong, given the big gains in nominals and some major weakness in commodity prices, with some particularly big downside in oil and gasoline futures on Wednesday and Thursday.  The 5-year TIPS yield fell 4bp to 0.94%, 10-year 9bp to 1.57% and 20-year 8bp to 2.06%.  The resulting 6bp drop in the benchmark 10-year inflation breakeven to 1.76% only left it about in line with the average seen over the past six months or so.  The squeeze at the very short end further intensified as quarter-end neared and a substantial reduction in bill supply looms with the maturity of US$165 billion in Supplemental Financing Program cash management bills over the next month.  The 4-week bill yield fell 2bp on the week to just 0.005%.  Mortgages struggled a bit early in the week, but outperformed as the market turned around after the FOMC meeting, after an initial move to the week's worst underperformance after the FOMC announced that it would still buy US$1.25 trillion total in MBS but would slow the buying to extend it through 1Q10 instead of 4Q09.  An announcement along these lines was expected but not until the November FOMC.  The slowed pace of Fed buying briefly added to investor worries about slowing private demand, after mutual fund giant Vanguard announced on Monday that it was changing the benchmark of a number of its bond index funds to a ‘free floating' version that excludes Fed MBS holdings, which will be near 25% of the agency MBS market when buying is complete.  At least for now, though, these concerns proved unfounded, as private demand appeared to be stepping up to offset slowed Fed buying.  By Friday, current coupon MBS yields were down near 4.25%, four-month lows that should allow 30-year conventional mortgage rates to hold near the recent 5% level, which is back not far from the record lows close to 4.75% seen from late March to late May.  As mortgage yields moved down to multi-month lows, swap spreads continued narrowing, with the benchmark 10-year spread falling 4-16bp, a low since May, while the benchmark 5-year spread hit a record low of 32bp (though partly as a result of the roll into the new 5-year Treasury).  Also supportive of spread narrowing was a continued move to new lows by Libor, with 3-month Libor back to setting daily record lows, declining 0.5bp on the week to 0.283%, which kept the spot 3-month Libor/OIS spread around 11bp, in line with pre-crisis norms.  Forward spreads remain higher, but are starting to capitulate to the persistence of the normal spot levels, with the forward Libor/fed funds spread in December down to near 17bp and the forwards in 2010 and 2011 down to close to 20bp.  Given this unstressed picture, the Fed announced in the past week a quicker move towards getting rid of the TAF and forcing banks to go back to relying on markets for their financing instead of the government, an announcement that so far has been taken in stride with no apparent impact on interbank rates or spreads. 

The improvement in forward Libor/OIS spreads came as eurodollar gains outpaced a dovish repricing of the Fed path in futures markets after the FOMC affirmed that the near zero fed funds rate would remain unchanged for an "extended period" and did not otherwise discuss exit strategies.  There was some reversal of an initially bigger post-FOMC move in futures on Friday after a Wall Street Journal editorial by Governor Warsh in which he predicted that the Fed was far from raising rates but would probably need to move aggressively and pre-emptively when the time for normalization eventually arrives.  Even after Friday's partial reversal, however, there was still a modest dovish repricing on the week.  There wasn't any fundamental shift, though, with a 1.5bp gain in the May fed funds contract to 0.525% still pricing the first rate hike to 0.50% at the April FOMC meeting, a 1.5bp gain in the July contract to 0.735% still pricing a 0.75% funds target in mid-2010, and a 6.5bp rally in the Jan 2011 contract to 1.46% still pricing in a 1.50% year-end 2010 fed funds target.  We also look for the funds target to be at 1.50% at the end of next year, though we think the hikes will start a bit later than current market pricing. 

Risk markets had a recently rare run of weak days, if only slightly so, at the end of the past week that resulted in modest losses for the week as a whole and helped to support the post-FOMC interest rate market gains.  The S&P 500 lost 2.2%.  No major sector particularly stood out on the weak side, though the weakness in commodity prices caused energy (-3%) and materials (-5%) to lag, and financials (-4%) also underperformed.  Credit was somewhat mixed, with investment grade losing ground but high yield holding steady to continue a great month.  The old series 12 IG CDX index was 6bp wider on the week at 109bp late Friday, while the new on-the-run series 13 was up to 101bp after ending its first day of trading Monday at 92bp.  On the other hand, the HY CDX index was 22bp tighter on the week and 205bp tighter on the month at 634bp through Thursday's close and was still holding a bit in the green for the week after a half-point loss Friday.  The leveraged loan LCDX index performed similarly well, holding onto a 22bp tightening to 540bp through midday Friday.  This pattern of outperformance down the quality scale was also seen in the commercial mortgage CMBX market, where the AAA index lost 1.16 points on the week to 79.45, while the lower-rated indices added to the prior week's huge gains even after pulling back somewhat later in the week.  Even after coming off the mid-week highs, in the past three weeks the junior AAA CMBX index is up 31%, AA 57%, A 59%, BBB 42% and BBB- 37%.

The economic calendar in the past week was light and somewhat mixed but overall softer as a result of a worse-than-expected durable goods report.  Durable goods orders fell 2.4% in August as a result of a 42% plunge in the volatile civilian aircraft component.  Underlying orders weren't as weak but were still sluggish, with non-defense capital goods ex aircraft orders, the key core gauge, dipping 0.4%.  The decline in core orders was driven by small drops in high-tech (-0.7%) and electrical equipment and appliances (-0.5%) that more than offset a gain in machinery (+0.7%).  Non-defense capital goods ex aircraft shipments posted a larger 1.9% decline, pointing to a weaker gain in 3Q equipment investment than we had previously expected.  Overall durable goods inventories were also weaker than expected, plunging 1.3%, pointing to a smaller add to 3Q growth from slowing inventory liquidation.  Building in these results, we cut our 3Q GDP forecast to +3.7% from +3.2%.  For a couple of months, our 3Q GDP estimate had been getting marked consistently higher as the data surprised on the upside, but over the past few weeks this has turned the other way as our forecast has retreated from almost 5% at the peak earlier in the month. 

Meanwhile, there was mixed housing market news, as sales were a bit disappointing in August but inventories continued to show rapid improvement.  Existing home sales declined 2.7% in August to a 5.10 million unit annual rate.  Even after this pullback, however, sales are still up 14% from the 12-year low hit in January.  Single family (-2.8% to 4.48 million) and condo (-1.6% to 620,000) sales posted similar declines in August.  Even with the pullback in sales, the months' supply of unsold homes plunged to 8.5 months from 9.3 months, as the number of homes for sale plummeted by a near-record 11%.  This was the lowest months' supply since early 2007 after a major correction from the high since the mid-1980s of 11.3 hit in April 2008.  Current supply is not too far from returning to a more balanced level near six months.  New home sales rose 0.7% in August to a 429,000 unit annual rate, extending the rebound off the January low to an enormous 30%.  This sharp pick-up in sales, together with the ongoing plunge in housing completions - which continue to catch up with the prior plunge in starts, hitting a record low in August - is making a significant dent in the inventory of unsold new homes as well.  The number of newly constructed homes available for sale fell 3% in August to 262,000 units, the lowest level since 1983.  Combined with the improved sales pace, this lowered the months' supply of unsold new homes to 7.3 from 7.6 in July, even closer to a balanced level of around six months after having been at a record high of 12.4 months in January. 

The economic calendar is very busy in the coming week, but back-end loaded into Thursday and Friday when the initial round of key September figures are released, employment Friday and ISM and motor vehicle sales Thursday.  Thursday also sees testimony by Fed Chairman Bernanke on financial oversight reform and announcement of another huge run of supply of 10-year TIPS, 3s, 10s and 30s.  Other data releases due out include consumer confidence Tuesday, revised GDP Wednesday, personal income and construction spending Thursday, and factory orders Friday:

* We expect the Conference Board's measure of consumer confidence to rise slightly to 55.0 in September.  The various sentiment gauges sent conflicting signals in early September.  The University of Michigan index posted a solid gain, while the weekly ABC barometer drifted lower.  Surprisingly, the main driver of the weakness in the latter has been the personal finances component.  All in all, the mixed results point to little change in the Conference Board index.

* Downward adjustments to inventories and private non-residential construction point to slightly lower -1.3% 3Q GDP growth relative to the previously reported reading of -1.0%.

* We forecast a 0.1% rise in August personal income and 1.1% gain in spending.  The surge in vehicle sales tied to the cash-for-clunkers program should lead to a significant gain in personal consumption spending.  And this upside should be reinforced by a solid rise in retail control as implied by the retail sales report.  On the income side, the employment report points to a small gain in aggregate wages and salaries.  Obviously, this combination of income and spending will lead to a sharp drop in the personal saving rate in August. However, much of this swing should be unwound over the next couple of months.  Finally, our translation of the CPI data points to a 0.06% increase in the August core PCE, which would push year-on-year rate down a tick to +1.3%. 

* We expect the manufacturing ISM to be steady at 53.0 in September.  The regional surveys that have been released so far paint a mixed picture of factory activity during September.  On an ISM-weighted basis, Empire and KC registered solid gains but Philly and Richmond showed some slippage. Taken together, this implies little change in the national ISM.  One source of potential downside this month is the inventory component which has a 20% weight in the headline index. The ISM methodology implicitly assumes that declines in inventories are ‘bad' and that increases in inventories are ‘good', even though this is not always the case.

* We look for a 0.4% dip in August construction spending, largely as a result of some further softness in the commercial sector.  Also, the sharp rise in the private residential category seen in July was somewhat surprising because the number of homes under construction continues to decline even though the monthly volume of new housing starts appears to have bottomed.  Thus, we look for renewed slippage in this category of construction expenditures.  Finally, public sector activity is expected to begin to edge higher as the federal stimulus dollars start to flow through the system.

* We look for a significant pullback in September motor vehicle sales to a 9.2 million unit annual rate, somewhat below the 9.6 million unit selling pace seen during the first half of the year, following the expiration of the cash-for-clunkers program. The expected softness in September sales reflects both a payback effect and widespread shortages of popular models as the cash-for-clunkers jump in sales further depleted already thin inventories.  Any sales shortfall at this point is unlikely to prompt a cutback in vehicle assembly plans because inventory levels are so far below normal.

* We forecast a 150,000 decline in September non-farm payrolls, a further moderation in the pace of decline, reflecting the 29,000 drop in initial claims on a survey week to survey week basis and the recent pullback in the volume of layoff announcements.  Admittedly, the signals coming from the continuing claims figures have not been quite as encouraging, but we are discounting these data somewhat because they have exhibited an unusual degree of weekly volatility of late and because we believe that the dramatic extension of benefits creates an incentive structure that can distort the structural relationship between continuing claims and broader labor market conditions.  By sector, we look for a smaller pace of job loss in manufacturing, which has been influenced by some unusual seasonal gyrations over the past couple of months.  Also, note that this is the first occasion that the Labor Day holiday has fallen within the survey week since 1998.  However, we do not detect any identifiable bias in the results for past Septembers with the same calendar.  Meanwhile, the unemployment rate is expected to tick higher even though the household survey is expected to begin to show a slower pace of job loss.  Finally, average hourly earnings are expected to flatten out in September following some above-trend results in both July and August that may have been at least partly attributable to the final phase-in of a minimum wage hike.

* We look for a 0.4% decline in August factory orders.  The drop in the durable goods component points to a decline in overall factory bookings even after accounting for an energy price-related advance in the non-durables category.  Meanwhile, shipments are also expected to edge down about 0.5% and inventories are likely to be down 1.0%.

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