Clients and colleagues have pushed back hard on our call, largely because the target is aggressive, but also because many of the key drivers needed to validate the call are not yet evident. Far from backing off, however, our conviction level remains high, as we see strong hints that many of the key drivers are falling into place. Treasury supply is starting to weigh on bond prices as concerns are growing that healthcare reform and other spending may add to budget deficits; companies are on the cusp of accumulating inventory; consumer credit appears to be stabilizing; and slack in the economy and housing markets is ebbing.
Change in Fed rhetoric needed. For our call to work directionally, some of those drivers will suffice. To get to our admittedly lofty target, however, we'll also need clear signals that will turn Fed rhetoric from dovish to hawkish - persistently rising inflation expectations, the economy growing sustainably above trend, and a shift in the inflation outlook. That will trigger a repricing of the future path of monetary policy, which in turn will drive up real yields. We think that all of these factors will come into play this year. In what follows, we review the analytics and the evidence.
Long-term real risk-free rates tend to fluctuate around 3%. To understand the analytics of our call, we think it's important to review the basics, although for those familiar with our views, there will be inevitable repetition. Such a review is needed because investors over the past decade have become accustomed to a world of low real rates; measured by 10-year Treasury yields less the trailing core CPI, real yields averaged 2.15% in the 2000-09 period. The cornerstone for our view is that this era is ending.
What drives real rates? In the long run, and on average through the cycle, real rates should reflect returns on capital and potential real growth. Those who believe that returns on investment, productivity and potential growth have declined in recent years would argue that there should be a corresponding decline in real rates. We do not buy that story; trend productivity and potential growth are certainly lower than they were in the 1960s and in the late 1990s, but at about 2% and 2.5%, respectively, they are in line with the average of the last 60 years. Returns on capital declined as corporate overinvestment in the technology boom boosted capital-output ratios, and returns have declined cyclically in the recession. But to maintain profitability, Corporate America has slashed capital spending and boosted productivity; witness the 3.6% annualized increase in labor productivity over the two years ended in 4Q09. That brisk pace is clearly not sustainable, but a 2% trend is.
Meanwhile, investors need compensation for taking on duration risk (e.g., the risk of holding a 10-year security as opposed to rolling over 10 one-year instruments). Our colleague Jim Caron thinks that this ‘term premium' for risk in normal times should be at least half a percentage point or 50bp. Adding that to the 2.5% potential growth rate yields a 3% norm for real, risk-free yields. Thus, we think real, risk-free, long-term rates may fluctuate around that 3% norm, well above today's levels.
But supply and demand can prevail in the short term. In the short-to-medium run, other factors can persistently drive real rates away from those long-term norms - both lower and/or higher. In our view, the spectrum of real yields over a medium-term time frame is determined by supplies of saving and demands for investment, or their financial counterparts, the supply and demand for credit. Of course, saving always equals investment ex post; the ex ante question is always at what price - what interest rate - will the market clear?
Exceptionally low real rate levels for an extended period. Using those tools, we find it easy to explain why real rates continue to be exceptionally low despite record-low net national saving. First, the deepest recession since the Great Depression has hit investment across the board - in housing, corporate capital and inventories - and it is the excess of saving over investment that has driven rates down. In the corporate arena, the corporate financing gap (the difference between internally generated cash flows and corporate fixed and inventory investment) fell to a record low of -3.1% of non-financial corporate GDP in 3Q09. Correspondingly, the demand for credit has plummeted to record lows.
Second, on the supply side, the Fed designed its Large-Scale Asset Purchase programs (LSAPs) to take massive amounts of duration and convexity risk out of the fixed-income markets. Since the beginning of 2009, the Fed has purchased more than US$1.5 trillion of Treasuries, agencies and MBS. The LSAPs thus have kept rates lower than they would otherwise be, inducing investors through portfolio balance effects to take on more risk. In our view, when investment rebounds, even modestly, the supply/demand balance driving real interest rates will change dramatically. Moreover, as the Fed ends the LSAPs at the end of this month, duration and convexity will very gradually return to the fixed-income markets, and portfolio balance effects will begin working in reverse to tighten the supply of credit.
In the very short run, technical factors may be the primary catalyst for higher yields. For example, our colleague Jim Caron has long believed that there is a high level of interest rate sensitivity in the investment community that may prompt traders to sell bonds as rates go up - in a move akin to convexity hedging by mortgage investors and servicers (see 2010 Global Interest Rate Outlook: The World Is Uneven, November 30, 2009; and Asymmetric Risks Point to Higher Yields, Steeper Curve, December 10, 2009). Jim and his team believe that those technical factors could push 10-year yields up quickly to 4.5%. In addition, with interest rate volatility plunging and the private demand for credit weak, the issuance of Treasury debt becomes a dominant factor in the market, dwarfing the size of Libor-related issuance. For example, we currently expect net issuance of MBS to be zero. Thus, we see the relative issuance of USTs versus Libor-based products mainly accounting for the inversion in swap spreads. This is a first sign of stress leading to higher UST yields not to be missed (see Less Than Zero: A First Sign of Stress Not to Be Missed; A Harbinger for Higher UST Yields, March 24, 2010).
Checklist for the market. What's the evidence so far that these forces are at work in the marketplace? In late January, we thought that the Treasury would need to issue US$2.5 trillion (gross) in coupon securities to finance a deficit of US$1.325 trillion and begin the process of lengthening the average maturity of Treasury debt from 48 months to about 6-7 years. Now it appears that Treasury borrowing may not be quite as onerous, with coupon financing of US$2.4 trillion. But that slight reduction in borrowing is mainly due to paydowns of TARP assistance and an improving economy. Indeed, tax receipts are beginning to rise at a faster-than-expected pace, indicating stronger corporate profits and personal income. And, we're just a few weeks away from the start of the April tax season, which could have a significant impact on near-term budget and financing estimates. On the spending side of the ledger, lawmakers have passed a US$17.6 billion jobs bill, and the Administration is proposing much-needed foreclosure assistance programs. These may not expand the deficit much in the near term either because Congress has found or may find other revenue streams to pay for them, or in the case of the foreclosure programs because the lender takes the initial loss.
But these developments reinforce longer-term concerns regarding fiscal sustainability in the US. We expect the unemployment rate to remain quite elevated for the next few years and thus additional attempts to stimulate the job market may lie ahead. Moreover, the latest incarnation of the Obama Administration's mortgage modification program appears to shift a considerable amount of default risk to the FHA - which already seems to have significant exposure to mortgage-related losses over the long term. Finally, it's worth keeping in mind that 85% of federal government outlays are tied to defense, entitlements and interest on the debt. And, as we have pointed out in the past, neither raising taxes on the wealthiest Americans nor ‘inflating our way out' is a viable solution to the budget problem.
Consumer credit demand stabilizing. Likewise, we believe that private credit demands are poised to rebound. Household deleveraging and rising wealth have substantially restored balance-sheet health for consumers and, coupled with increasing income, have given them more wherewithal and confidence to borrow again. To be sure, it's a new era for American consumers, one of rising thrift and moderate growth in consumer spending. Consumer deleveraging likely will continue into at least the summer as debt paydowns and write-downs exceed new originations. Soon after that, we think consumer borrowing - including consumer credit and mortgages - will begin to grow, although much more slowly than income. Indeed, consumer credit turned up in January after declining for 15 of the previous 17 months; it's too soon to argue that those data represent a turn higher, but they hint at stability.
Corporate financing needs to turn positive. For its part, Corporate America will likely soon start to accumulate inventories and boost capex, and credit availability should continue to improve. Thus, corporate external financing needs are likely to turn positive soon as those factors combine with slower growth in corporate cash flows. The combination is apt to boost corporate credit demands, perhaps sooner than expected. There are signs that inventory liquidation may be turning to accumulation in the first quarter, as the book value of durable good stocks rose in the first two months. While equipment spending growth slowed to an estimated 6% annualized rate in 1Q from 18% in 4Q, most of that deceleration represents a payback from the end of investment tax incentives in 2009. Meanwhile, corporate cash flow was strong through 4Q, with non-financial book profits jumping 50% from a year ago. But that pace will slow dramatically in the coming months, implying an upturn in financing needs.
Checklist for the Fed. Finally, for our call to work, we also need clear signals - persistently rising inflation expectations, confirmation that the economy is growing sustainably above trend, and a shift in the inflation outlook - that will turn Fed rhetoric hawkish. Each of the first two factors is now shifting in a way that increases the odds of the Fed tightening sooner than expected. After falling for much of the year, distant-forward breakevens have risen by 10bp to 2.73%. Moreover, signs of stronger growth are emerging, with March data appearing to show strength following a weather-induced slowdown in February (see Treasury Market Commentary, March 26, 2010). The inflation outlook, in contrast, will change more slowly. In our view, slack in the economy is beginning to shrink, and we see incipient signs of pricing power emerging again. However, the Fed has yet to change either its inflation outlook or its rhetoric. We think that will start at the April FOMC meeting, and trigger a significant change in how the market is pricing the future path of monetary policy.
Q) Where do things stand at this point?
A) President Obama signed into law The Patient Protection and Affordable Care Act (H.R. 3950) on March 23, 2010. This bill was approved by the House last Sunday, March 21, 2010, and by the Senate on December 24, 2009. There are a number of provisions in the bill that are unacceptable to a majority of House members and thus Congress also passed a budget reconciliation bill (H.R. 4872) that contains some ‘fixes' to H.R. 3950. The pesident is expected to sign H.R. 4872 into law within the next few days. All of the facts and figures contained in the Q&A below pertain to the combined impact of H.R. 3950 and H.R. 4872. By the way, the budget reconciliation approach was used because it required a simple 51 vote majority in the Senate - as opposed to the 60 vote supermajority that would have been difficult to attain in the wake of the recent election outcome in Massachusetts (note: Wikipedia has some good background information on ‘reconciliation' legislation if you are interested in learning more).
Q) Does this legislation affect the outlook for the US economy?
A) Possibly, but it seems unlikely that there will be any meaningful impact over the next few years. That's because many of the key provisions of the legislation don't kick in until 2013 or 2014. Here is a link to a helpful Wall Street Journal summary of effective dates for some of the most important provisions: http://online.wsj.com/article/SB10001424052748704117304575137370275522704.html
One small caveat - the bills are very complex and there appears to be some confusion regarding the effective date of many of the key provisions. It's conceivable that some employers might be reluctant to add new workers because of the perceived costs associated with the healthcare reform initiative. However, we assume that this confusion will be short-lived and should begin to evaporate in the coming days and weeks as the timetable associated with the new law becomes better understood.
Q) What about the longer-term impact on the cost of private healthcare in the US?
A) The impact on the rate of growth in healthcare spending is uncertain. Some analysts believe that there are legitimate cost containment measures and efficiency gains in the legislation which will prove effective in slowing the rate of growth in healthcare spending. Alternatively, others believe that healthcare spending will rise at an even faster rate as a result of this legislation. After all, the basic laws of supply and demand suggest that prices must adjust upward if increased coverage leads to a higher demand for health care services while supply remains unchanged. However, most analysts - including the Congressional Budget Office (CBO) - seem to believe that (relative to current law) the impact of the legislation on insurance premiums for most of those already covered will be relatively modest. For more details, see the CBO study, An Analysis of Health Insurance Premiums Under the Patient Protection and Affordable Care Act, November 30, 2009. The bottom line is that overall healthcare costs across the economy will probably rise as a result of this legislation, but the per capita cost of private insurance might not change too much - and could even decline - because some of the costs associated with providing care for the uninsured that were previously borne by the private sector will now be shifted to the public sector.
Q) What about the budgetary impact?
A) CBO estimates that the gross cost of the legislation will total US$938 billion over the F2010-19 period. Most of this is related to the new subsidy payments for individuals and increased expenditures for expanded Medicaid coverage. But, the bulk of this spending won't start to show up until 2014.
Q) If the costs associated with health care reform amount to US$938 billion, why does CBO say that the budget deficit will be reduced by US$143 billion, compared with current law, over the F2010-19 timeframe?
A) CBO estimates that the budgetary impact of the aforementioned costs will be more than offset by new taxes contained in the bill and some cutbacks in spending. Specifically, the legislation includes: cuts in Medicare, Medicaid and other outlays (US$455 billion), a new tax on unearned income and a hike in Medicare taxes (US$210 billion), fees on the healthcare industry (US$107 billion), penalties on employers and uninsured individuals (US$65 billion), an excise tax on so-called Cadillac plans (US$32 billion) and a number of other smaller provisions that push the overall net budget impact into the black. However, many of the assumptions that CBO had to work with seem questionable. For example, drastic cutbacks in Medicare reimbursement rates for physicians have already been postponed a number of times and this legislation would constrain payments for other Medicare providers. This seems highly impractical. The estimates also assume that a new advisory board, established under the bill, will impose changes that limit the future growth in Medicare spending. In sum, many analysts are skeptical that the specified cost savings will actually materialize and thus the legislation could lead to wider future budget deficits compared to current law (see http://www.cbo.gov/doc.cfm?index=11376 for estimates associated with some of the most questionable assumptions).
Q) Is there an employer mandate to provide coverage?
A) Yes and no. Companies with fewer than 50 workers won't face any penalties if they do not offer insurance. Moreover, companies could get tax credits to help buy insurance if they have 25 or fewer employees and a workforce with an average annual wage of up to US$50,000. However, starting in 2014, firms with more than 50 employees that do not offer coverage would have to pay a fee of up to US$3,000 per full-time employee if any of their workers receive government-subsidized insurance coverage in the exchanges. The first 30 workers would be excluded from the assessment.
Q) Is there an individual mandate?
A) Yes, most Americans would have to have insurance by 2014 or pay a penalty. The penalty would start at 1% of income and rise to 2.5% by 2016. Low-income individuals will be eligible for Medicaid as long as their incomes don't exceed 133% of the federal poverty level (US$29,326 for a family of four). Other individuals will be eligible for government subsidies to help pay for private insurance sold by new state-based insurance marketplaces, called exchanges, slated to begin operation in 2014. Families with incomes between 133-400% of the poverty level (US$29,326-88,200 for a family of four) will be eligible for subsidies on a sliding scale. For example, a family of four earning 150% of the poverty level, or US$33,075 a year, would have to pay 4% of its income, or US$1,323, in premiums. A family with income of 400% of the poverty level would have to pay 9.5%, or US$8,379. In addition, if your income is below 400% of the poverty level, your out-of-pocket health expenses would be limited.
Q) What is the expected impact on insurance coverage?
A) CBO estimates that the legislation will reduce the number of uninsured by 32 million over the next 10 years - leaving about 23 million residents uninsured (around one-third of whom would be illegal immigrants). The share of legal, non-elderly residents with insurance coverage would rise from 83% at present to 94% in 2019. The estimated 32 million additional insured reflects: 1) 24 million people who are expected to purchase their own insurance through the new exchanges (an estimated 5 million of whom previously purchased insurance on their own and another 3 million of whom were previously covered by their employers, so the net addition of newly covered individuals in the exchanges would be 16 million), and 2) 16 million who are expected to be covered by the expanded Medicaid program. The expected 3 million decline in employment-based coverage reflects a number of offsetting factors. First, demand for coverage through employers is expected to increase by 6.5 million as a result of the new mandate. Second, some firms with fewer than 50 employees are expected to drop coverage because it might be cost effective for them to do so and their employees - an estimated 8.5 million - would likely be able to obtain better coverage (using government subsidies) through the exchanges. Third, 1.5 million are expected to switch to the exchanges even though they are still covered by their employer. Of course, all of these estimates are subject to considerable uncertainty.
Q) Finally, can you provide more details on the tax changes for individuals?
A) The legislation imposes a new Medicare surtax on earned income for some taxpayers beginning in 2013. The additional payroll tax is 0.9% on annual wages above US$200,000 (US$250,000 for couples). This takes the employee portion of the Medicare payroll tax from 1.45% to 2.35%. Also, there is a new 3.8% tax on investment income above US$200,000 (US$250,000 for couples). This tax will also apply to investment income of an estate or trust. Note that investment income includes interest, dividends, royalties, rents and capital gains (except income from a trade or business, unless the business is considered a passive activity or a business trading in financial instruments or commodities). The tax would apply to gains from the sale of a partnership interest or shares in an S corporation only to the extent that the partnership or S corporation assets had built in gains. The tax would not apply to distributions from qualified retirement plans. The effective tax rates on investment income for certain individuals would increase as follows if Congress does NOT extend the current lower rates on capital gains and dividends:
Capital gains tax rate starting in 2013: 23.8% (maximum rate)
Tax rate on dividends starting in 2013: Ordinary rates plus surtax (which implies a top rate of 43.4%).
Treasuries had their worst week of the year over the past week, suffering sizeable long-end-led losses as the passage of the healthcare bill provided an impetus for long-simmering domestic fiscal fears to flare up in a big way. This showed up in a rapid acceleration of the trend swap spread narrowing seen over the past year, with 5-year and 10-year spreads plummeting to record lows, and the worst run of Treasury auctions in recent memory. The healthcare bill itself should have minimal actual impact on the budget or Treasury financing for at least a few years, but with the federal budget deficit on pace to run at close to 9% of GDP this year after the 10% gap in fiscal 2009 and fiscal worries having been an increasing global focus for investors this year as the problems in Europe have intensified, the introduction of a major new government program was apparently enough to spook Treasury market investors regardless of the actual near-term estimates of its budget impact. Very loose fiscal policy became more the market focus and driver the past week, but the extremely easy monetary policy that to a major extent has driven the trend spread narrowing also continued to look increasingly problematic as economic data extended a run of solid results and investors shifted their attention to what is likely to be a robust run of figures for March that will start to be reported in the coming week. Home sales data for February held up reasonably well, showing only a small further decline that based on recent upside in mortgage applications should mark the bottom of the payback from sales pulled ahead of the initially scheduled expiration of the homebuyers' tax credit last year. And the durable goods report showed capital goods orders and shipments extending their positive trend recovery since last spring's lows after some unusually big volatility over year-end that probably reflected seasonal adjustment problems and some temporary paybacks also from investment pulled ahead of the year-end expiration of accelerated depreciation schedules. These reports extended a consistent run over the past month of surprisingly resilient February data, suggesting more underlying economic momentum than expected a month ago that helped to offset the negative impact of the terrible weather. We expect this better underlying picture combined with a snapback from weather disruptions to lead to a strong run of March data starting with the upcoming week's employment, ISM and motor vehicle sales reports. The latest weekly claims report showed the 4-week average of initial claims and continuing claims both at new lows since late 2008, while the latest regional manufacturing surveys from the Richmond and Kansas City Fed Districts were stronger. We continue to look for a 300,000 gain in March non-farm payrolls, and slightly boosted our ISM forecast to 57.0 from 56.5. Early industry reports also continue to point to a surge in auto sales to the strongest pace since September 2008 outside of the peak of cash-for-clunkers sales. The durable goods and home sales reports left our 1Q GDP forecast at +2.6%, but the expected ramp-up in activity in March should leave 2Q on pace for a snapback to a +4% growth rate.
On the week, benchmark Treasury yields rose 1-17bp and the curve saw a significant move back steeper after having been flattening steadily for a month from the record-steep levels since mid-February. The old 2-year yield rose 1bp to 1.01%, 3-year 7bp to 1.62%, old 5-year 11bp to 2.57%, old 7-year 15bp to 3.29%, 10-year 17bp to 3.85% and 30-year 17bp to 4.75%. Off-the-run bonds were the worst-performing area, with yields in the 15-year area rising about 20bp. Long-dated zero yields with about 20 years and more maturity rose through 5% at the worst of the rout Thursday and stayed there through Friday's close even though this move at least temporarily helped halt the losses as it brought in some buying. Except for the short end, which was hurt by commodity price weakness as the dollar surged on continued worries about Europe, TIPS outperformed, but the sell-off in the market in the past week-and-a-half since the recent low in yields on March 17 continues to be largely in real rates. Over the past week, the 5-year TIPS yield rose 9bp to 0.44%, 10-year 12bp to 1.61%, and 30-year 9bp to 2.19%. Since March 17, the nominal 10-year yield is up 21bp and the 10-year TIPS yield is actually up a slightly greater 22bp. The pressure on financing rates that was previously pressuring the market and contributing to the prior flattening was largely set aside as a major market focus in the latest week in favor of worries about long-end supply, and there was a bit of easing that allowed bill yields to decline a bit. The average Treasury overnight general collateral repo rate was at 0.17% Friday, at the lower end of the recent range, and there was expected to be some brief downside over quarter-end, though much less than we've seen at prior quarter-ends the past couple of years, with overnight trades for March 31 at around 0.06%. This is likely to reverse back up quickly, however, given the heavy coupon supply that will hit the market on March 31 when this week's auctions settle. Effective fed funds was also down slightly, to about 0.17% most of the week from 0.18% in the second half of the prior week. This helped the 4-week bill yield dip 2bp to 0.11% and 3-month 2bp to 0.13% after they had reached their highest levels since last summer.
A sharp drop in swap spreads was the main story in interest rate markets the past week, more so than the pressure on Treasury yields. Spreads have been narrowing persistently for some time, supported by extremely easy monetary and fiscal policy - the former contributing to a general tightening in spreads amid declining volatility and rising complacency about the prospects for future rate hikes and the latter causing a relative cheapening in Treasuries. Clearly, reasons to increasingly worry about the budget and Treasury financing outlook have been rising for a couple of years, though this seemed to be a secondary consideration mostly even as sovereign credit risk was becoming a key focus in Europe. The passage of the healthcare bill seemed to provide a trigger for these worries to start showing up in a more pronounced way in US markets, although the actual budget impact of the bill is negligible for at least the next couple of years. With domestic fiscal fears heightened, the benchmark 10-year swap spread fell to near a record-low 3bp Monday and then broke dramatically lower Tuesday and Wednesday, trading down to as low as -10bp before seeing a small reversal to end the week near -6bp, a 10bp drop for the week. The 7-year spread also turned slightly negative, and the 5-year spread hit a record low, with both seeing similarly big declines for the week. Mortgages had been performing quite well relative to Treasuries recently even as Fed buying slowed significantly as the March 31 end to MBS purchases approached. But the back-up in rates and some upside in volatility as the disorder intensified in rates and spreads led to severe losses and significant underperformance versus Treasuries Wednesday and Thursday. There was some reversal of this, however, late in the week, and near-term relative performance may be market-directional, as many duration-focused portfolio managers and servicers seem to have decided to wait to see how things develop before making major adjustments to their portfolios. After Fannie 4.5% MBS broke below par at the day's lows Thursday, the late-week bounce left current coupon mortgage yields near 4.45% Friday, up about 12bp on the week. This was a bit better than the Treasury performance, though way behind swaps. Volatility has seen a bit of a reversal during the sharp sell-off of the past week-and-a-half. Normalized 3-month X 10-year swaption volatility was up near 100bp at the end of the week after having been down near 90bp at the recent low in rates on March 17, which was the lowest level since November 2007. The current level is still well below year-end 2009 levels near 125bp and 2009 peaks over 200bp last summer.
Volatility also remained quite low in stocks, which saw a bit more intraday volatility at least over the past week, but on a day-to-day basis continued to barely move. The S&P 500 gained 0.6% on the week, with the VIX rising to 17.8% from 17.0% at the end of the prior week and an almost two-year low of 16.4% hit Tuesday. Moves by major sectors also remained muted, with 2% gains by financial and consumer discretionary stocks and a 2% drop in energy marking the narrow ends of the performance range. Amid the collapse in swap spreads, credit markets performed better after previously having been lagging stocks recently. The prior on-the-run series 13 investment grade CDX index tightened about 5bp on the week to near 82bp, not far from the tights of the year hit in mid-January and a bit stronger than the 2009 close of 85bp (the new series 14 started trading on Monday and was at 87bp Friday). The high yield CDX index tightened about 20bp on the week to near 500bp. This is also now about 20bp tighter on the year for the high yield index. Performance in the latest week by the leverage loan LCDX index was in line with HY CDX, but this sustained a much better year-to-date performance, with the LCDX index near 385bp Friday after closing 2009 at 426bp. Although federal government financing fears hurt Treasuries and compressed spreads the past week, muni bond credit protection continued to trade to a significant extent in sympathy with peripheral Europe, which meant decent improvement in the latest week, as the eventual agreement by the EU on a support structure for Greece helped Greece's 2-year debt over Germany narrow about 65bp to below 350bp, a two-month low. Tracking this tightening, the 5-year MCDX index was about 15bp tighter at 128bp in Friday afternoon trading, a low since November. Agreement by the EU to add to IMF support for Greece if it has trouble issuing debt clearly doesn't do anything to help fiscally strained US states, so some differentiation seemingly should start to become more evident going forward between muni and peripheral EMU sovereign credit risk trading.
The main data release in a quiet calendar the past week was the durable goods report for February, which indicated that business investment is on pace for a modest further gain in 1Q on top of the 19% surge posted in 4Q. Non-defense capital goods ex aircraft orders, the key core gauge in the durables report, rose 1.1% in February, in line with the solid trend since the trough last April after some big recent volatility around year-end. Recent gyrations have been concentrated in machinery, which surged 5% in February after dropping 9% in January after a 7% gain in December. Since April, machinery orders are up 15% annualized, leading the rebound in capital goods. Core capital goods shipments gained 0.8% in February, also resuming solid growth after big recent swings. We estimate that this left business investment in equipment and software on pace for a 6% rise in 1Q, with overall investment likely to post a marginal decline when another big expected drop in the structures component is included. This left our 1Q GDP forecast at +2.6% after the slightly downwardly revised 5.6% gain in 4Q. We see final sales growth (GDP ex inventories), however, accelerating to +2.2% from +1.7% and final domestic demand (GDP ex inventories and trade) to +2.3% from +1.4%. An acceleration in consumption to +3.5% from +1.6% is expected to account for most of the pick-up in underlying demand.
On top of the significant upside in ex auto retail sales seen in January and February, 1Q consumer spending growth should be supported by a renewed upswing in auto sales after some payback in 4Q after cash for clunkers. Early industry surveys indicate that motor vehicle sales could have surged to near a 12.5 million unit annual rate in March from 10.3 million in February, which would be the best month since September 2008 aside from the 14.1 million recorded in August 2009 at the height of cash for clunkers. Meanwhile, the Richmond and Kansas City Fed manufacturing survey's showed upside in March after mixed results from the previously reported Empire State and Philly Fed reports. As a result, we boosted our March ISM forecast to a robust 57.0 from 56.5. And with the 4-week average of initial claims moving to the lowest level since September 2008 and continuing claims since December 2008 in mid-March, the underlying improvement in the labor market seen in the February employment report appears to still be on track after some recent distortions in claims from weather and processing backlogs in California. We continue to look for a 300,000 surge in March non-farm payrolls. March appears to have ended a somewhat sluggish 1Q - restrained by bad weather, tax paybacks in housing and business investment, and production consolidation after a major rebound in 2H09 - on a strong note, with snapback from February weather disruptions adding to a reasonably solid underlying trend, which we think for GDP will be near +3.25% this year. A positive end to 1Q would leave 2Q with a good starting point to snap back from the sub-par 1Q, and we continued to forecast a +4% rise in 2Q GDP.
The employment report will be released Friday. SIFMA is officially recommending a 12:00 bond market close on Friday (in observance of Good Friday), but trading will probably be effectively done for the day well before that as soon as post-employment report adjustments are made. The Friday employment report will cap what should be a strong run of initial key data for March that also includes the manufacturing ISM and motor vehicle sales on Thursday. There's a brief break from the supply pressures that hurt the market so badly in the past week, but Thursday will see the announcement of the next run of heavy issuance, with a longer duration tilt than the past week's supply, in the first full week of April. We look for US$82 billion in gross issuance to be announced for auction the next Monday to Thursday - US$8 billion in 10-year TIPS, US$40 billion 3s, US$21 billion 10s, and US$13 billion 30s. Other data releases due out include personal income and spending Monday, consumer confidence Tuesday, factory orders Wednesday and construction spending Thursday:
* We forecast a 0.2% rise in February personal income and 0.3% gain in spending. The employment report showed a slight decline in aggregate payrolls, which points to another subdued result for personal income in February. However, weather-related factors appear to have played a role, so we look for a pick-up next month. On the spending side, a very sharp jump in retail control should be partially offset by a dip in car buying, leading to a modest rise in overall consumption. Meanwhile, our translation of the CPI data points to a flat reading for the headline PCE price index and a 0.07% rise in the core index. The latter is expected to slip a tenth to +1.3% on a year-on-year basis.
* The sharp decline in the Conference Board index seen in February remains somewhat of a puzzle since it was not mirrored by the other sentiment gauges. Moreover, the weekly ABC index showed a near-record improvement in mid-March. So, we look for a rebound in the Conference Board measure to 51.0 in March from 46.0 seen in February.
* We forecast a 0.2% rise in February factory orders. A modest rise in the durable goods component implies only a fractional gain in overall factory bookings. Meanwhile, shipments are likely to edge down a bit this month. Finally, inventories are expected to match the 0.2% uptick seen in January.
* We expect the manufacturing ISM to rise to 57.0 in March. The regional surveys that have been released to this point have tilted to the upside. So, we expect ISM to post a modest gain relative to the 56.5 reading seen in February. In particular, orders and shipments seem poised to rebound. Finally, the price index is expected to hold near the 67 reading seen last month.
* Unusually severe winter weather, along with ongoing underlying weakness in non-residential activity, is expected to lead to a steep 2.5% fall-off in overall construction spending in February.
* We forecast a jump in motor vehicle sales in March to a 12.5 million unit annual rate. The sales pace averaged about 10.5 million units during the first two months of 2010, but industry surveys point to a very sharp pick-up in March. The improvement appears to be largely attributable to a few key factors, including better weather in some parts of the country, heavy discounting, and some easing of credit conditions.
* We forecast a 300,000 gain in March non-farm payrolls. Good Friday is generally a market holiday, but it is not a federal government holiday. So, every few years the employment report falls on that day and the bond market has to remain open. Such is the case in 2010. We look for a sharp jump in headline payrolls, reflecting some underlying improvement in labor market conditions and two important special factors. Specifically, we believe that unusually severe winter storms shaved about 100,000 from February payrolls and anticipate that just about all of those jobs will be recouped in March. Also, we look for about 100,000 census-related hires to show up this month. Thus, our March payroll forecast ex-census and weather rebound is +100,000. Even though the initial jobless claims figures have been somewhat noisy in recent weeks, a downward trend seems to have re-emerged. Moreover, the expected pick-up in underlying employment growth is consistent with: 1) the recent jump in temp help hires, 2) the sharp deceleration in layoff announcements, and 3) the recent improvement in withheld tax collections at the federal government level. Finally, over the past couple of months, the household survey has shown far larger employment gains than the establishment survey. But the household survey sample size is very small and we look for some reversion toward the mean this month. This, combined with an expected rise in labor force participation, is likely to lead to a slight uptick in the jobless rate.
In this focus piece, we look at the issue of competitiveness across CEE, with a particular emphasis on the Central Europe ‘core' (the Czech Republic, Hungary, Poland), as well as Romania and Bulgaria. We look at the issues of cost, tax and overall business environment, which are an investor's main considerations when deciding where to invest. We conclude that, even though the region is not as cheap as it was years ago, it continues to offer a compelling cost advantage along with an improved business environment. We believe that protectionist threats are not credible and investment flows will continue, especially as the FDI cycle picks up. This underpins our view that, even if not at the breathtaking speed of 2004-07, convergence will continue.
Huge FDI flows, especially in the aftermath of EU accession, have been a significant growth driver across CEE. These flows, regarded as more stable and growth-enhancing than debt and portfolio flows, financed a significant part of the external deficits of most countries. Predictably, they dried up in 2008-09, as foreign corporates retrenched, reinvested less money in the region and provided less funding to their CEE subsidiaries (greenfield FDI, reinvested earnings and intercompany loans are all included in FDI).
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