Brazil
No Fiscal Exit
November 24, 2009

By Marcelo Carvalho | Sao Paolo

While Brazil's recent IOF tax on capital flows underscores the authorities' unease with currency appreciation, we expect further policy tension to arise next year as unabated fiscal stimulus means that monetary policy will have to carry most of the burden of policy adjustment. With the return of robust domestic growth, the authorities will sooner or later need to start thinking about how to unwind the policy stimulus already put in place this year. But fiscal policy looks set to remain expansionary ahead of the 2010 October elections, and therefore Brazil's ‘exit strategy' will likely need to rely on monetary tightening. In turn, higher interest rates could support currency appreciation - the very trend that recent capital controls seek to counteract. In all, ongoing fiscal expansion should pose near-term challenges for monetary and foreign exchange policies next year.

Policy Unease about Currency Appreciation

What is the bigger picture behind recent capital controls? The authorities announced last week a 1.5% IOF tax on new issuance of depositary receipts in response to concerns that the currency's gains were weakening trade competitiveness. The finance ministry's first response, introduced in October, was a 2% IOF tax on foreign fixed income and equity inflows. But interventions such as the 2% IOF tax create distortions, loopholes, arbitrages and unintended consequences - such as a migration of equity trading to ADRs (American Depositary Receipts). Now the government is trying to close that loophole.

What worries us is the broader policy shift away from orthodoxy and towards a more interventionist approach, rather than the specific IOF tax itself. Regulatory uncertainty has increased and could be amplified with the elections set for next year. If the currency appreciates further, it would not surprise us to see more measures down the road (see "Brazil: Policy Drift", EM Economist, November 6, 2009).

What else can the authorities do? First, increasing the IOF tax itself seems the easiest, most obvious option. Second, the finance ministry sounds keen on the idea of using the Treasury (perhaps through a sovereign wealth fund) to buy US dollars in the spot market, on top of what the central bank already does. Third, lock-up periods seem a possibility too, with a sliding tax for longer holding periods. Fourth, facilitating capital outflows seems more in the hands of the central bank and may take longer to implement. Last, another possibility is to tax outflows as a way to discourage inflows in the first place - probably the least likely measure at this stage. As for the idea of exempting local IPOs from the 2% IOF tax, the implicit underlying notion that IPO inflows are better than other equity inflows would likely prove hard to implement in practice, as money is fungible.

No Fiscal Exit

There is no need for further policy stimulus, in our view, in light of abundant signs of strong domestic expansion. Indeed, the authorities say Brazil's real GDP is enjoying a "Chinese growth" rate of 9% in 3Q (sequential, quarter-on-quarter, annualized pace).  The official 3Q GDP release is set for December 10. Local retailers are calling this year's holiday shopping season the "best Christmas on record". Net formal job creation is now back to pre-crisis levels - indeed, the latest reading was actually the best October on record. Perhaps the automobile sector illustrates best the sharp turnaround this year: while car production was cut back sharply and workers in the sector were dismissed early in the year, re-hired workers have gone on strike and recent collective wage negotiations in the automobile sector managed to obtain nominal wage gains above 8%, well above inflation.

But fiscal policy remains loose. In fact, fiscal accounts have worsened significantly. Brazil's headline primary surplus (excluding interest payments) over the last 12 months through September weakened to just 1.2% of GDP. That is down from 3.7% at end-2008, or from a peak of 4.3% in October last year. The latest number is actually the worst primary fiscal performance in the decade. The primary surplus is now well below the official target of 2.5% for 2009 as a whole. We think it will be very hard to reach the official target without resorting to creative accounting mechanisms. In turn, the burden of interest payments is not shrinking enough to fully offset the deterioration in the primary balance this year. The resulting nominal budget deficit worsened to 4.3% of GDP in September, from 2.0% last December, or from a best-on-record mark of 1.3% last October.

Federal spending leads the fiscal deterioration. The federal government is to blame for most of the fiscal worsening this year - as opposed to regional governments and state-owned enterprises. At the federal level, revenues have come down on tax breaks and on the economy's downturn earlier in the year, while spending is accelerating. Ahead, the growth recovery should eventually support revenues. But the worry is that the bulk of fiscal deterioration comes from rising federal spending of questionable composition, at an accelerated pace, and of a permanent nature - such as wages, rather than investment. So far this year (January-September), total federal expenses have increased by R$57.8 billion over the same period a year earlier, or 16.5% over a year ago. Where did that spending increase go to? Of the total R$57.8 billion increase in spending, the increase in investment was just R$2.4 billion. Put another way, in terms of contributions to the total nominal change in spending so far this year, the increase in investment contributed with just 4.1% - by contrast, the increase in payroll expenses accounted for 30.3%, social security contributed with 31.7%, and running expenses contributed with 22.3% of the increase. In terms of shares of overall federal spending, investment remains a relatively small item, representing just about 5.0% of federal spending.

There is little hope for much fiscal adjustment next year, ahead of the October 2010 elections. While the authorities like to claim that current fiscal easing is "counter-cyclical", the fiscal situation seems better described as a permanent increase in sub-optimal spending. The authorities hope that the primary fiscal surplus improves from an official target of 2.5% of GDP in 2009 to an official target of 3.3% in 2010. Instead, in our view, figures closer to the 1% mark seem more likely in both years - at least before taking into consideration accounting mechanisms that can make the official headline figure look better. After all, the authorities have already indicated in the local press that the official targets are not "imperative". The local perception is that meeting the fiscal targets will largely depend on a rebound on tax revenues, as spending is bound to increase going into the elections. As has already happened, the authorities could well revise the fiscal targets lower again or resort to further changes in accounting, if the expected rebound in tax revenues fails to compensate for the programmed jump in spending - ranging from the minimum wage and pensions to public sector wages.

Besides headline fiscal easing, quasi-fiscal expansion has been remarkable too. The authorities have pushed public sector banks to lend aggressively, including through the national development bank (BNDES). The increase in domestic credit provided by public sector banks so far this year exceeds three percentage points of GDP. Looking ahead, there is little sign of any meaningful reversal in this trend ahead of the 2010 elections.

Fiscal Policy Complicates Monetary Policy

Ongoing fiscal expansion can complicate monetary policy decisions next year. Fiscal and monetary policies worked in the same direction (easing) in 2009. But they seem set to work in opposite directions in 2010, which may increase policy tensions within the administration. Indeed, while the issue for the central bank next year is when and by how much to tighten, all the signals and body language from Brasília suggest that fiscal policy is set to remain in expansionary mode. For instance, despite evidence of strong domestic sales of durable goods, the authorities decided last month to extend the (IPI) tax break on white-line goods for yet another three months, until end-January 2010.

Brazil's policy mix is not ideal. The fiscal authorities often note that a high burden of interest payments hurts the overall budget balance - they seem to judge that interest rates are too high in Brazil, and appear willing to compensate with fiscal stimulus for what they see as overly tight monetary policies. In turn, the central bank seems to judge that one reason why real interest rates are still relatively high in Brazil has to do with fiscal concerns. Beyond any blame game, a combination of contained fiscal spending and looser monetary policies would probably prove a superior policy mix for Brazil over time. In the meantime, the easier fiscal policy is, the tighter monetary policy will have to be - all else equal. With little hope for much fiscal tightening next year, the bulk of the policy adjustment in 2010 will depend on rate hikes.

Fiscal considerations may play a rising role for monetary decisions. It is hard to handicap the precise impact of fiscal easing on growth and on the central bank's reaction function. But it is notable that recent monetary statements now talk more explicitly about the fiscal picture. For instance, the latest quarterly inflation report (September) has warned that fiscal deterioration in part reflects "spending trends that may prove hard to reverse in the future", given the downward "rigidity" in certain government expenses. When it considers its balance of risks, the central bank warns about the risk that the lagged impact from previous monetary and fiscal easing could peak exactly when slack in the economy is at its lowest, noting that the economic impact from fiscal expansion already put in place is yet to fully materialize.

The central bank is not in a hurry to hike rates, to be clear. It judges that there is still slack in the economy, inflation is under control, and near-term inflation prospects look benign. However, the COPOM will need to start thinking about exit strategies if slack shrinks under strong domestic expansion and inflation expectations start to drift higher (see "Brazil: Exit Strategy", EM Economist, October 23, 2009).  In all, we assume that the central bank starts hiking rates at some point in 2Q10. Our forecast sees the policy rate increasing from the current 8.75% mark to finish 2010 at 11.0%, and then rising further to a peak of 12.0% in 2011 - still short of the latest peak of 13.75%, before the central bank started easing in early 2009.

What about the political calendar? We assume that the central bank will remain committed to the inflation-targeting regime and thus hike rates as appropriate, despite the election calendar. However, recent press reports linked to a departing board member of the central bank suggest that the political tensions between the central bank and the administration were much higher, and the stakes greater, than we had previously thought (Valor Econômico, November 13, 2009).  If true, the revelations could begin to undermine the market's perception about the central bank's operational independence.

In that context, further changes at the board of the central bank are likely to be closely watched by the market.  Last week's announcement of a replacement for the director of monetary policy left observers with the impression that the COPOM might turn slightly less hawkish, in the sense that the departing hawkish director is being replaced with someone whose opinions on monetary policy are yet unknown. But the key positions to watch are the remaining two board members that originally came from the private sector - the governor himself and the director of economic policy. The local perception is that both are likely to stay or leave together. The governor has already joined a political party, which is a necessary condition to run for elections in October 2010. He has indicated that a decision will be taken in March: if he decides to run, the rules require him to leave the central bank six months ahead of the October elections.

Be ready for rising tensions within the administration. For its part, monetary policy matters for fiscal numbers and for the currency too. Whenever the central bank does decide to start tightening monetary policy next year, higher rates will entail a fiscal cost in the form of a higher burden of fiscal interest payments on the government's debt stock. In addition, the risk is that higher rates could work against efforts by the finance ministry to contain currency appreciation, which could further aggravate policy tensions within the administration.

Bottom Line

Fiscal policy looks set to remain loose ahead of elections next year. That can create policy coordination concerns, as the bulk of Brazil's ‘exit strategy' in 2010 will need to rely on monetary tightening. In turn, interest rate hikes run the risk of spurring currency appreciation, which is the very trend that recent capital control measures are trying to contain. In all, fiscal policy seems likely to increase near-term policy tensions within the administration next year.

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United States
Review and Preview
November 24, 2009

By Ted Wieseman | New York

Treasuries had a good bid over the past week in generally quiet and somewhat illiquid trading, as investors and financial institutions appear to be moving early to close the books on the year and scale back risk and balance sheets.  A movement into cash-like investments that carry over New Year was particularly pronounced, with bills maturing in January all moving to zero yields, while the 3-month yield plunged to just above zero and the 6-month to a record low.  There has been a regular pattern during this crisis of bills being badly squeezed around quarter-ends, but it's happening a lot earlier than normal this time around, a week before we've even hit the Thanksgiving holiday that often marks the beginning of a year-end holiday lull in market activity.  This movement into safer assets and the general slowing down in activity also boosted Treasury coupons, especially the shorter end, sending the yield curve towards record-steep levels, as investors decided to ride carry and roll-down for now after Fed Chairman Bernanke's reiteration of the super-dovish FOMC statement and amid a rapid decline in interest rate market volatility to levels not seen since before the Lehman Brothers collapse.  Rising risk-aversion and balance sheet reduction ahead of year-end also appeared to prompt investors to start booking profits in equity and credit markets late in the week while giving the recently struggling dollar a boost as carry trades were pared back after the dollar index had hit a new low since mid-2008 following Fed Chairman Bernanke's reiteration of the Fed's disturbingly dovish outlook on Monday.  Despite the better bid to Treasuries during the week, TIPS continued to perform very well, as investors remained nervous about the Fed's ongoing ramping up of quantitative easing after the recession has already clearly ended and lack of any indications that the rapidly growing flood of excess liquidity would begin to be withdrawn any time soon.  With market focus turning towards year-end book-closing, the past week's mixed economic data were largely ignored.  Figures for October were somewhat disappointing.  Retail sales overall were way up on the rebound in auto sales, but underlying sales growth was not quite as solid as expected.  With a slightly slower trajectory for consumption in the second half combined with some downside in retail inventories in August and September, which will likely be followed by an offsetting boost to 4Q, we now see 3Q growth being revised down to +2.7% from +3.5% instead of to +3.0%, but we see 4Q GDP growth also running at +2.7%, up from our prior +2.5% forecast.  In addition to the slightly softer-than-expected retail sales results, industrial production was flat in October after a strong recovery over the prior three months, and housing starts pulled back significantly as there was apparently a major housing lull in October and part of November as buyers and builders waited to see what would happen with the homebuyers' tax credit.  Looking to November, however, early signs for the next key round of data were solid.  Jobless claims extended a nearly three-month run of consistent improvement into the survey period for the employment report, pointing to continued underlying improvement in labor market conditions.  This appears to have been masked in the last two disappointing employment reports by unusually negative seasonal adjustment - but this swings around in the other direction in November, and we expect to see a notably improved report.  And mixed results from the initial round of regional manufacturing surveys suggested that the national ISM in November will probably hold on to most of the surge seen in October. 

On the week, benchmark Treasury coupon yields fell 6-11bp and the curve continued to steepen, with 2s-30s up 4bp to 357bp, just below the cycle high of 361bp hit May 27 and all-time high of 367bp reached in 1992.  Over the past three weeks, the 2-year yield has now fallen 19bp, while the 30-year yield has risen 7bp as investors have reacted to the surprisingly dovish FOMC outcome.  In the latest week, the 2-year yield fell 10bp to 0.72%, 3-year 11bp to 1.24%, 5-year 9bp to 2.17%, 7-year 7bp to 2.89%, 10-year 7bp to 3.36%, and 30-year 6bp to 4.30%.  There were some unusual moves along various parts of the rest of the curve - notably a very good relative showing by the bond contract and off-the-run bonds and the 5-year contract and off-the-run 5s but, conversely, a poor performance by off-the-run 2s - that apparently reflected bad positioning and year-end balance sheet clean-up amid declining liquidity.  The FOMC surprise and reiteration of the dovish FOMC message from Chairman Bernanke have kept inflation expectations rising during the recent upside in the market, with TIPS putting in another very good week despite a late-week pullback in energy prices as the dollar rebounded.  The 5-year TIPS yield 16bp to 0.29%, 10-year 10bp to 1.16%, and 20-year 11bp to 1.83%, which lifted the benchmark 10-year inflation breakeven 3bp to 2.20%, near the highest level since mid-2008 after a 50bp rise in the past seven weeks.  With inflation expectations on edge, a bit of upside in the CPI report, even if it appeared to be largely just a one-off correction in autos, was TIPS-supportive.  The consumer price index rose 0.3% in October, but was still down 0.2% from a year ago, as energy prices fell less than they normally do in October, resulting in a 1.5% gain after seasonal adjustment, and auto prices surged the most in almost 30 years.  Energy prices are likely to rise again in the next report versus a huge decline in November 2008, which should lift overall inflation above zero for the first time since February.  The end of cash-for-clunkers discounts resulted in a 1.6% jump in new vehicle prices, while the junking of so many old cars during cash for clunkers contributed to a 3.4% spike in used car prices.  On the other side, the key owners' equivalent component was flat for another record-low 1.2% gain from a year ago.  Big deceleration in OER has fully accounted for the percentage point drop in overall core inflation over the past few years.  Ex-shelter core inflation has actually been seeing an acceleration. 

As notable as these moves in coupons over the past week was the increasingly severe squeeze in the very short end. The 3-month bill yield collapsed 5bp to just 0.01%, the 6-month yield fell 3bp to a record-low 0.13%, and every bill with a January maturity is at zero yield (with scattered negative quotes).  Ahead of year-end we seem to be seeing a much earlier-than-normal scaling back of balance sheets by financial companies and apparently also some risk reduction ahead of year-end by a broader base of investors later in the week as the crunch in bills worsened while stocks pulled back.  Short-end and funding dislocations are certainly not uncommon around quarter and year-ends, especially during the past couple years of market stress, but even last year when the financial turmoil was near its peak, we didn't see the pressures intensifying so far ahead of the actual calendar turn (on November 20, 2008, the 4-week was at 0.05%, 3-month at 0.03%, and 6-month at 0.51%).  Financing markets are also starting to look ahead towards potential issues over year-end.  Overnight Treasury general collateral repo rates over the year-end turn are trading near 0.03% versus a Friday average of 0.08%, and our financing desk thinks it is likely on New Year's Eve that we will see a repeat of the previously unprecedented negative overnight rates first seen at the end of September.

Meanwhile, mortgages had a poor relative performance in the latest week, with current coupon yields holding steady near 4.1%, but this followed a very good showing in the prior week.  Over the past two weeks, MBS yields are down about 20bp, while the 5-year Treasury yield is down 13bp, and the current level of 4.1% should keep 30-year conventional mortgage rates close to recent near record-lows just above 4.75%.  The MBS market has been supported recently by a big decline in interest rate volatility, which has plummeted since the FOMC meeting to reach levels not seen since the Lehman bankruptcy.  A major slowdown in mortgage origination activity also helped for a while, but this seems to be turning around.  The National Association of Homebuilders reported in its monthly survey that the housing market went into a "holding pattern" for much of October and November, while buyers and builders waited to see what would happen with the homebuyers' tax credit.  So far this has been reflected in an 11% plunge in October housing starts, a run of very weak outcomes from the weekly mortgage applications survey for new purchases, and a period of very light MBS origination, and it will probably be reflected as well in the coming week's report on new and existing home sales.  With the tax credit having been recently extended and expanded and mortgage rates near record-lows, however, housing affordability is near all-time highs, and a notable pick-up in mortgage origination over the past week suggested that the housing market lull might be coming to an end. 

Risk markets had a strong start to the past week, but later on it appeared that investors were starting to take some chips off the table and scale back their exposure into year-end, adding to the rush into cash.  The S&P 500 ended down only marginally for the week but a couple of percent below the year's best close hit Tuesday.  The Fed's extremely dovish policy clearly remains dollar-negative over time, but risk-reduction generally and, to the extent that the dollar has become a funding currency, scaling back of leverage and risk positions into year-end could continue to be dollar-supportive for now after this apparently provided a boost over the course of the past week after a drop Monday to another new low since mid-2008.  The dollar and stocks continue to have a strongly inverse correlation, so the dollar rebound went along with the stock market pullback, with the energy sector underperforming during the late-week sell-off with about a 3.5% drop from Tuesday to Friday.  Credit markets have been very calm recently, hardly moving for a couple of weeks now.  In late trading Friday, the investment grade CDX index was 3bp wider at 102bp, having closed for two weeks only between 98bp and 102bp.  High yield has been similarly stable, with the HY CDX index 7bp tighter 657bp through Thursday and then moving back towards unchanged after a small Friday sell-off.  The leverage loan LCDX index was also on pace for minimal net movement for the week after only minor day-to-day volatility.  Non-agency mortgage markets had a better week, though this was generally a result of a strong start to the week followed by not much movement later on as volatility in other markets also slowed.  The AAA CMBX index only managed a marginal gain on the week, even as the first CMBS deal in quite a while was brought to market with help from the Fed's TALF, but the junior AAA was up 6% and AA 7%, while the AAA subprime ABX index gained 3%. 

Incoming data continued to point to a slightly weaker trajectory for second half growth than we expected a couple of weeks ago, but it looks as if we could start to see a more positive run of data as we move into the early December run of initial November figures, with clear upside risks, in our view, to the next employment report. 

Underlying details in the October retail sales report were not as strong as expected, pointing to slightly slower consumption growth in 3Q and 4Q.  Overall retail sales gained 1.4%, sharply boosted by a surge in autos (+7.4%) after the correction seen in September following the end of cash for clunkers.  Ex-auto sales ticked up a much smaller 0.2%, and there were small downward revisions to September (+0.4% versus +0.5%) and August (+0.8% versus +1.0%), though the solid run over the past three months still represents a huge turnaround from the collapse seen into mid-year.  In line with the solid chain store sales results, general merchandise (+0.8%) was strong, building on a solid back-to-school shopping season, an encouraging sign for holiday sales, and clothing stores (+0.4%) also extended a robust recent trend.  But this was partly offset by moderation in the heavily weighted grocery store component (+0.1%) after a couple of unusually strong gains, a big pullback in building materials (-2.4%), and softness in furniture (-0.8%) and electronics and appliances (-0.6%).  The key ‘retail control' grouping (sales ex-autos, building materials, and gas stations) jumped a robust 0.5% in October, as we expected.  There were some small downward revisions to prior months, however, with September adjusted down to +0.4% from +0.5% and August to +0.5% from +0.7%. These downward revisions to retail control point to a downward revision in 3Q consumption to +3.2% from +3.4%.  And although the October retail control gain matched our forecast, the downward revisions to prior months provided a slightly softer starting point for 4Q.  We now see 4Q consumption running at +2.3% instead of +2.5%.  Meanwhile, retail inventories pointed to a smaller inventory boost to 3Q, but with offsetting upside likely in 4Q.  Retail ex-auto inventories fell a larger-than-expected 0.6% in September on top of a downward revision to August to -0.7% from -0.3%.  We now see inventories adding a couple of tenths less to 3Q but a few tenths more to 4Q.  Combining these swings with the slightly lower trajectory for consumption, we now see 3Q growth being revised down to +2.7% from +3.5% instead of to +3.0%, but we see 4Q GDP growth also running at +2.7%, up from our prior +2.5% forecast. 

The first couple of quarters of recovery from the recession that ended mid-year, the deepest and longest recession in the post-war period, thus look very muted, but we at least appear likely to see solid results in the next round of key economic data after Thanksgiving.  Jobless claims continue to show improvement every week moving into the survey period for the November employment report, with the 4-week average of initial claims now down for 11 straight weeks and continuing claims for nine.  We've had two disappointing employment reports during this nearly three-month run of claims improvement, but it appears that unusually negative seasonal adjustment in September and October largely accounted for the worse-than-expected reports - and this flips around to be a positive in November.  Because there was such a sharp drop-off in economic activity around this time last year (along with a more modest drop-off around the same time of the year in 2007), it seems that the seasonal adjustment process has identified some of the ‘real' decline in economic activity experienced in late 2008 and late 2007 as seasonal and is trying to adjust for it.  In fact, the pattern of revisions to the seasonal factors for the payroll data over the course of recent months, the huge swing in the seasonal factor in November 2008, and the residual seasonal factor that remains for November and December 2009 point to significant upside influence on payrolls relative to that seen historically.  Our preliminary forecast is for a 75,000 decline in November non-farm payrolls and a decline in the unemployment rate to 10.0% from 10.2%.  Risks appear to be tilted towards a stronger report than this, but this will probably show up in notable upward revisions to payrolls in October and September.  After the 3-point surge in October to a robust 55.7, early signs point to another good ISM report in November as well.  The Empire State survey on an ISM-comparable basis fell to 51.1 from 56.2, but the Philly Fed jumped to 50.0 from 46.2, so these two reports are back in line with each other after a divergence of unprecedented size last month.  Our preliminary forecast is that the national ISM will be little changed at a strong 55.0 in November.  We will update our forecast as the remaining regional surveys are released over the next week-and-a-half.

There's a fair amount jammed into the economic calendar during the first two-and-a-half days of the upcoming holiday week before the Thanksgiving holiday.  There's an early close Friday for the few people that actually come to work, and the official recommendation for no early close Wednesday is certain to be widely ignored.  Before investors start heading home midday Wednesday, focus will be on another record run of Treasury supply, the FOMC minutes, and a number of data releases.  The Treasury will sell US$44 billion 2s, US$42 billion 5s and US$32 billion 7s on Monday, Tuesday and Wednesday.  These are all record sizes as usual, but the 2-year was held steady from last month, while the 5-year and 7-year sizes were boosted by another US$1 billion each.  So it appears that in addition to generally sharply boosting coupon supply and paying down bills in an effort to quickly and substantially extend the average maturity of the outstanding debt, the Treasury may also now be shifting the relative composition of coupon supply somewhat towards longer maturities.  The last FOMC statement was surprisingly dovish in fully retaining the "exceptionally low levels of the federal funds rate for an extended period" language and providing no hints at all that the Fed is moving towards starting to reverse the rapid expansion of its balance sheet any time soon.  This super-dovish message was subsequently reiterated by Fed Chairman Bernanke, so it seems unlikely that we're going to find anything too surprising in the FOMC minutes released Tuesday, though inflation-wary investors will still be hoping for some indication that the Fed is moving towards an exit strategy before too long.  Notable economic data releases due out in the coming week include existing home sales Monday, revised GDP and consumer confidence Tuesday, and durable goods, personal income and spending and new home sales Wednesday:

* We expect October existing home sales to fall to a 5.20 million unit annual rate.  Mortgage application volume tailed off sharply over the course of October as potential buyers awaited details of a possible expansion of the homebuyer tax credit.  Thus, we look for about a 6.5% dip in resale activity following on the heels of a nearly 10% jump in September.  Uncertainty related to the homebuyer tax credit was resolved in early November when an expanded version of the benefit was enacted, so we should see a snapback in sales in the coming months.  Finally, note that even though the pending home sales index posted a sharp jump in September, we have found that this gauge is no longer a valid leading indicator of resale activity.

* 3Q GDP growth is likely to be revised down to +2.7% from +3.5%, mostly as a result of a sharp upward adjustment to imports.  Business investment in structures and inventories (with an offsetting positive in 4Q) are also likely to be noticeably pushed down.

* We look for the Conference Board's consumer confidence index to drop again to 45.0 in November.  In early November, media reports trumpeted the fact that the unemployment rate had breached the 10% barrier.  This appears to have triggered a further deterioration in consumer sentiment.  So we look for the Conference Board gauge to slip nearly 3 points to its lowest reading since April.

* We forecast a 0.8% gain in October durable goods orders.  Headline order activity is expected to show a modest gain, reflecting a bit of upside in the volatile aircraft category and higher prices for some metals.  We also look for a rise in core order volume, which has been lagging behind the improvement seen in the orders component of the ISM survey over the past several months.  Finally, shipments are likely to register a gain, while inventories are expected to slip another 1%, further moderating the I/S ratio.

* We look for a 0.2% increase in October personal income and 0.6% gain in spending.  The October employment report points to another sub-par rise in income.  Meanwhile, a rebound in vehicle sales and a nice jump in retail control suggest that consumption will show a solid rise.  Obviously, the expected combination of income and spending performance implies a dip in the personal saving rate (to a shade below 3%).  Finally, we look for a 0.1% uptick in the core PCE price index, which would lift the annual rate a tenth to +1.4%.

* We look for a decline in October new home sales to a 375,000-unit annual rate.  Speculation regarding an expansion of the homebuyer tax credit became increasingly widespread over the course of October.  This appeared to lead some potential buyers to push the pause button as mortgage application volume declined and homebuilders reported a drop in floor traffic.  So, we look for a nearly 7% decline in sales of newly constructed residences.  As it turned out, buyers were right to wait.  An expanded version of the homebuyer tax credit was signed into law in early November.

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United States
Calibrating the Credit Crunch
November 24, 2009

By Richard Berner | New York

Credit headwinds to growth abating.  The credit crunch is not completely over; far from it.  This most severe financial crisis since the Great Depression likely will leave lasting scars on risk appetite and a legacy of impaired balance sheets that will take time to repair.  Indeed, with housing activity turning lackluster and home prices starting to decline again, consumer sentiment declining, and commercial real estate fraught, it might appear that those scars are resurfacing in weaker activity.

But in our view, courtesy in part of aggressive monetary, credit and quantitative easing, the credit headwinds to growth are subsiding.  That abatement is evident broadly in funding markets, credit spreads and risky asset prices - indeed, in most indicators except in net credit creation itself.  Moreover, we believe that what was a vicious circle of credit losses, tightening lending standards and economic recession is starting to turn virtuous and will gather strength in 2010.  The ongoing improvement in financial conditions supports our call for a moderate and bumpy but sustainable recovery, and Fed moves away from an ultra-accommodative monetary policy next year.

Two-tier improvement in financial conditions.  Despite this improvement, there is a sharp dichotomy in financial conditions that not only makes calibration difficult, but also casts doubt on the basic thesis.  Access to and functioning of many parts of the capital markets have improved dramatically.  But banks remain relatively reluctant to lend.  Consequently, credit availability for households and small businesses still seems to be impaired.  But is it really?

There's no mistaking the improvement in money and capital markets.  Start with the cornerstone for funding and transacting, namely short-term money markets.  Thanks to the ongoing effects of strong government backstops for financial institutions, the Fed's and other central banks' liquidity and funding facilities, as well as an unprecedented flood of liquidity, short-term money market spreads are back to pre-crisis levels.  Suppliers of term (up to 90-day) unsecured and secured funding are now willing to assume counterparty risk for a few basis points, the ‘basis curve' has normalized to a more traditional upward slope, and haircuts have settled at economically viable levels.  Despite the prospect of synchronized fiscal year-ends for both new bank holding companies and their customers, Libor-OIS forwards evince little pressure over the turn of the year.  That reflects reduced systemic tail risk in the banking system, conditional commitments by officials to keep policy rates low, and the extension of liquidity facilities through February.  But it also reflects genuine improvement in perceived counterparty risk, with higher capital buffers, lower leverage and thus greatly reduced idiosyncratic tail risk.  As a result, the use of Fed facilities that carry a penalty rate has steadily dwindled and the Fed this week trimmed the provision of term funding at the discount window, reverting from 90 days to the pre-crisis 28-day repo maximum. 

Capital markets revival.  This funding improvement, coupled with the Fed's securitization facilities and the Treasury's Public-Private Investment Program (PPIP), has revived parts of the capital markets, providing borrowers - including some consumers - with greatly improved access to credit.  The Fed's Term Asset-Backed Securities Loan Facility (TALF) has breathed life into the asset-backed securities (ABS) market that is critical for financing consumer loan portfolios.  To be sure, the government lifeline remains a huge source of support for markets and institutions.  Yet so much has the market improved that the utilization of TALF financing has clearly waned.  Since the TALF's inception in March, about US$90 billion of securities have come to market. 

In addition, there is a growing list of non-TALF consumer ABS issuance.  My colleague Vishwanath Tiruppatur notes that after months of anticipation, and thanks in part to TALF, we have finally seen new issuance in the commercial mortgage-backed securities (CMBS) market with the Developers Diversified Realty Corp (DDR) transaction (US$400 million of bonds backed by 28 shopping centers in 19 states).  The enthusiastic response to the DDR CMBS transaction set a positive tone to the CMBS market, which had been bereft of new issuance for well over a year-and-a-half.  The TALF program for legacy CMBS, which has not had as much traction as the consumer ABS version, has nonetheless contributed to increasing liquidity in the secondary markets.  Likewise, the so-called public-private investment funds (PPIF) launched under the PPIP umbrella, while still in their initial stage, have resulted in a buying capacity of over US$15 billion and helped buoy secondary markets in non-agency RMBS and CMBS. 

More traditional corporate borrowers, including many who lacked access to markets a few months ago, have also benefitted from this improvement, as investors flocked back to credit markets.  Both the investment grade and high yield debt markets have provided a significantly higher volume of funding this year.  Investment grade issuance has reached US$440.6 billion year-to-date versus US$289.8 billion in 2008.  And monthly average high yield issuance has nearly quadruped since March to US$19.6 billion. 

Contracting bank credit: Weak demand.  In contrast with these improvements, bank lending is contracting, partly because credit demand is weak.  There is strong evidence for weak demand: Businesses are in the time-honored, early-cycle process of deleveraging, as cash flows are far outstripping declining inventories and capex, implying scant need for external funds.  Since commercial and industrial (C&I) loans are mainly used to finance working capital and inventories, it should hardly be surprising that C&I loan originations are nil and outstandings are contracting.  That is not an impediment to growth, and we expect that loan demand will increase with financing needs next year.

Critically, moreover, CFOs are paying down credit lines drawn at the height of the crisis and are ‘terming' out loans by issuing longer-term debt in the capital markets.  So businesses are liquidating C&I loans originated months ago.  To quote the Fed's October Senior Loan Officer Survey: "In response to a special question on the sources of the decline in C&I lending this year, the two sources domestic banks cited most often as being ‘very' important were decreased originations of term loans and decreased draws on revolving credit lines."  That willingness and ability to substitute borrowing in markets for bank loans is healthy and important, because it indicates that larger businesses are confident enough to issue longer-term debt and have the flexibility to fund their needs even when bank lending standards are tight. 

For their part, consumers are also deleveraging in a process that is proceeding rapidly, but likely has another 12-18 months to run.  Repairing consumer balance sheets is a difficult, but ultimately constructive development.  Looking more closely, some of the demand-driven deleveraging is voluntary and prudent, reflecting wealth losses and recession-induced uncertainty.  But some of the change is involuntary and immediate, as defaults, the credit crunch and income losses squeeze consumers and businesses.  Of course, looking to loans outstanding does not help identify these cross-currents in credit; arithmetically, the change in outstandings reflects the sum of new originations, repayments and defaults (net charge-offs), each of which has demand and supply elements. 

But also supply restraint. We also have strong evidence that constrained supply, or reduced availability of credit, continues to play a role in the contraction of bank credit.  Banks continue to tighten the terms on which they grant credit and the standards for most loan types.  Collateral requirements or downpayments are higher, spreads over benchmark funding costs are wider, covenants are more stringent, and maturities are shorter.  Small wonder: Credit losses in 2007 and 2008 eroded the capital base for leveraged lenders, promoting the credit crunch.  In turn, an ‘adverse feedback loop' from the credit crunch to the economy and back to credit losses promoted a deleveraging of the financial system that pushed the US economy into recession.  Despite the incipient economic recovery, delinquencies and charge-offs continue to rise, lagging behind the economy in time-honored cyclical fashion.   

Moreover, policy uncertainty is likely contributing to banker caution.  As Fed Chairman Bernanke noted this week, cautious banks are holding much larger cash buffers than before the crisis.  We suspect that uncertainty about capital and liquidity regulations is making lenders more conservative.  And changes to accounting rules under FAS 166/167 will require banks to bring conduits, securitized credit card and other assets back onto their balance sheets at the start of 2010.  Looking further ahead, commercial real estate developers face US$2.6 trillion in maturing debt that must either be rolled over or paid down over the next five years. 

Listening to loan officers: Pace matters.  Although improvement in capital markets is an offset to bank credit restraint, the substitution is only partial.  As a result, the ominous litany of bank credit headwinds at first sounds inconsistent with a moderate recovery.  The key to reconciling the two is pace: For example, the Fed's Senior Loan Officer Survey indicates that banks were still tightening lending standards in October, but at a significantly slower pace.  To quote the October Survey:

In the October survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households. However, the net percentages of banks that tightened standards and terms for most loan categories continued to decline from the peaks reached late last year.

The cumulative tightening in standards affects the level of lending or activity, but it is pace (or the proportion of respondents tightening) that matters for growth.  Correspondingly, tight lending standards are still depressing the level of lending and thus output relative to what they would otherwise be, but their effect on growth is abating.  To be sure, the Senior Loan Officer Survey results are presented as a diffusion index, and readings greater than zero mean that more banks are tightening standards than easing.  The survey is qualitative, not quantitative, so we don't know how to calibrate the difference between tightened ‘considerably' and ‘somewhat'.  Thus, empirical work is needed to quantify the impact. 

Empirical evidence.  Updating past empirical work by Fed researchers supports our conclusions: Given aggressive policy stimulus and the healing in capital markets, the recent slower pace of tightening bank lending standards is consistent with slower declines in bank lending and an improving economy.  Two studies pioneered in examining the relationship between the proportion of lenders changing standards and loan and economic growth.  They show that changes in loan standards have a strong correlation with loan volume and business activity: Tighter standards trigger events resembling credit crunch, easier standards promote recovery.  Importantly, the proportion of lenders changing standards (the numerical level of the survey responses) influences growth in loans and output.

Our replication and updating of these results revealed a striking development: The influence of changes in lending standards on loan growth increased over time and became much more statistically significant.  In contrast, the influence of such changes on output or demand, while important, was relatively stable over time.  For example, for the periods ending 1998 or 2000, the Fed and we estimate that a 10 percentage point change in standards, other things equal, allows a 0.6 percentage point change in business loan growth.  Extending the results to 3Q09, we find that a 10-point drop in the proportion of banks tightening standards allows a one-point increase in business lending growth - nearly half again more sensitivity as in the earlier period.  And the statistical precision of the estimate more than doubled. 

In contrast, our work and others' suggests that the effects of changes in lending standards on business activity are relatively stable over time.  For example, other things equal, a six-point drop in the proportion of banks tightening mortgage lending standards will promote a one-percentage-point increase in housing demand.  Estimates by Macroeconomic Advisers suggest that a 10-point increase in banks' willingness to lend would yield a 0.3 percentage point increase in PCE.    

These empirical results underscore three important developments.  First, despite the steady disintermediation of banks and other depository institutions, the availability or supply of bank credit - proxied here by changes in bank credit standards - has an important effect on bank loan and economic growth.  Second, the recent increased sensitivity of bank credit growth to changes in lending standards probably reflects the increased availability of credit through the capital markets through 2007.  In other words, when banks tighten standards but markets are still functioning, borrowers may turn to other sources of credit, and banks lose market share.  Third, however, systemic shocks that promote deleveraging across banks and capital markets will result in deep and lasting recessions. 

Positive but bumpy outlook.  In our view, the reversal of those systemic shocks is now promoting recovery, and renewed gloom about the economy and concerns about an intensifying credit crunch are overdone.  While uncertainty about the economy and policy are creating borrower and lender hesitation, we see a positive feedback loop developing from financial conditions to the economy that will promote a sustainable recovery in 2010 and 2011 (see Hiring Still Poised to Improve Early in 2010, November 9, 2009).

In particular, we and our large-cap bank analyst Betsy Graseck believe that bank risk appetite will improve as uncertainty over capital and liquidity requirements dissipates; this uncertainty should lift when regulators release capital and liquidity proposals in early 2010.  In addition, banks are currently holding excess liquidity in part to show the breadth of resources they have available to repay TARP loans.  As growth in bank earnings accumulates, and banks repay those loans, the excess liquidity will likely translate into securities purchases and loan growth.

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