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UK
UK Economy, Fiscal and Gilt Market Outlook 2010 January 19, 2010 By Melanie Baker, Laurence Mutkin, Owen Roberts, Graham Secker, Cath Sleeman | London & Charles Goodhart | Senior Economic Consultant Conclusion: By All Means Be Gloomy, but Don't Get Carried Away The UK recovery is likely to be sub-par, but it would be unwise to write off the prospects for a stronger recovery. However, assuming a sub-par recovery, monetary policy tightening is unlikely before the end of 2010. What happens to monetary policy will also be substantially affected by what happens to the fiscal outlook (with the election a major complicating factor). On fiscal policy, we continue to think that more needs to be done than on the existing government's plans. Debt issuance will remain enormous in 2010-11, and without Bank of England buying there will be a shift in the balance of supply and demand. However, we think that demand worries are overdone and that worries about UK solvency remain significantly overdone. However, the (albeit weak) economic recovery will ultimately ensure higher bond yields. The prospect of higher bond yields is the main reason why we remain cautious on UK equities. UK Economy: Sub-Par Recovery, but There Are Upside Risks • Our central forecast for UK GDP growth in 2010 (and 2011) is decidedly sub-par (1.2% and 1.4%, respectively). Several factors should keep that recovery lacklustre: 1) the household savings rate will remain at higher levels and disposable income growth is unlikely to recover strongly; 2) the banking sector continues to face significant challenges; 3) fiscal policy tightening will be increasingly anticipated by households and corporates, and real government spending growth will start slowing rapidly by late 2010. • However, while we have a sub-par central forecast, there are several sources of potential upside. It would be wrong to rule out a robust UK recovery: 1) UK corporates, in many ways, look in good relative shape to benefit from an upturn in demand. Business investment could be stronger than we expect; 2) Net exports could yet get a much-stronger-than-expected boost on the back of lagged effects from sterling's depreciation; 3) We have yet to see the inventory cycle turn. Monetary Policy Outlook: Fiscal Policy-Related Uncertainty • QE should and, we think, will be paused in February, and followed by a period of (monetary policy) calm waiting for the political dust to settle post-election. The path for fiscal policy is somewhat unclear and will have a key bearing on the monetary policy outlook. • Given how deep policy is into ‘unconventional territory', we think that the MPC will want to get back to a more normal policy setting sooner rather than later, once there is evidence that the economy is on a firm, sustainable path to recovery. However, this could be ‘later rather than sooner', given a sub-par recovery. We don't expect the first rate rise until the end of 2010. At that time we'd also expect QE to start to reverse. Fiscal Outlook: Aim to Reduce Indebtedness Faster • There will be a high degree of interaction between monetary and fiscal policy ‘exit', and the scope for policy error is inevitably large. • On the fiscal front, we still think that rather more needs to be done than in the existing government's plans. The result of the general election (which must occur by June 3, 2010) will be a key determinant of the fiscal policy stance. • Whatever the result of the general election, we would expect significant fiscal tightening to begin in earnest in 2011: 1) the recovery should be on a slightly steadier footing by then; and 2) political momentum. There could even be some silver linings: 1) it's a good time to take long-term beneficial decisions; and 2) fiscal tightening doesn't have to severely damage GDP growth. Debt and Debt Issuance • The enormous scale of Gilt issuance in 2009-10 (£225 billion) is expected to continue into 2010-11 (£223 billion), despite a fall in the borrowing requirement. This is partly because redemptions of Gilts will more than double from 2009-10 to 2010-11; and partly because we expect the DMO to reduce the outstanding stock of Treasury Bills. • Supplementary issuance methods (syndications and mini-tenders) are proving very successful; and we expect the DMO to increase its use in 2010-11. Hence, we expect Gilt issuance via auctions in 2010-11 to be lower than in 2009-10 (~£169 billion versus ~£184 billion). • The maturity distribution of conventional Gilt issuance in 2010-11 will probably be similar to that in 2009-10. • We expect the DMO to increase Index-linked Gilt issuance to a record £45 billion. Gilt Supply and Demand: From BoE Buying to Regulation-Driven Buying • Bank of England total purchases in 2009-10 nearly matched total gross Gilt issuance. We estimate that Gilt yields may have been suppressed by about 80bp as a consequence. We expect the BoE's Gilt purchase programme to end in February. • But continued high issuance is more likely to keep the yield curve steeper for longer rather than push all yields decisively higher. • The FSA liquidity regime will force banks to increase their holdings of liquid assets. We expect banks to replace the Bank of England as the main purchaser of Gilts in 2010-11. • The end of the recession and end of BoE buying should push Gilt yields higher. But the below-par economic recovery and the shallow upward trajectory of the policy rate will limit the rise in yields. We forecast the 10-year Gilt yield to rise to 4.60% by December 2010, and for the 2/10 Gilt yield curve to flatten to 220bp. Our 10-year yield forecast is in line with market forwards, but the forwards discount about 40bp more flattening than we expect. The Market Is Too Worried About the UK's Fiscal Situation • The UK debt/GDP ratio is projected to rise to reach the European average in 2011. Initial low levels put the UK in a reasonable debt/GBP position relative to comparable economies. • The government's debt service cost as a percentage of GDP will rise in coming years. But for debt service/GDP to return to historical highs in the next five years, yields on new-issue Gilts would have to be 5 percentage points higher than today's market yields. The market-implied probability of this happening is less than 5%. • We believe that conditions in the UK would have to get dramatically worse before investors should worry about the solvency of the UK government. • UK sovereign 5-year CDS, at 80bp (or a 7% implied default probability with a 40% recovery rate), looks particularly high to us. Equities: Bond Yields Are Key Focus for 2010 • While we agree with the bulls that short rates will stay low for longer, we believe that the key to stocks in 2010 is what happens to sovereign bond yields - we expect these yields to rise. While we believe that markets will go higher in the short term and are bullish on 2010 profit growth (we forecast 34% versus bottom-up consensus of 30%), we are relatively more concerned about the impact of the start of a new tightening cycle. For details, see UK Economics and Strategy: UK Economy, Fiscal and Gilt Market Outlook 2010, January 18, 2010.
United States
Review and Preview January 19, 2010 By Ted Wieseman | New York Treasuries posted big gains, led by the belly of the curve over the past week, after some sizeable back-and-forth swings. There was a fair amount of economic data later in the week, but it was broadly in line with expectations and had little market impact. Both exports and imports are still on pace to show another quarter of big gains in 4Q after the initial recovery in 3Q from the collapse into mid-2009, but after a wider-than-expected trade gap in November, we now see net exports being a slight negative for 4Q growth instead of a small positive. This lowered our 4Q GDP estimate to +4.8% from +5.2%. Retail sales in December were weaker than expected, but with a partially offsetting upward revision to November not enough to further alter this forecast. Other releases were more positive, with jobless claims and the Empire State survey pointing to good results from the January employment and ISM reports after the economic recovery seems to have paused in December, probably mostly as a result of a sizeable negative swing in the weather. Instead of the mixed economic news, the decline in yields was supported by the surprisingly early beginning of liquidity-draining measures in China, which took market focus off the recent disappointment with the Fed's delay in moving in a similar direction, another quite well received run of supply, during which the Street managed to get itself badly out of position by moving in a meaningful way into 10s-30s steepeners heading into what turned out be an aggressively bid 30-year reopening Thursday, and some renewed anxiety about the state of the banking system after JP Morgan reported a higher-than-expected addition to consumer loan loss reserves in 4Q and the White House proposed a hefty tax on financial firms that could meaningfully further depress lending going forward. On the week, benchmark Treasury yields fell 9-15bp, with the intermediate part of the curve eventually moving into the lead as the gains Thursday and Friday pulled mortgage yields to their lowest level in a month. The 2-year yield fell 9bp to 0.87%, 5-year 14bp to 2.42%, 7-year 15bp to 3.15%, 10-year 13bp to 3.68% and 30-year 12bp to 4.58%. TIPS performance was mixed but reasonably solid even as China's reserve requirement rate hike put pressure on commodity prices that was added to petroleum products by bigger-than-expected gains in weekly inventories. Oddly, the short end of the TIPS market actually managed to significantly outperform even as February oil fell US$4.75 a barrel to US$78, more than reversing what remained of the surge in the first few days of the year. Short TIPS even did unusually well for some reason following the moderate and as expected 0.1% rise in December CPI. Looking ahead to January, upside in retail gasoline prices, which are on pace for about a 5% gain this month, are likely to provide a boost to CPI, but it was still quite unusual for the short end of the TIPS market to move counter to oil prices. Benchmark TIPS issues, unlike the short end, lagged the nominal gains by a fair amount, causing benchmark inflation breakevens to pull back from the highs since mid-2008 hit at the end of the prior week. The 5-year TIPS yield fell 6bp to 0.20% and the 20-year (suffering recently from its impending loss-of-benchmark status when the 30-year returns in February) was flat at 1.98%, while the new 10-year closed at 1.33% after being auctioned Monday at 1.43%. This left the benchmark 10-year inflation breakeven 11bp lower at 2.35%, though about half this move came from the 5bp yield pick-up in the new 10-year TIPS over the old issue. The squeeze in the very short end saw a recently rare bit of easing Friday, with a back-up in the overnight Treasury general collateral repo rate to 0.10% from levels close to 0.05% through the first part of the week contributing to the 4-week bill yield rising to 0.03% from zero levels seen through most of the week (and even a slightly negative close Monday). The 3-month yield also rose a couple of basis points on the week to 0.06%. Corporate tax day and settlement of the week's Treasury auctions helped boost the repo rate, but supply in the bill sector is likely to continue to plunge over the next few weeks, so near-term upside in yields seems quite limited. The amount of T-bills outstanding has fallen US$48 billion at the first two weekly Thursday settlements, and we expect to see a further paydown of US$72 billion over the next three weeks. The mortgage-backed securities market extended a much improved performance that began shortly before New Year through the last week, continuing to rebound from a terrible run through much of December, with the upside helping to boost Treasuries late in the week and support outperformance by the intermediate part of the curve. Current coupon mortgage yields fell about 15bp over the past week from a bit above 4.5% to near 4.35%, a low since mid-December after a move to above 4.6% on December 28 from the recent low of 3.9% reached November 30. That earlier sell-off lifted national average 30-year conventional mortgage rates from a record-low 4.71% in the first week of December to a recent high of 5.14% in the last week of December according to Freddie Mac's survey. This has come down to 5.09% in the past couple of weeks, and current MBS yields, if sustained, should be consistent with a further move down to near 5%. This is certainly supportive of a renewed pick-up in home sales after what will likely be a big pullback in the results for December to be released in a couple of weeks, as there is a temporary payback from sales pulled ahead of the initially scheduled expiration of the homebuyers' tax credit at the end of November. But housing affordability is so extremely elevated now with prices so low, the tax credit having been extended and expanded, and mortgage rates still very low from a longer-term perspective that swings in rates around the current level are probably not material for housing market activity. Even if average mortgage rates were as high as 7.5% now, housing affordability by conventional measures (which don't include the added support from the tax credit, which is worth about 50bp on rates for a median-priced house) would only fall to about average levels. Credit availability (especially outside of conventional mortgages), job and income growth, and consumer confidence are much more important for the home sales outlook at this point than rates. Risk markets traded down over the past week, with credit lagging stocks to extend a bit of a recent reversal of the trend seen late last year and into the early part of January. The S&P 500 just barely hit a new high Thursday, but a 1% drop on Friday left it down a bit less than 1% on the week. Materials (-3%), financials (-2%) and energy (-2%) led the pullback after having led the early year upside, weighed down by the pressure on commodity prices that was driven partly by expectations that China's moves would cool global demand and for financials by renewed concerns about loan losses after JP Morgan's report and also the feared impact on earnings of the proposed financial firms' tax hike. Late Friday, the investment grade CDX index was 6bp wider on the week at 84bp, only marginally better than the 85bp close to 2009, while stocks are still up almost 2% year to date. The high yield CDX index similarly was 2bp wider on the week at 486bp through Thursday, but was moving towards only slightly better on the year relative to the 518bp close on December 31 after a 0.75-point sell-off Friday. After a rough week, reversal in the commercial mortgage CMBX and subprime ABX markets has been more severe after a stronger start to the year. The AAA CMBX index is now down slightly for the year after peaking on January 5 after a 3% rally the first two days of the year, while the junior AAA index is down 3% now after jumping 6% in the first two days of the month. The AAA ABX index is also now unchanged for the year after starting the month with a 6% spike. Another area that has been seeing a lot of weakness recently has been the municipal bond MCDX market, which is being hurt both by the continued severe problems with state budget positions that was further highlighted by a downgrade in California's rating during the week by S&P, and also, the broader rise in the sovereign credit concerns as the Greece situation in particular has been worsening. In late trading Friday, the 5-year MCDX index was nearly 25bp wider on the week at around 157bp. Several data releases impacting our tracking estimate for 4Q GDP led us to reduce our forecast a bit to +4.8% from +5.2%. Retail sales were worse than expected in December, but an offset in November left our 4Q consumption forecast at +1.8%. The real trade deficit widened more than expected, however, and we now see big gains in both real exports and imports netting to no net impact on 4Q GDP growth instead of the modest positive we previously estimated. Note that most of the surge we forecast in GDP is expected to come from a slower rate of inventory accumulation. The moderate 1.8% gain we forecast for consumption is close to the +1.5% increases we see in final sales and final domestic demand, with inventories expected to add over 3 percentage points, the highest amount since 1987. Importantly, even with this big positive, we still forecast that inventories were liquidated at a fairly hefty pace in 4Q, just a lot less so than in 3Q. And with the business inventories report for November released the past week showing that the big inventory overhang that developed in 2H08 when demand collapsed has now been pretty much worked off, inventories should start to move towards accumulation over the next year. So, rather than there being a payback in early 2010 from this huge expected 4Q inventory boost, a further catch-up in production to demand should continue to support growth through 2010. The trade deficit widened more than expected to US$36.4 billion in November from US$33.2 billion in October, a high since January, with exports up 0.9% and imports 2.6%. Upside in imports was led by petroleum products, capital goods and consumer goods. The petroleum gain was entirely a result of higher prices, but the upside in the other categories - which was surprising after port data had pointed to a slowdown in imports from Asia - left real goods imports up a solid 1.5%. The export gain was largely accounted for by a big rise in food that was supported by higher prices. Even with support from higher prices, industrial materials were weak, and consumer goods also saw a big pullback. As a result, real goods exports fell 0.6%. This combination resulted in a surprisingly large widening in the real trade deficit as well. We now see net exports being about neutral for 4Q GDP growth instead of adding a few tenths. Both exports and imports rose at an estimated annual rate of nearly 20% in the second half of the year, a decent start to a rebound from the collapses seen into mid-2009. Meanwhile, consumer spending appears to have been weaker than expected in December, though with a bit of an upward revision to November, this should be more negative for 1Q10 than 4Q09. Retail sales fell 0.3% in December, with auto sales declining 0.8% in contrast to the modest upside reported for unit sales and ex auto sales falling 0.2%, though the weakness in non-auto sales was largely offset by an upward revision to November (+1.9% versus +1.2%). The pullback in December was concentrated in electronics and appliances (-2.6%) after a big gain in November, grocery stores (-0.8%), which also reversed an unusually big gain last month, and general merchandise (-0.8%). The drop in general merchandise was surprising after upside seen in department store and discounter chain store sales results, but a third straight modest decline in clothing stores (-0.6%) was in line with the monthly company reports. The key retail control grouping (sales excluding autos, building materials and gas stations) fell 0.3% in December, below our +0.4% forecast but with an offset from an upward revision to November (+0.8% versus +0.5%). As a result, we continue to see 4Q consumption rising 1.8%, though the December weakness provides a worse starting point for 1Q. A swing to unusually cold weather appears to have had a meaningfully negative impact on the December employment report and probably December economic activity broadly, but some early indications released the past week point to a renewed pick-up in January. The jobless claims report saw yet another week in a lengthy run of consistent improvement, with the 4-week average of initial claims hitting another low in a year after a run of 19 straight declines, and continuing claims plunging even including various extended, emergency and federal programs. Job growth appears on pace to turn solidly positive in January. Meanwhile, after the industrial production report showed a pause in manufacturing activity after a big rebound that began in July, strong results from the Empire State manufacturing survey pointed to a resumption of the recovery in January. The headline sentiment index in the Empire survey rose to 15.92 from 4.50, and an ISM-comparable weighted average of the key activity measures also showed big improvement, rising to 53.5 from 48.5 on surges in the orders, shipments and employment components. Our initial ISM forecast is for a marginal increase to a strong 56.0 in January from 55.9 in December. The economic data calendar is light in the upcoming holiday-shortened week, so the peak corporate earnings reporting season and impact on stocks and economic expectations will probably be the main market focus, though attention will also have to quickly shift back to supply with the announcement Thursday of the 2-year, 5-year and 7-year issues that will be auctioned the following week. Notable economic releases due out include housing starts and PPI Wednesday and leading indicators Thursday: * We expect December housing starts to fall to a 540,000 unit annual rate. The employment report pointed to some softening in construction activity during the month of December. We believe that this is at least partly related to an unusually dramatic shift in weather conditions around the time of the labor market survey. And, this was followed by a severe winter storm later in the month. From a more fundamental standpoint, we expect to see a pullback in the volatile multi-family category on the heels of an unusually sharp jump in November. The bottom line is that we look for about a 6% decline in overall starts this month. * We forecast a 0.1% decline in the overall producer price index in December and 0.1% increase excluding food and energy. A modest decline in quotes for energy-related items (particularly gasoline) should help to restrain the headline PPI this month. Meanwhile, the food category should post another jump, driven by higher prices for milk, fruits and vegetables. Finally, the core should be reasonably well behaved this month, assuming that car and truck prices settle down. In fact, even if this assumption proves incorrect, we continue to view the PPI's measurement of vehicle prices as random noise that is totally disconnected from reality. Therefore, we believe that the main focus in this report should be on the core excluding motor vehicles (expected to be +0.1%). * The index of leading economic indicators is likely to extend its strongest run since 1983, with another sharp rise of 0.7% expected in December. The biggest positive contributors are the yield curve, jobless claims and stock prices. There are no negatives among the components available at this point. |