On the Fiscal Edge
November 10, 2009
By Daniel Volberg | New York
When late last month the authorities sent to Congress a proposal to suspend the ‘Ley Cerrojo' - the law prohibiting the government from restructuring the defaulted debt in the hands of the holdouts - they telegraphed the clearest signal yet that Argentina may be on the verge of rejoining the club of nations with access to international capital markets. The legal framework that would allow a new restructuring offer could be ready by the end of this month, and we suspect that the terms of the offer may be announced before year-end. But while credit markets may be giddy with excitement at the prospect of Argentina regaining market access, we suspect that the bigger issue that may drive the outlook for Argentine asset markets in the quarters ahead may be the dramatic deterioration in Argentina's macro fundamentals, especially on the fiscal front.
A New Restructuring?
Argentine authorities have taken several key steps in recent weeks that signal another offer to restructure the remaining defaulted debt may be imminent. On October 22, authorities sent to Congress a proposal to suspend the law prohibiting another restructuring. And on October 27, the authorities filed an annual report with the Securities and Exchange Commission in the US, another prerequisite of an eventual move to restructure the defaulted debt. Indeed, the authorities made a similar filing only in 2005 when the original restructuring offer was made and in October of last year when the authorities had originally hoped to pursue a fresh debt restructuring before the global financial turmoil made a deal unworkable. Now, with markets healing faster than many expected and with risk appetite still going strong, the timing seems right for Argentina to try to deal with the near $24 billion in face value of leftover outstanding past due defaulted debt. We suspect that Congress will approve the necessary legal changes this month, allowing the authorities to open up the restructuring before year-end. A successful restructuring would complete the first step of a two track strategy the authorities are pursuing to regain access to debt capital markets at single-digit rates. The second track - which we suspect has been given less priority as the authorities gauge whether the debt restructuring would be enough to achieve market access - involves a rapprochement with the IMF and a settlement of the past due Paris Club debt. It remains to be seen whether much progress can be made there - it has been several years that the authorities have been unable to come to an agreement with either.
Fundamental Deterioration
While the efforts to restructure defaulted debt and tap capital markets may be center stage in Argentina today, we suspect that a bigger underlying issue is the deterioration in the macro fundamentals. The authorities are betting that their efforts to restructure the defaulted debt and perhaps even settle with the Paris Club would allow them to regain access to debt capital markets. If successful, it will not be a moment too soon as severe fiscal deterioration means Argentine appetite for debt financing is set to rise dramatically. Indeed, the macro fundamentals in Argentina have eroded quickly over the past year. We are principally concerned by two key issues clouding Argentina's near-term economic outlook - the growth dynamic and the fiscal deterioration.
Business Climate Clouds Growth Recovery
We are concerned about Argentina's weak prospects for economic recovery. A key turning point occurred roughly a year ago when, in the aftermath of the nationalization of the private pension fund system, in October of 2008 the authorities inherited large equity stakes in virtually every large Argentine corporation. Since then, despite initial denials, the authorities have named board members to the boards of directors of some of the largest companies in Argentina, including in the energy, banking and manufacturing sectors. The government's intervention in the boardroom has been pervasive. As a result of these measures, we believe that companies' willingness to invest in the quarters ahead may be limited.
An additional headwind for growth is the deterioration in the business climate for Argentina's farmers. The authorities have severely limited the farmers' ability to export beef, corn and wheat - items that accounted for roughly 13% of Argentina's exports in 2008 - by replacing automatic export permits with discretionary ones. It is thus hardly surprising that the production of these key products is expected to see only limited recovery despite a sharp rebound in international prices.
Policy heterodoxy may constrain economic growth. While official statistics paint a relatively resilient economy with output growing 0.6%Y in 1H09, we estimate that the recession in Argentina was quite severe, with output contracting 5.6% in the first six months of the year. We suspect that the depth of the contraction was exacerbated by the adverse business climate, a risk we had highlighted back when the nationalization just took place (see "Argentina: The Three Risks", EM Economist, October 31, 2008). Indeed, even according to the more optimistic official growth statistics, investment took a plunge in 2009, falling by 12.3%Y on average in the first two quarters. Looking ahead, we have not seen any significant improvement in the business environment and are concerned that limited investment growth could keep Argentina's economy bumping around the bottom despite a sharp recovery in external conditions, principally the rise in soft commodity prices and a turnaround in the Brazilian economy (Argentina's top trading partner). We continue to expect Argentina to post real economic growth near 1% in 2010.
Poor Growth Drives Fiscal Deterioration
After six consecutive years of surpluses, Argentina's fiscal accounts have dipped into the red, intensifying concerns about the sustainability of the country's fiscal accounts. The big change in the first nine months of this year is that tax revenue growth has fallen sharply below the pace of expenditures. Indeed, when late last month the authorities submitted to Congress proposals to suspend for two years the Fiscal Responsibility Law that sets limits on provincial and Federal deficits and debt financing, they were simply acknowledging that fiscal slippage in Argentina is here to stay.
This year we have seen a serious fiscal deterioration in Argentina. The four-quarter rolling overall fiscal balance has deteriorated to a deficit of Ar$3 billion, or roughly 1% of GDP in 3Q of this year from a surplus of 1.9% of GDP in the same period of 2008. Much of the deterioration has come on the back of sharp declines in revenue growth while the pace of expenditures proved inelastic. Total revenues grew, on average, below 10%Y in the first nine months of the year - a sharp decline from the near 33% annual growth last year. By contrast, the pace of expenditures in the first nine months of the year was more than twice as high as the pace of revenues, averaging 24.3%Y - a light decline from the near 31% average annual expenditure growth in 2008. While the drop in revenue relative to expenditure has been seen across the region, we are concerned that in Argentina the issue may be more structural in nature. The underlying driver for this fiscal deterioration is poor growth performance that is driving down revenue growth and policy distortions that prevent an expenditure adjustment. Much of the decline in revenue growth comes from just three categories: income taxes, VAT taxes and export taxes. Income taxes and VAT taxes are driven by the pace of economic activity and, in the case of VAT taxes, the pace of inflation. Meanwhile, on the expenditure side, much of the elevated pace of spending is driven by public sector wage growth, pensions and subsidies. With growth prospects constrained by policy heterodoxy, the fiscal slippage in Argentina may not be cyclical in nature.
We are concerned that the worst of the fiscal deterioration may still be ahead. Given the seasonal nature of fiscal expenditures - the bulk of which comes in December of every year - the current pace of fiscal deterioration may be signaling that Argentina could slip into a fiscal deficit of beyond -2% of GDP by year-end. Of course simply extrapolating current revenue and expenditure growth would be misleading, given the deep recession that Argentina went through this year. Indeed, our estimates of economic activity show that Argentina's economy has bottomed out in April-May and the turnaround in activity has already translated into some sequential pick-up on the revenue front. Still, our modeling work suggests that given our forecasts for a limited economic recovery in the remainder of this year and given our forecast of 1% growth in 2010, the overall balance could slip further to a deficit of roughly -1.6% of GDP this year and a deficit of -2.9% of GDP in 2010.
And for Argentina the fiscal slippage at the Federal level may be exacerbated by the fiscal shortfall in the provinces. While the provinces had also run surpluses in 2003-06, their fiscal accounts had already slipped into a light, 0.1% of GDP deficit in 2007. With the data on provincial fiscal accounts running only through the first half of 2008, we had to resort to estimates to gauge the extent of overall fiscal deterioration in Argentina. The results leave little room for comfort - our work suggests that the provinces may add as much as 1.1% of GDP to the consolidated deficit this year and 1.9% of GDP in 2010. When combined with the Federal fiscal balance that is heading for a 2.9% of GDP deficit next year, the overall fiscal shortfall in Argentina could reach 4.7% of GDP in 2010. That is a dramatic deterioration from our estimate of a consolidated surplus of near 1% of GDP last year.
Financing Needs
With a deteriorating fiscal position, investor concerns about Argentina's ability to honor its debt obligations may intensify. While the markets were pricing a high probability of default through 1H09, in recent months they have been buoyed by the global recovery in risk appetite. We welcome this development since we have consistently argued that the authorities can count on significant savings and pockets of liquidity that should allow them to honor Argentina's debt obligations, even without market access this year and next. The authorities could rely on part of the near $19 billion in public sector deposits, on the expansion of the monetary base, part of the $45 billion in international reserve and other pockets of liquidity. But we suspect that the authorities are so keen to tap capital markets exactly because the fiscal deterioration means that they are racing against the clock. Indeed, the pace of fiscal slippage may be the biggest source of uncertainty about next year's financing needs. We expect Argentina's financing gap to reach $15.5 billion in 2010 on the back of a 1.3% of GDP primary deficit. But the authorities are working with the assumption of a 1% of GDP primary surplus and thus expect financing needs to be a much more comfortable $7 billion. When we use our models to try to capture the main difference in the projections for financing needs, it is the projection on primary surplus that makes the biggest difference. In turn, the primary surplus is largely driven by the growth forecast through the eventual impact on the revenue stream. While we expect Argentina to post 1% growth in 2010, we are concerned that the authorities' forecast of 2.5% growth and thus a significantly better revenue stream may prove optimistic.
Forecast Changes
Given the continued deterioration in the fiscal accounts and the limited prospects for economic recovery, we are revising our forecasts for the fiscal balance in 2009 and 2010. Our new forecast envisions a fiscal shortfall of -1.6% of GDP in 2009 (from -0.6% of GDP previously) and -2.9% of GDP in 2010 (from -0.9% of GDP previously). In addition, we are revising our currency forecast for 2009 and 2010, as improving external environment and some recovery in domestic demand have translated into stabilization of demand for dollars - a safe-haven currency in Argentina - and are giving the authorities more room to stabilize the exchange rate near current levels. We now expect the exchange rate to reach 3.9 in 2009 (from 4.2 previously) and 4.2 in 2010 (from 4.7 previously).
Bottom Line
While credit markets may be getting excited at the prospect of Argentina regaining market access, we suspect that the bigger issue that may drive the outlook for Argentine asset markets in the quarters ahead may be the dramatic deterioration in Argentina's macro fundamentals, especially on the fiscal front. With economic growth likely to remain subdued on the back of intensified policy heterodoxy over the past year, we expect tax revenue growth to continue to run at an inferior pace to the growth in spending. Indeed, after six years of consecutive fiscal surpluses, Argentina may be faced with a Federal deficit of 2.9% of GDP and a consolidated deficit of 4.7% of GDP in 2010. While it may not be enough to force the authorities to default, we suspect that if the markets continue to rally in the months to come, they may be ignoring the rapid deterioration in Argentina's fundamentals.
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The Peloton Holds Firm
November 10, 2009
By Manoj Pradhan | London
Central bank exit policies are centre stage. Markets are wary of unpleasant surprises from central banks by way of hawkish talk or action, or an earlier-than-expected start to their respective hiking cycles. The Great Recession made a compelling case for central banks to cut policy rates in a synchronised fashion, resulting in large positive spillovers. On the way up, policy is also set to be tightened in a more synchronised way, with most central banks happy to ride within the ‘central bank peloton'. However, there are at least two sets of central bankers that are different. The set of early hikers has been tempered by the dual headwinds of currency appreciation and high asset prices, while another set of central banks has made concerted efforts anew to benefit from the liquidity provided by über-expansionary policies in the major economies. Both sets of policymakers are finding out that raising rates in the central bank peloton is raising challenges that did not exist in past cycles (if you'll pardon the pun).
The peloton and cycling strategy... Riders in a peloton stand to cut wind-drag by as much as 40%. Front-riders have more of an advantage if they want to set the speed, but they have to battle more with the wind than those in the middle of the peloton. Riders in the densest parts of the peloton get the greatest benefits of this mass battle against the winds, but they have to react very quickly to changes that occur just ahead of them - the ‘elastic band' effect (for more details, see "The Peloton, the ‘Elastic Band Effect' and Monetary Policy", The Global Monetary Analyst, September 2, 2009).
...and monetary policy: Central banks are experiencing much the same thing. Our global economics team expects 19 of the 28 central banks we cover to raise rates in the foreseeable future (2Q or 3Q10). These form the bulk of the peloton, primarily because smaller central banks have aligned themselves to ride with the major ones to get the most out of the liquidity that the heavyweights have been and are still providing. Our US team expects the Fed to start its rate hike cycle in 3Q10, while the ECB and the BoE are both expected to raise rates in 2Q10. In these two quarters, 16 other central banks, including the central banks of China, Brazil and Russia, will also likely raise rates in a globally synchronised move that has no parallels in the past.
At the front of the peloton... The front-riders - i.e., the early hikers like the BoI, Norges Bank and the RBA - have more flexibility right now. However, they face headwinds in their attempts to take away some of the monetary easing that is in place. First, risky assets are very strongly linked to their counterparts in the major economies, so that financial conditions will tighten less than they would have in other cycles. Second, concerns about currency appreciation and their impact on exports, particularly with global demand still weak, will also deter aggressive action. It is interesting to note that while these headwinds weaken the impact of policy tightening right now, the situation will be very different when the major central banks start their tightening campaign. Then, the headwinds to tightening could turn into tailwinds, which means that front-runners could find their financial conditions tightening without doing much policy-wise, which in turn could lead their currencies to weaken. Importantly, these headwinds to the front-riders are a direct result of the über-expansionary policy of the major central banks in the peloton.
...similar concerns, different headwinds: As one would expect, there are similarities and differences among the front-runners. The BoI started its rate hike cycle to ward off inflation and has intervened in currency markets consistently to counter currency appreciation. It has not hiked rates further following two weak inflation prints. The other two central banks to hike already - the RBA and Norges Bank - have both been concerned about inflation and property prices. Norges Bank, however, has voiced more concern about currency appreciation than has the RBA, and struck a more dovish note after its policy rate hike on October 28 compared to the RBA, whose statement after its own rate hike yesterday was more even-handed. Finally, the Reserve Bank of India, concerned by the projected rise in inflation, recently set the stage for withdrawing emergency liquidity measures and then tightening policy, with its first rate hikes probably in 1Q10 (see RBI Takes First Step Toward ‘Exit', October 28, 2009). In addition to worries about currency appreciation and a rapid build-up of asset (and particularly property) prices, the RBI also stated concerns in its last statement about "perverse incentives" that could result in an increase in capital flows as it raises rates relative to and in advance of the rest of the peloton even as Brazil has recently moved to try and stem the inflow of ‘hot-money'.
However, not everyone is eager to get a head-start: Another group is eager to move firmly into the peloton to get the most out of the liquidity benefits of riding with the heavyweights. The central banks of Russia, Romania and Hungary have been cutting rates aggressively recently and are likely to continue to deliver more of the same. Additionally, the RBNZ in its last policy statement on October 29 went out of its way to make a rather unusual comment that markets were pricing in too many rate hikes. Effectively, the RBNZ cemented its place firmly in the peloton, content to get as much stimulus for its weak economy as it can, given its benign inflation outlook. Finally, while markets have focused on the BoJ's phased removal of the corporate bond purchase programme as a sign of tightening, our Japan economics team points out that the more significant policy move on October 30 was actually a further easing via the unprecedented use of Fed-like commitments to "maintain the extremely accommodative financial environment for some time" (our italics). Given that the BoJ has a forecast of deflation for the next three years, our economics team suggests that further rate cuts or bond purchases should not be ruled out.
The peloton holds firm: With the Fed, the ECB and the BoE and 16 other central banks likely to start raising rates only in 2Q and 3Q10, their easy-money stance until then will continue to deliver considerable liquidity to the global economy. Actions of central banks that want to hike early, as well as the actions of those who want to cut their ‘wind-drag' as much as possible, cannot be made independently of the behaviour of this peloton of central banks. To borrow from Douglas Adams' Hitchhiker's Guide to the Galaxy, resistance, while not futile, may be very difficult.
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Review and Preview
November 10, 2009
By Ted Wieseman | New York
The Treasury curve saw a huge steepening move over the past week, with the long end falling hard and the short end rallying modestly, as an overall solid run of key economic data even after another disappointing employment report increased confidence in the sustainability of the recovery and left investors worried about inflation risks with the lack of any movement by the Fed to scale back its extraordinarily easy monetary policy. The FOMC's continued prediction of "exceptionally low levels of the federal funds rate for an extended period" and no indication that it would soon direct the New York Fed's trading desk to start draining the enormous and still rapidly growing flood of excess reserves in the banking system seemed increasingly inappropriate and risky in an economy that appears to have moved into a sustainable, though probably still muted, recovery. Excess reserves surged another $72 billion, or 7%, in the latest two-week reserve maintenance period to a $1.06 trillion daily average, and without offsetting Fed action - which the FOMC statement gave no indication was imminent - we expect them to continue rising towards a peak near $1.25 trillion in 1Q as sizable MBS purchases extend through March. Excess reserves have now surged 33% since the end of August, resulting in a 111% annualized spike in the monetary base over this period, even though it seems increasingly likely that the NBER will eventually mark the recession as having ended in July. While the weakness at the long end of the Treasury market and bear steepening of the curve was also influenced to some extent by heavy looming long end supply at the upcoming refunding auctions, signs of rising inflation concerns were clearly also at play given a big rise in TIPS inflation breakevens, renewed weakness in the dollar, and upside in commodity prices seen during the week. The week's economic data overall were positive, though the key employment report ended things on a soft note. Nonfarm payroll weakness did moderate in October but less than expected, and much more severe ongoing losses in the household survey led to a sharp rise in the unemployment rate to above the 10% level we had for a while previously thought might mark the cycle peak. The workweek also remained depressed at a record low, so overall labor input continued to decline. We now see 4Q GDP growth running near +3%, up from our +2.5% forecast coming into the week, so the decline in hours worked early in the quarter suggests that the incredible 8%+ annualized spike in productivity in 2Q and 3Q may have been extended to a substantial degree in 4Q. Eventually nothing close to that is going to be sustainable, so at some point employers are going to have to start adding jobs and expanding hours if the economy keeps growing, but at least through October it appears they were continuing to squeeze enormous efficiency gains out of their existing workforces. The boost to our 4Q GDP growth forecast came mostly as a result of early indications pointing to a strong October retail sales report. Motor vehicle sales sharply rebounded after the big cash-for-clunkers payback in September, and chain store sales results were solid overall, pointing to further upside in ex auto retail sales after the surprisingly robust back-to-school shopping season in August and September. Meanwhile, growth in the broad economy continued according to the ISM surveys, though a big jump in the manufacturing index to a three-and-half-year high was certainly a lot more impressive than a slight decline in the nonmanufacturing survey to just above the 50 boom/bust line.
For the week, decent front-end gains and big long-end losses drove a major steepening of the yield curve, with 2s-30s rising 23-354bp, high since July and not far from a new high since the early 1990s. The 2-year yield fell 6bp to 0.85%, 3-year 5bp to 1.36%, and 5-year 2bp to 2.30%, while the 7-year yield rose 3bp to 3.02%, 10-year 11bp to 3.50% and 30-year 17bp to 4.40%. After the big net paydowns in October, bill issuance turned slightly positive the past week, and the added supply helped to slightly ease the crunch at the very short end, with the 4-week bill yield up 4bp to 0.06%, though the 3-month held steady at 0.05% for an odd curve inversion. TIPS had a great week as the Fed's lack of any movement towards scaling back its extremely easy monetary policy raised inflation fears. The 5-year TIPS yield fell 10bp to 0.52%, 10-year 3bp to 1.34% and 20-year 4bp to 1.98%. This lifted the benchmark 10-year inflation breakeven 14bp to 2.16%, high since mid-2008. The 20-year breakeven was up a larger 20bp to near 2.37%. Agency mortgages had a solid week (in major contrast to a rough week for non-agency RMBS and CMBS), outperforming Treasuries somewhat. Current coupon yields ended up about unchanged on the week at a bit above 4 1/4%, which should be consistent with 30-year conventional mortgage rates holding near the 5% level they've been around the past few weeks. This is still a very low rate from a long-term perspective and only a bit above the record lows near 4 3/4% seen in the spring, which in addition to the extension and expansion of the homebuyers' tax credit Congress passed at the end of the week will keep housing affordability very high. Straight agency debt underperformed as the Fed scaled back its planned purchases to $175 billion from $200 billion citing lack of available supply. The swaps curve didn't steepen quite as much as the Treasury curve, as longer end swap spreads declined somewhat while shorter end spreads were more stable, with the benchmark 10-year spread declining a couple basis points to 16bp and the benchmark 2-year spread not much changed at 34bp.
Risk markets were somewhat mixed on the week, but for interest rate investors worsening conditions in CMBS and non-agency RMBS ended up being probably being more important than the more headline grabbing rebound in stocks and gave the front end some late week flight-to-safety support on top of the boost from the Fed and employment report disappointment. The S&P 500 gained 3.2%, starting November on a strong note after October was the first negative month since February. Industrials (+6%), consumer discretionary (+5%) and materials (+5%) led a broadly based rally, with usually high beta financial (+2%) lagging somewhat. Credit performance was more muted than stocks as there was more spillover from the CMBX and ABX weakness. The investment grade index did well, tightening 6bp to 103bp, but the high yield index was only 15 tighter at 684bp through Thursday and then was seeing minor weakness late Friday. The leveraged loan LCDX index lagged more, widening 8bp to 578bp through midday Friday, putting it on pace for its worst close in a month after a nearly 50bp widening in the past two weeks. The commercial mortgage CMBX and subprime ABX markets had rough weeks that made interest rate investors nervous even as stocks were rallying late in the week. The AAA index fell 1.58 points to 76.71 and is down 7% the past two weeks, while the junior AAA declined a more severe 2.40 points to 47.71 for a 9% drop the past two weeks and now a 21% pullback from the high hit in late September. The enormous rally in the AJ index seen in the second half of September has now been completely unwound. Non-agency residential mortgages also came under pressure, with the AAA subprime ABX index down 1.42 points on the week to 29.58 for an 11% drop over the past two weeks from the recent high hit October 23.
Nonfarm payrolls fell 190,000 in October, in line with smaller revised declines in September (-219,000 versus an initially reported -263,000) and August (-154,000 versus -201,000). The household survey again showed a much bigger drop in jobs, so even with a small further dip in the labor force, the unemployment rate jumped 0.4pp to 10.2%, another high since 1983 and rapidly closing in on the post-Great Depression high of 10.8% hit in 1982. The major areas of weakness for some time - manufacturing (-61,000), construction (-62,000) and retail (-40,000) - continued to show big job losses. On the positive side, however, business services payrolls have grown slightly the past couple months, with temp jobs, sometimes a leading indicator for overall payrolls, showing a big rise in October. Other details were mixed. Average hourly earning gained a sold 0.3%, but the average workweek was flat at a record low 33.0 hours. The drop in payrolls and flat workweek combined to cause aggregate hours worked to fall 0.2%. With the upside in average earnings, however, even with the drop in total hours worked aggregate weekly payrolls, a proxy for total wage and salary income growth, was flat, which should result in a small increase in overall personal income. Market reaction to the disappointing jobs reported was muted, partly because the improvement in jobless claims has been so large recently and has continued as the figures have moved past the survey week for the October employment report, so a slowing in the rate of deterioration of the labor market still seems to be underway even if the past couple employment reports have been worse than expected.
Early indications for October consumer spending pointed to a strong retail sales report that should put 4Q consumer spending on track for a decent further gain even with a big payback in auto sales after the end of cash-for-clunkers that led to a very large decline in consumption in September. Motor vehicle sales surged 14% in October to a 10.4 million unit annual rate, and almost all of the upside was in sales of domestically produced vehicles, with imports little changed. Outside of the cash for clunkers boosts in July and August, this was the best sales month in a year. Ex auto sales weren't this strong, but chain store sales results overall were quite solid even after accounting for easy comparisons with the collapse in consumer spending late last year. Incorporating these results, we look for a 1.8% surge in overall retail sales in October and a solid 0.5% gain in ex auto sales. And incorporating the upside in motor vehicle and expected ex auto retail sales, we raised our forecast for 4Q real consumption to +2.5% from +1.9%. Mostly as a result of this increase, we now see 4Q GDP growth running near +3% instead of +2.4%. A number of the missing pieces for 3Q growth that BEA initially had to make assumptions for were filled in over the past week, but overall they pointed to little net revision to the initial +3.5% print. Construction spending was a bit negative as a result of weakness in private nonresidential activity that pointed to a downward revision to third quarter business investment in structures, while there were offsetting inventory swings to the downside in nondurable manufacturing and upside in wholesale relative to BEA assumptions. At this point, 3Q growth looks like it will be adjusted down to +3.4% from +3.5%, so if the economy can expand near a +3% rate in 4Q, the expected slowdown in the current quarter would clearly turn out to be quite mild. A key thing to keep in mind is that while there will likely be some payback in auto sales in 4Q, sales are not what matters for GDP. Production is, and production continues to move higher as automakers seek to replenish inventories that were driven to unusually low levels by the cash-for-clunkers jump in sales. We see the motor vehicle sector adding another 0.5pp to 4Q GDP growth on top of the 1.7pp add to 3Q.
The ISM surveys continued to show growth in the economy, but with a broadening in the expansion in the manufacturing sector contrasting with much more mixed results in the rest of the economy. The composite manufacturing ISM index jumped 3 points in October to 55.7, the highest reading in three and a half years. Upside was driven by big gains in the production (63.3 versus 55.7) and employment (53.1 versus 46.2) gauges, the former to a five-year high and the latter a three-year. The inventory gauge (46.9 versus 42.5) also continued to normalize and point to a slower rate of destocking. On the negative side, the orders index (58.5 versus 60.8) pulled back a bit but remained at a high level. Growth was broadly based, with 13 of 18 industry groups reporting expansion in September. Meanwhile, the composite nonmanufacturing index dipped to 50.6 in October from 50.9 in September, remaining just barely above the 50-breakeven level. According to the report, respondents were "mostly cautious about business conditions and the overall economy". All of the weakness in the composite index was in the employment gauge (41.1 versus 44.3), which fell to a six-month low. Business activity (55.2 versus 55.1) and orders (55.6 versus 54.2), on the other hand, rose a bit further into growth territory. Activity was mixed by sector, with 9 industries reporting growth and 7 contraction.
After the very busy past week, there is very little going on in the upcoming week - which will only be four days with the Veterans Day holiday Wednesday - so Treasury market focus will be firmly on the refunding auctions, a $40 billion 3-year Monday, $25 billion 10-year Tuesday and $16 billion 30-year Thursday. All record sizes again after further $1 billion boosts to the 3-year and 30-year and $2 billion increase in the 10-year. Treasury's debt management team emphasized their goal of significantly expanding the average maturity of the outstanding debt over the coming year to around 6 years from the unusually low 4 years it hit at the end of fiscal year 2009 as a result of the massive bill issuance seen initially to fund the surge in the federal government's budget deficit. So even though we expect overall Treasury borrowing in the current fiscal year to be down a decent amount from F2009 (though still extremely high from a longer-term perspective), we look for a much higher duration of new supply to continue and for much higher gross and net issuance of coupons in F2010 than in F2009 offset by a significant net paydown in bills. This should continue to be reflected in continued boosts in almost all coupon sizes at regular issuance announcements through the first part of next year. There are only a few data releases of note in the coming week and none before Veterans Day. Weekly jobless claims, which have shown persistent and cumulatively quite substantial improvement for a couple months even as the results of the last two employment reports have been disappointing, will probably be the biggest data focus as the figures move close to the survey period for the November employment report. Other releases include the Treasury budget Thursday and trade balance Friday:
* We expect the federal government to report an October budget deficit of $153 billion, very similar to that seen in the same period a year ago ($156 billion). However, the mix is likely to be quite different. Spending should show a significant drop-off as the emergency outlays recorded during the height of the financial market turmoil have faded. But tax revenues have continued to plummet. Indeed, withheld income and payroll taxes are running at -12%Y.
* We look for the trade deficit to widen slightly in September to $31.2 billion from $30.7 billion, with exports and imports both rising 1.4%. All of the export upside should be accounted for by a surge in aircraft, as industry figures pointed to a big gain in overseas deliveries. Autos should also continue moving higher in line with rising North American assemblies, but factory shipments results point to some softness in ex aircraft capital goods and industrial materials. On the import side, a rebound in petroleum product volumes after a collapse to a ten-year low in August along with upside in autos should drive the gain. Note that our forecast implies an upward revision of a couple tenths to 3Q GDP growth.
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