United States
Review and Preview
May 17, 2010

By Ted Wieseman | New York

Treasuries ended fairly narrowly mixed over the past week as initial hopes that the massive EU/IMF support programs for fiscally strained eurozone members would halt the European crisis proved too optimistic and flight to safety into Treasuries resumed in a big way late in the week.  Peripheral European debt spreads narrowed very sharply in response to the support plan, but worries about the euro area seemingly just became more diffuse and less focused on the recently most strained peripheral countries, and this was vented through a big further drop in the euro.  After a brief partial improvement early in the week, funding pressures also worsened over the course of the week, and the biggest strains continued to be in dollar markets, notwithstanding the seemingly euro-focused nature of the current crisis.  The FX swap lines that were re-introduced over the weekend initially at least were offered at rates so far above market levels - 100bp over expected fed funds at the initial one-week operations Tuesday - that demand was non-existent in the UK and Switzerland and light in the eurozone.  Actually that there was any demand at all at the ECB operation at a 1.22% one-week rate was taken as a negative sign as dollar Libor continued moving higher and forward Libor/OIS spreads approached the highs hit May 6.  While Treasuries didn't move too much on net for the week, modest short-end gains and long-end losses did combine for a significant steepening of the curve.  TIPS inflation breakevens also moved significantly higher, reversing a substantial portion of the collapse in inflation expectations seen the prior week.  Easier ECB policy and concerns about ECB credibility and independence and the expected impact of the European crisis in keeping the Fed on hold for longer than previously expected even as domestic growth momentum has remained quite positive into early 2Q have increasingly moved investors towards our view that the medium-term impact of this situation will be inflationary and not deflationary (see the lead article "XXL Liquidity" by Joachim Fels in this week's Global Monetary Analyst).  The continued strength in Treasuries that has left long-end yields near their lows of the year as the market has largely priced out the likelihood of any Fed action this year comes as the US economy continues to show acceleration.  Indeed, despite what's happening in Europe, we made the first changes in our 2010 and 2011 GDP forecasts this week, raising our 2010 forecast to +3.5% from +3.2% (on a 4Q/4Q basis) and 2011 to +3.0% from +2.5% (see US Economics: Sovereign Credit Risk Means a Lower Path for US Rates, May 10, 2010). 

After a big rally Friday when Europe-driven flight-to-quality greatly intensified, the short end of the Treasury market ended slightly better on the week and the long end a bit weaker, resulting in a decent curve-steepening move that erased a majority of the prior week's flattening as the ultimate impact of the global monetary policy response to the European situation was reconsidered.  The 2-year yield fell 3bp to 0.79%, old 3-year 4bp to 1.25%, 5-year 2bp to 2.15% and 7-year 1bp to 2.86%, while the old 10-year yield rose 2bp to 3.45% and old 30-year 3bp to 4.31%.  Renewed flight-to-safety didn't carry through into the bill sector, with yields adjusting back up early in the week and then holding steady when Europe fears intensified again Thursday and Friday.  This left the 4-week bill yield up 8bp at 0.15% and 3-month 2bp also at 0.15%.  An issue in the money markets aside from the pressure on interbank rates was the implementation of new rules for money market funds requiring higher levels of seven-day liquidity as of May 5, so as longer-maturity CP that had rolled down to meet this requirement matured, it was more difficult for issuers to roll over and 30-day CP yields saw some notable upside along with the increase in T-bill yields.  Even with commodity prices seeing some major further weakness, most notably oil, with the June contract off another $3.50 a barrel for a $15 plunge the past two weeks and the dollar index jumping another 2%, TIPS outperformed on the week except at the short end, which along with the steepening reversal in the yield curve suggested a shift in investors' perceptions about the medium-term inflation risks of the global policy response to what's happening in Europe.  The 5-year TIPS yield fell 9bp to 0.30%, 10-year 4bp to 1.23% and 30-year 3bp to 1.78%.  If not for the ongoing flight-to-safety bid and miserable global fiscal backdrop that manages to make the US federal government deficit this year of around 8.5% of GDP somehow look not all that bad, it's hard to imagine that such extremely low real interest rates would be remotely sustainable in an economy with a negative net national savings rate and cyclically accelerating investment spending.  Meanwhile, interest rate market volatility saw a modest decline over the past week even after significant renewed upside Friday, which supported a continued strong tone by the mortgage market that has left 30-year mortgage rates not far from record lows.  The MBS market actually significantly outperformed the drop in volatility - which saw 3-month X 10-year normalized swaption volatility falling to 106bp from 114bp at the end of the prior week and 125bp at the recent high on May 6 - tightening significantly on a Libor/OAS basis and outpacing the Treasury market's stability in the intermediate part of the curve. 

Key funding measures being watched for spillover of the European crisis into broad global liquidity problems started moving rapidly back in the wrong direction over the past week, back to and in some cases through the prior worst levels hit on May 6 when European debt spreads peaked.  Spot 3-month Libor moved slightly lower Monday but moved higher the rest of the week to end 3bp higher at 0.445%, which resulted in the spread over expected fed funds over the next three months rising a slightly larger 4bp to 22bp, both highs since last summer.  Forward Libor/OIS spreads also moved out substantially to reverse modest early-week improvement.  The white eurodollar futures (maturing through March 2011) did rally modestly on the week, but they sold off hard Thursday and Friday and the upside mostly trailed a bigger adjustment in overlapping fed funds futures.  Indeed, with the Jan 11 fed funds contract rallying 6.5bp to 0.37%, market pricing of the Fed is now in line with our revised view that it is likely on hold until early next year.  As a result, the forward Libor/OIS spread to June dipped 1bp to 37bp, but this was up from 26bp Monday and nearly back to the 40bp high hit May 6, September rose 3bp for the week and 14bp from Monday to a new high of 44bp, December rose 3bp on the week and 12bp from Monday to a new high of 44bp, and March was steady on the week after rising 9bp from Monday 42bp, just below the prior high.  This had a direct spillover into swap spreads, which saw similar upside after a brief Monday moderation to nearly return to the prior recent wides.  The benchmark 2-year spread ended the week at 34.25, slightly narrower on the week but up 7bp from Wednesday and nearly back up to the 38bp recent wide close on May 6 after a run-up from just 15bp in mid-April.  Clearly, investors will now be hoping that European central banks will ease the terms, presumably set in close consultation with the Fed, on dollar injections at the upcoming week's operations, which will add a 3-month maturity from the ECB to the initial one-week offerings.  The initial operations were done at OIS plus 100bp, or 1.22%.  Thankfully, as much as Libor/fed funds spreads have widened recently, we're still at least way below 100bp, so the initial operations were ineffective and possibly even counterproductive since there was some surprise that strains for some banks were large enough that there were actually seven bidders willing to pay 1.22% for $9 billion. 

Risk markets managed to post decent gains on the week, but they were clearly heading quickly in the other direction Friday, as the plunging euro and rising LIBOR pressures intensified fears about Europe spillover.  The S&P gained 2.2% on the week but only after having been up 5.5% at Wednesday's close.  With industrial activity and global trade continuing to boom, industrials and tech were the week's best-performing sectors.  Equity market volatility also saw a big pullback, though it is showing a lot more upside relative to the lows of a month ago than rates volatility.  The VIX declined to 31.2% from 41.0%, which is still about double the three-year lows below 16% reached in mid-April before the European crisis started worsening.  Credit also ended better on the week but well off the best mid-week levels, with the investment grade CDX index tightening 10bp to 109bp and the high yield index gaining a bit less than 2 points (about in line with the stock market gain), which resulted in about a 50bp spread narrowing to near 575bp.  Even with peripheral Europe yield spreads over Germany coming way down during the week, the muni bond MCDX index remained under pressure as investors worried that this could be a next area of focus for government credit concerns.  After initially seeing a good tightening Monday in sympathy with Europe, by Friday afternoon, the 5-year MCDX index was trading several basis points wider than the previous recent wide of 164.5bp hit May 6 when European spreads peaked.  5-year MCDX is still somewhat below the prior peak for the year of 180bp hit during the wave of Greece fears in February.  The subprime ABX and commercial mortgage CMBX markets managed to post good gains for the week, but the tone was a lot worse Friday after a couple of days of significant losses after huge rallies Monday that were extended a bit into Wednesday.  The AAA ABX index gained 2% for the week but fell 5% from Monday's high for the week.  The AAA CMBX index gained 2% on the week, junior AAA 4%, AA 9% and A 8%, but also only after reversing notably bigger gains earlier in the week.

The past week's economic data calendar was light, with key data generally strong but with mixed GDP implications.  Overall and ex autos retail sales growth was better than expected in April but only due to a surge in the building materials component that for GDP purposes is considered residential investment instead of consumption.  The narrower measure that feeds most directly into consumption estimates was a bit softer in April, but there were upward revisions to March and February, so we've seen consumption in 1Q being revised up to +3.8% from +3.6% but we still see 2Q running at +3.2%.  There were offsetting growth impacts from the trade report, which was very strong in showing major gains in both exports and imports.  The deficit result in March was a bit wider than we expected, however, providing a more negative trajectory for 2Q net exports, but it was narrower than the BEA assumed, pointing to upside to 1Q.  We now see trade adding 0.2pp more to 1Q but 0.2pp less to 2Q.  Inventories were a bit of an offset.  Overall inventories rose 0.4% in March, as expected, but the gain in ex auto retail inventories (the key new piece of information in the monthly business inventory and sales report) at +0.4% didn't rise as much as the BEA assumed.  As a result, we see the 1Q inventory contribution being lowered a tenth but see that being made up in 2Q.  Adding these impacts up, we look for 1Q GDP growth to be revised up to +3.4% from +3.2%, but we see 2Q tracking at +3.4% instead of +3.5%.  Underlying demand should be much stronger in 2Q than 1Q - we seen final sales accelerating to +4.0% from a revised +1.8% and final domestic demand to +3.7% from +2.3% - but at this point we see a pause in the recent inventory normalization subtracting a bit more than a half a point from 2Q GDP growth.  Inventories will need to see substantial further upside going forward, however, to move them back to a more sustainable level after the economy-wide inventory-to-sales ratio plummeted to an all-time record low in March. 

Retail sales rose 0.4% in April, boosted by a small gain in auto sales (+0.5%) that sharply contrasted with the pullback in unit sales, a surge in building materials (+6.9%) that might have partly reflected the ‘cash for appliances' program, and an uptick at gas stations (+0.5%) despite lower prices on a seasonally adjusted basis.  The key retail control grouping that strips these categories out dipped 0.2%, though there were upward revisions to already strong March (+0.7%) and February (+1.4%), with seasonal adjustments problems with the early Easter probably causing some distortions over the March/April period.  Generally strong results were seen over these two months in key discretionary categories even with April weakness.  The upward revisions to March and February retail control point to an upward adjustment to 1Q consumption to +3.8% from +3.6%.  They also provided a stronger starting point for 2Q that offset the April downside and left our 2Q forecast at +3.2%. 

The trade deficit widened slightly to $40.4 billion in March from $39.9 billion in February, as exports (+3.2%) and imports (+3.1%) soared, with most of the upside reflecting higher volumes instead of prices.  Export strength was led by industrial materials, capital goods outside of a pullback in aircraft, and consumer goods.  The biggest contributor to the import gain, which came despite a pullback in services after February was boosted by royalty payments for Olympics broadcast rights, was petroleum products, with both volumes and prices up significantly.  Autos and consumer goods also posted good gains.  The March trade deficit was significantly narrower than BEA assumed in preparing the advance 1Q GDP estimate and pointed to the trade contribution being adjusted up to -0.4pp from -0.6pp.  The March deficit was a bit wider than our forecast, however, so we now see an offsetting smaller add to 2Q growth from trade of 0.2pp instead of 0.4pp.  Despite the worsening economic outlook for Europe, the export picture for the US looks quite positive at this point, thanks to the accelerating growth in Canada, Latin America and Asia.  Through the first three months of this year, US exports to the European Union only grew 2% from the same period last year, but exports to Canada and Mexico surged 25%, South and Central America 23% and Pacific Rim countries 38%.

The manufacturing sector continues to lead the recovery, with the extremely strong ISM report for April fully confirmed by robust results for industrial production.  As muted as the broader economic rebound remains, the factory sector is seeing a strong V-shaped recovery with help from export strength.  Industrial production rose 0.8% in April even with a further weather drag on utility output (-1.3%).  The key manufacturing gauge surged 1.0% even with a drop in the volatile motor vehicles component, for a 9% annualized rebound from the mid-2009 trough, the best run since 1998.  Motor vehicle and parts output fell 2.3%, as assemblies fell 5%, with the auto sector contribution to GDP likely to flatten out in 2Q after a major boost over the prior three quarters.  Manufacturing ex motor vehicles surged 1.2% in April for a 7.4% annualized gain since the June 2009 low.  Every sector except motor vehicles and aerospace were up in April, with big gains in machinery, fabricated metals, primary metals, paper and petroleum refining.  We'll get some important early indications for May factory sector activity with the release of the Empire State manufacturing survey on Monday and Philly Fed on Thursday. 

Before the recent turmoil, Wednesday's release of the March FOMC meeting minutes would have attracted significant focus for signs of the timing of the implementation of the Fed's exit strategy, with new focus ahead of that meeting on the possibility of MBS sales.  That will likely be an important area of discussion in the minutes and could still be implemented in modest size in the coming months, but the Fed has likely been moved firmly to the sidelines for now with the turmoil in Europe and spillover impacts into US markets.  Key data releases due out include housing starts and the producer price index Tuesday, consumer price index Wednesday and leading indicators Thursday:

* We look for 0.1% decline in the headline PPI in April and 0.2% rise in the core.  Prices for wholesale gasoline rose by less than the seasonal norm, and quotes for natural gas declined.  So we look for a pullback in the energy category.  Also, food prices are expected to flatten out in April following an unusual spike in March that was tied to skyrocketing vegetable prices.  Meanwhile, the core is expected to show a bit of acceleration this month tied to an expected rebound in vehicle prices, which continue to be quite volatile from month to month.

* We expect housing starts to rise to a 640,000 unit annual rate in April.  Weather conditions have been unusually favorable over the past couple of months - a big swing relative to the unusually severe conditions that prevailed earlier.  Also, we suspect that the rush to qualify for the homebuyer tax credit may contribute to a near-term boost in construction (to qualify, contracts had to be signed before May 1 and the deal closed by July 1).  Moreover, the employment report showed a sharp jump in hours worked within the construction industry during April.  This all points to some upside in starts, so we look for a 2% rise this month. 

* We look for the headline CPI to be flat in April and the core to rise 0.1%.  Gasoline prices rose by less than the seasonal norm. So, the energy category appears likely to show a significant decline.  However, the core is expected to be a bit higher than in recent months (note that our unrounded estimate is +0.10%).  Specifically, survey data point to some upside in vehicle prices - both new and used.  And industry figures show that hotel rates are now climbing.  Most important, there are widespread reports of improving rental market conditions, suggesting that rent and OER are at or near a bottom.  A turnaround in these key categories - which have accounted for the bulk of the moderation in the core CPI seen over the past few years - is expected to lead to a near-term pick-up in core inflation despite a still very wide output gap.  Finally, on a year-on-year basis, the core CPI should tick down to +1.0% in April.

* Based on currently available components, the index of leading indicates should rise 0.1% in April, just barely posting its 13th straight increase after the prior 12 gains cumulated to the sharpest annual increase since 1984.  Significant positive contributions in April are expected to come from the yield curve, manufacturing workweek and stock prices, with negative offsets from supplier deliveries, money supply and jobless claims.

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