United States
Review and Preview
March 09, 2010

By Ted Wieseman | New York

Treasuries posted significant losses across the curve over the past week as the key early run of economic data for February indicated that the economy held up a lot better than expected during the severe snow storms, pointing to more underlying momentum that we anticipate will show up in a notable rebound in activity in coming months.  The market was also hit by upward pressure on repo rates and effective fed funds and a reduced flight-to-safety bid as fears about Greece's fiscal situation eased substantially following the passage of additional budget tightening measures and the successful sale of a 10-year issue.  Even with what appears to have been a significantly bigger negative impact from weather and a smaller offsetting boost from census hiring, payrolls only fell 36,000 in February, and the jobless rate was steady at 9.7%.  We think that payrolls probably would have risen more than 100,000 excluding snow disruptions, and it now looks increasingly likely that the unemployment rate peaked at 10.1% in October.  Our early baseline for March payrolls is for a 300,000 gain, including 100,000 temporary census workers.  The surprisingly resilient employment report came after strong results from the ISM surveys - manufacturing down somewhat but to a still quite robust level and non-manufacturing rising to a more than two-year high - and upside in early consumer spending indications that pointed to a solid February retail sales report.  Softer data for January on construction spending and capital goods orders and shipments and some negative impact on February activity still from weather led us to cut our 1Q GDP forecast to +2.0% from +2.2%, but it's increasingly looking as if we could see a fairly strong snapback in 2Q, and we think growth will rebound to near +4%. 

Meanwhile, short-term financing and policy rates saw some notable upside over the past week, with the main driver being an immediate impact from the ramping up of SFP bill issuance, the most significant step the Fed has implemented yet in moving towards an exit from its super-easy monetary policy.  The US$45 billion in additional SFP bill issuance in the past couple of weeks comes on top of a seasonal shift to higher regular bill issuance during peak tax refund season and heavy ongoing coupon supply every couple of weeks.  The big boost this has provided to Treasury supply and thus Treasury collateral available in the repo market drove the average overnight Treasury repo rate up to 0.19% Friday from around 0.10% in the days before the SFP announcement, and effective fed funds traded up through the week to near 0.17% Friday after a lengthy period near 0.12%.  In addition to the boost from rising repo rates, the effective fed funds rate was also lifted by anticipation of falling cash balances at the GSEs as Fannie and Freddie are moving aggressively to buy delinquent mortgages out of MBS pools.  Because they trade in the fed funds market but by law can't be paid interest on their Fed balances since they aren't depository institutions, the home loan banks and Fannie and Freddie are key drivers of the gap between effective fed funds and the 0.25% interest rate being paid on excess reserves.  So if GSE cash falls and shifts to banks as investors deposit the proceeds from MBS prepays, the gap between effective fed funds and the rate on reserves could be sustainably narrower than the 13bp seen fairly consistently over the past couple of quarters.  Upside in repo rates and fed funds effective also was felt in the FX swaps market, with upward pressure on the implied dollar Libor rate there, and this helped give the dollar a boost on the week even as investor fears about Greece eased considerably.  The spread of Greece's 2-year debt over German bunds narrowed about 140bp on the week to near 380bp, more than reversing a 100bp widening over the prior couple of weeks to move the spread to its lowest level since late January.  Even with German and some EU government officials claiming that there was no imminent plan to announce a support plan for Greece, press reports indicated that discussions were ongoing behind the scenes on such a proposal.  And prospects for such a step seemed higher after Greece passed substantial new budget reduction measures that could lower its deficit to below 9% of GDP this year from almost 13% last year.  On top of the less negative sentiment on Greece, US rates markets were rattled a bit (more so than Europe it seemed actually) by somewhat earlier-than-expected further moves by the ECB to wind down its emergency liquidity injections, with an announcement after Thursday's meeting that the last 6-month refi operation would be at a variable rate (so if the ECB decides to hike rates within the next six months, the rate on the borrowing would go up) and 3-month operations would shift to auction from full allotment next month.  US markets may have been more rattled by this shift than European markets since it came just as investors here were starting to focus closely on recent upside in US financing rates, and certainly these moves in Europe could add to similar further upside in Europe too.  Interestingly, Japan may be heading in the other direction, with the BoJ potentially ready to consider additional easing measures, in line with the expectations of our Japan economics team (see BoJ Watch: Nikkei Article on BoJ Easing: Direction Clear, Timing Murky by Robert Feldman and Takehiro Sato, March 5), and the yen sold off sharply late in the past week as Japan money market rates eased while US short rates were rising. 

On the week, benchmark Treasury yields rose 6-11bp, with the intermediate part of the curve significantly outperforming, as the front end was hit hardest by the financing rate pressures, the long end was pressured by upcoming supply, and the belly seemed to find some support by dislocations in mortgages and swaps.  Weakness in response to Friday's strong payrolls data though resulted in a bear steepening sell-off and big widening in TIPS breakevens, so investors seemed to be showing some cautiousness about whether the Fed would respond appropriately to an improving economic outlook.  The 2-year yield rose 10bp to 0.90%, 3-year 8bp to 1.41%, 5-year 6bp to 2.34%, 7-year 7bp to 3.10%, 10-year 9bp to 3.69% and 30-year 11bp to 4.64%.  By holding about unchanged, TIPS solidly outperformed, with most of the upside in inflation expectations coming Friday.  TIPS were also helped by a strong week for commodity prices, which performed unusually well as the dollar index rallied a bit (gaining significantly against the yen, ending up about unchanged versus the euro after a lot of volatility, but selling off substantially against the Canadian dollar).  Improved optimism on growth added to fears about the impact of the earthquakes in Chile to lift metals prices in particular, with the LME's industrial metals composite index up 5% to just below the prior recent high hit in early January.  Energy prices were more sensitive through the week to the dollar but still ended up with good gains, with April oil up US$1.84 a barrel (+2%) to US$81.50 and April gasoline gaining US$0.08 a gallon (+4%) to US$2.27, a new high for the front month since autumn 2008 as we move into a seasonally elevated period for gasoline prices.  The 5-year TIPS yield fell 1bp on the week to 0.19%, 10-year rose 1bp to 1.46% and 30-year rose 3bp to 2.15%.  This lifted the benchmark 10-year inflation breakeven 8bp to 2.22%, reversing the majority of the prior week's 14bp decline. 

There were some unusual and volatile moves in swaps and mortgages through the week and some substantial politically driven volatility Friday in agencies - but rates volatility actually declined substantially through most of the week and saw only limited upside during Friday's market sell-off.  Swap spreads continued moving lower through Thursday before widening back a bit in Friday's sell-off.  For the 10-year spread, this resulted in a series of record-low closes through much of the week, with an intraday move below 2bp before an all-time low close of 3.25bp Thursday and then a partial reversal to 4.25bp at Friday's close, which represented a halving from the 8.5bp at the end of the prior week.  There was some swapping of corporate issuance at times during the week, but the spread narrowing seemed more to be driven by stop-outs of long spread trades.  Meanwhile, the MBS market was thrown into some turmoil as market participants tried to figure out the impact of Fannie Mae's Monday announcement that it would buy 150,000-200,000 delinquent mortgages out of its MBS pools in March.  The initial interpretation of Fannie's statement was that buying would start in higher coupons and then work down, and higher coupon MBS sharply outperformed early in the week in response, but this assumption was thrown into question mid-week after Fannie released a servicing guide update that suggested a more even distribution across the coupon stack (see GSE MBS and Debt Weekly Overview: Fannie Buyouts Get Murkier by Janaki Rao, Bernard Gordon, and Zofia Koscielniak, March 5, for details and their revised estimates of the impact on prepay speeds).  After a lot of volatility across the coupon stack during the week as investors tried to adjust to this uncertainty, mortgages significantly outperformed Treasuries broadly, with help from falling interest rate volatility, the lagging volatility moderated somewhat to widen several bp on a Libor OAS basis.  Lower-coupon MBS still ended up lagging higher coupons a bit on the week, but current coupon yields ended up about unchanged near 4.33%, in the middle of a stable recent range that has kept 30-year conventional mortgage rates very close to 5% for the past couple of months.  Amid some of the seemingly volatile moves in different rates markets, a big drop in implied volatility was impressive.  This made more sense early in the week as Treasury yields were barely moving, but there wasn't much of a reversal at all Thursday and Friday when they did see some big gyrations.  On the week, 3-month x 10-year normalized swaption volatility declined 10bp to 93bp, only rising 1bp Friday from the lowest reading since late 2007 hit Thursday. 

Risk markets ended up posting good gains on the week, largely as a result of decent rallies Friday.  Volatility in stocks and credit was quite low through the week, and this seemed more appropriately reflected in a big drop in the VIX, which fell to 17.5% Friday, a low since autumn 2008, from 19.5% at the end of the prior week, than the surprising stability of rates volatility near the lows late in the week.  The S&P 500 gained 3.1% on the week to move back into the green for the year by 2.1%.  The best-performing equity sectors on the week were materials, boosted by the metals price surge, and consumer discretionary, helped by the surprisingly strong chain store sales results.  Credit is still lagging stocks so far this year, but big gains late the past week at least erased prior losses.  In late Friday trading, the investment grade CDX index was a strong 7bp tighter on the week at 85bp, which is where it ended 2009.  The high yield CDX index was 17bp tighter at 552bp through Thursday but a gain of more than a point Friday also got it near 2009's closing spread of 518bp.  Performance by the commercial real estate CMBX market continued to be mostly comparatively quite poor.  A 1% gain on the week by the AAA index left it flat for the year, but a 3% rally by the junior AAA index still left it down 10% so far in 2010, and the AA index was down another 1% in the latest week to extend its year-to-date plunge to 11%. 

Non-farm payrolls fell only 36,000 in February even with what appeared to be a big negative impact from weather and significantly smaller-than-expected 15,000 offsetting boost from census hiring.  The number of people in the household survey saying they weren't at work during the survey week because of the bad weather soared to 1.1 million, the highest February on record and second-highest of any month in the past 28 years after only the ‘Storm of the Century' in January 1996.  We estimate that this points to a 150,000 drag on payrolls from weather.  So excluding weather and census, we estimate that underlying job growth was close to +100,000, a significantly better outcome than the flat reading we expected.  Growth continued to be particularly strong in temp hiring, which gained another 48,000 in February for a record 44% annualized surge since October - a positive leading indicator for permanent job growth going forward.  Manufacturing jobs also managed a small 1,000 further gain on top of a 20,000 rise in January.  Rising manufacturing jobs has been an infrequent occurrence since the late 1990s and this upside reflects how strong the recent growth in this area has been as it has led the economy out of recession.  The manufacturing ISM employment gauge moved above the 50-breakeven line in October and reached its best level since 2005 in February.  On top of permanent gains to factory jobs the past couple of months, a good portion of the record surge in temp employment since October has probably been attributable to the manufacturing sector.  On top of the recent upside in temp hiring, a good result for the workweek was also a positive leading indicator.  The average workweek only fell a tenth to 33.8 hours, a smaller impact than we've seen in prior major weather-impacted months, and it seems likely to move up to a new cycle high of 34 hours or higher when weather impacts are reversed in March.  Meanwhile, the unemployment rate was steady at 9.7% on another big gain in the household survey employment measure.  It now looks increasingly likely that the unemployment rate peaked at 10.1% back in October.  Looking ahead to March, our initial baseline expectation is for a 300,000 gain in non-farm payrolls including a 100,000 boost from census hiring, which would result in an average 75,000 gain in ex-census hiring in February and March. 

Both ISM surveys showed robust results in February, with non-manufacturing starting to close the gap with the manufacturing sector that led the economy out of recession.  Upside in the employment gauges was the most notable part of both reports.  The composite manufacturing ISM index fell 2 points in February, but to a still quite strong 56.5, the second-best reading after January since late 2005.  The orders (59.5 versus 65.9) and production (58.4 versus 66.2) gauges saw significant pullbacks from unusually strong readings in January but still held well above the 50-breakeven level, while the employment gauge (56.1 versus 53.3) surged to a five-year high.  Low inventories continued to support output.  Respondents continued to gradually slow their inventory liquidation, with the inventory index up a point to 47.3, while the customers' inventory gauge rose 5 points but remained at a very low 37.0, with a third of respondents saying their customers' inventories were too low and only 7% too high.  Meanwhile, the composite non-manufacturing ISM index surged to 53.0 in February from 50.5 in January, a high since December 2007.  The business activity (54.8 versus 52.2) and orders (55.0 versus 54.7) moved solidly into growth territory, and the employment index (48.6 versus 44.6) improved to its least negative outcome since early 2008. 

Despite widespread reports of a significant negative weather impact, early indications for February consumer spending were surprisingly positive.  Motor vehicle sales declined to a 10.3 million unit annual rate in February from 10.8 million in January, which was a fairly good result actually considering that industry sources estimated that sales might have been reduced by about 700,000 by weather and 300,000 by Toyota's recalls.  Major retailers also broadly reported a significant hit from weather but still managed to report significantly better-than-expected chain store sales results for February, with aggregate comp store sales growth accelerating to the strongest rate in three years (excluding a few months that were distorted by holiday timing shifts).  Clothing, department, club and discount retailers all posted good gains in sales.  Incorporating this upside, we boosted our 1Q consumption estimate to +3.0% from +2.8%.  Weaker-than-expected construction spending results in January, which will likely carry into February given the weather, and negative revisions in the factory orders report to the pullbacks in capital goods shipments and orders figures in January after big gains late last year, however, offset this upside and left our 1Q GDP forecast to +2.0%.  We think that this figure is likely to be depressed by weather and also by paybacks from activity accelerated by the homebuyers' tax credit that initially was scheduled to expire at the end of November and the accelerated depreciation schedules that expired at the end of December.  As the weather improves and the tax-driven payback fades, we look for GDP growth to double to +4% in 2Q (see Richard Berner's March 5 note, US Economics: Payback Here, Snapback Coming, for a full discussion). 

The economic calendar is light in the coming week, with focus on the retail sales report Friday.  Prior to that, it's another heavy Treasury supply week, with a US$40 billion 3-year auction Tuesday, US$21 billion reopening of the 10-year Wednesday, and US$13 billion reopening of the 30-year Thursday.  Ongoing developments in repo and fed funds markets and any comparable developments overseas are likely to remain in focus, and any news on the Greece situation will also be watched for.  Data releases due out include the Treasury budget Wednesday, trade Thursday and retail sales Friday:

* We expect the federal government to report a US$220 billion budget deficit for February, about US$25 billion wider than in the same period a year ago, reflecting the ongoing impact of the Making Work Pay tax credit, an increase in cyclically sensitive spending items such as unemployment insurance, and rising outlays for grants to state and local governments.  On the positive side, corporate profits taxes jumped about US$7 billion, and receipts from the Federal Reserve increased US$6 billion.  For the fiscal year as a whole, we still see the budget deficit tracking at US$1.325 trillion or about 9% of GDP.

* We look for the trade deficit to widen by US$1 billion in January to US$41.0 billion, with exports down slightly and imports up marginally. These swings would represent some flattening out on the heels of the steady increases seen over 2H09.  On the export side, industry figures and factory shipments results point to softness in capital goods concentrated in a pullback in aircraft from a lofty December reading.  Upside in industrial materials helped by higher prices should provide a small boost.  On the import side, oil imports should be little changed as a moderation in volumes after a surge in December should offset a gain in prices, while port data also point to little change in non-energy goods imports after a big prior run-up. 

* We forecast a 0.3% gain in February retail sales, overall and ex autos.  The February chain store reports pointed to solid gains in discretionary categories, such as general merchandise and apparel. Moreover, we look for a pick-up in categories such as pharmacies and grocery stores. Also, even though unit sales of motor vehicles edged down in February, our model points to a slight uptick in the auto dealer component of retail sales. Meanwhile, gas prices were little changed on a seasonally adjusted basis and bad weather in parts of the country likely kept some drivers at home. So, we look for a flat reading for the service stations category.  On the downside, we are factoring in some significant weather-related declines in sectors such as home electronics, furniture, hardware, sporting goods and restaurants. Still, the key core retail control item that factors directly into the calculation of personal consumption spending is expected to be +0.5% for the month, which puts our tracking estimate for 1Q consumption at +3.0%.