New normal: RIP? We don't want to short-change the growth debate; it remains central, as the tepid employment report underscores. Non-farm payrolls rose just 103,000 in December; inclement weather likely depressed the job tally somewhat. It's far from a boom or even a truly vigorous recovery. Nonetheless, average monthly private payroll growth in 4Q10 was the strongest in nearly four years. Thus, despite well-worn and obvious, lingering headwinds, we think that the debate about growth is largely over. And several factors at the least assure moderate growth and raise the odds of a more bullish outcome this year and next: the combination of generally better-than-expected incoming data, faster-than-expected deleveraging, the one-two punch from new fiscal stimulus and a Fed committed to achieve its dual mandate, and a dramatic reduction in political uncertainty. Consequently, we continue to expect 4% real growth over the four quarters of 2011.
The inflation debate, however, is even more important: It has only just begun, inflation is not in the price, and thus even a genuine bottoming in inflation, let alone an increase, would have significant market and policy consequences. We don't think inflation will rise back to the Fed's ‘mandate-consistent' rate of 2% or just below until 2012. But a rise in core inflation back above 1% in the next several months is highly likely, in our view, and that inflection point will kick off the inflation debate in earnest. Here's why.
Inflation inflection point. We believe that inflation is bottoming and will gradually move higher. A tug of war is under way: Significant slack in markets for goods and services, housing and labor will depress inflation. But stable-to-higher inflation expectations will push it higher. While operating rates are low and the jobless rate is high, changes in those gaps - so-called ‘speed effects' - are promoting an inflation inflection point. That is especially the case for rents, which are a major inflation component and which are already moving higher. While we've discussed this view elsewhere at length, we think the uncertainty around the inflation process makes it worth reviewing some fundamentals.
In addition, several global factors seem likely to contribute to US inflation over the next few months. Among them: Strong global demand and limits on supply are boosting energy and food quotes. Energy quotes jumped by 17% (not annualized) in the three months ended in December. While the pace should slow from here, our commodity team believes that the direction is higher. Measured in the CPI, meanwhile, US retail food prices have also accelerated - admittedly to a modest 2.4% annual rate in the September-December span. But the strength of global demand is pushing food prices higher, and there are upside risks to our November view that food inflation would be limited to 2-3%. Finally, many prices for imported goods are beginning to turn up again, despite the recent stability in the dollar. We believe that sellers typically pass some of these price hikes through to core prices with roughly a 2-4-month lag, and these price hikes may also contribute to US inflation by reviving inflation expectations.
Two-tier economy to persist. The impressive improvement in most incoming data and the onset of new federal fiscal stimulus hint that 4% growth is likely, perhaps even conservative. But neither of those developments changes the ongoing dichotomy in overall economic performance: Strong leadership from exports and capital spending will continue to outweigh the drag from weak housing activity/home prices and from ongoing state and local government budget cuts, but those two headwinds may take one percentage point or more from growth this year.
The upper tier is strong... Reflecting the strength of global growth, exports have been a boost to US growth, but until recently a surge in imports has been an even bigger drag. Now, net exports seem likely to provide a major boost as the import surge reverses and import growth seems likely to be subdued. In addition, pent-up demand for capital spending is healthy; in the recession, capex slipped well below depreciation expense. Together with the acceleration we expect in economic activity and the business expensing provisions of the new tax deal, that pent-up demand should spur hearty gains in capex in the coming year. And we think improving fundamentals will boost capex outlays in 2012 despite the inevitable ‘payback' in outlays after the tax expensing provision expires.
...while the lower tier is still fraught. In contrast, housing imbalances remain the most significant single downside risk; we expect a 6-11% decline in home prices this year, which will limit the supply of mortgage credit, restrain consumer net worth, and thus cap growth in consumer spending. Mortgage credit is still tight; indeed, in 4Q banks signaled tighter standards for mortgage lending. The ongoing issues around mortgage ‘putbacks' continue to keep origination criteria from loosening, although recent developments have greatly reduced the uncertainty associated with putbacks. Second, state and local government finances remain weak; faced with additional shortfalls, officials are likely to cut spending and employment somewhat further, especially as federal grants fade. In particular, some $26 billion in assistance for Medicaid will disappear in July. The good news is that revenues are starting to improve, which should somewhat mitigate that risk.
Shift in policy mix implies higher real rates. QE2 was aimed at reducing real yields to boost credit-sensitive demand; its impact was always likely to be small, given its limited scope. But anticipation of QE2 did reduce real yields and promote refinancing, and perhaps more importantly, it helped to break the policy logjam and uncertainty that plagued businesses and consumers during the spring and summer. In contrast, the shift to fiscal stimulus - and the expectation of its success - implies that real and nominal yields will continue to move somewhat higher. Partly for that reason, we expect that 10-year Treasury yields will move 50-75bp higher, to 4%, over the course of 2011.
Fed on hold through 2011 - but markets likely will anticipate a move in 2012. In addition, expectations of a change in monetary policy may contribute to an increase in yields across the maturity spectrum. Our Fed call is unchanged: An inflection point in inflation and hearty growth will not be enough to trigger any change in monetary policy in 2011. Inflation will still be below the Fed's ‘mandate-consistent' rate of 2% or slightly below, and the unemployment rate will still be far above an acceptable level. But by mid-year, we think investors' outlook for inflation will begin to change as the forces pushing inflation higher start to gain the upper hand and the infection point is clearly in sight. At that point, anticipation of the first step away from zero policy rates that we expect early in 2012 will begin to affect the front end of the yield curve.
Six risks to the outlook: A matter of degree rather than of kind. Notwithstanding our more upbeat view for 2011, we're acutely aware of the risks that still lurk. In varying degrees, we've tried to capture six in our baseline outlook. So, the six risks that we see all represent an intensification of factors that we or our colleagues have flagged as challenges for economic or market performance.
Two of these risks are domestic: Housing prices could decline by more than the 6-11% we and our housing research team expect. With seven new GOP governors coming into office, and both budget and funding pressures persisting, state and local government spending cuts could be more intense than we anticipate. Four of the risks represent intensification of global challenges that are already in our baseline global view: more spillover from Europe's sovereign crisis; more Chinese monetary tightening; a surge in crude quotes to $120 or more; and politics interfering with appropriate policy responses. On the last risk, the looming battle over budget priorities seems likely to crystallize in a showdown over increasing the federal debt ceiling, which could prove disruptive to financial markets.
For full details, see US Economics: Growth Debate Over, Inflation Debate Begins, January 7, 2011.
The political winds appear to be pointing to a repeat of the 1995-96 showdown between the president and House Republicans, when the US Treasury came perilously close to missing a coupon payment, auction schedules were disrupted, and the federal government shut down for weeks at a time. While incoming House Speaker John Boehner has indicated that elected representatives need to act like "adults" when it comes to dealing with the debt ceiling, it's not clear that this message is getting through to the rank and file.
Over last weekend, a number of new members of Congress appeared on the political talk shows and pledged to block a debt ceiling hike unless "significant" fiscal reforms are adopted. The desired policy measures appear to include a $50-100 billion cut in discretionary spending levels that would return budget appropriations to FY 2008 levels. But, there seems to be more at work than here than just an attempt to use the debt ceiling to achieve broader policy objectives. For example, one well-known Congressional Republican (Michelle Bachmann of Minnesota) is promoting an internet-based petition opposing a hike in the debt ceiling under any circumstances. In any event, most Washington insiders sense that a major political battle looms - and we concur. In this note, we analyze the timeline and the potential consequences of the debt ceiling showdown.
First, some background. A statutory limit on the amount of federal government debt outstanding has been in place since 1917, when Congress enacted the Second Liberty Bond Act. The current limit is $14.294 trillion. Since 1940, the debt ceiling has been increased on 80 separate occasions.
The ceiling applies to almost all federal debt, including: 1) marketable issuance, 2) non-marketable securities (such as savings bonds and State & Local government securities - or SLGS - issued in conjunction with a municipal bond refunding), and 3) debt that the US government owes to itself (such as trust fund obligations for social security, Medicare, civil service retirement, etc.). Thus, the public auctions held by the Treasury on a regular basis are not the sole determinant of growth in the debt subject to limit. Indeed, intragovernmental obligations currently account for nearly one-third of the overall debt subject to limit.
The debt ceiling showdown amounts to a high stakes game of chicken. Obviously, Treasury officials want to avoid default at all costs. But, at the same time, they don't want to make it appear that they can easily skirt the constraints imposed by the debt ceiling and allow the key players to continue bickering in a seemingly unending manner. Such a scenario could disrupt the standard and predictable cycle of debt issuance and raise borrowing costs. Since it often seems that Congress won't act until forced to - and since a vote in favor of a hike in the debt ceiling is politically unpopular - the threat of default needs to be taken seriously enough to spur action. Hence, a game of chicken ensues. We expect to see an extended period of threats and counter-threats play out over the course of the spring and summer, leading to auction delays, shortened when-issued trading periods and investor uncertainty.
Likely timeframe. The government's borrowing needs are highly seasonal and fluctuate according to individual and corporate tax dates, benefit payment dates, and debt service payment dates. We illustrate our estimate for the amount of borrowing capacity remaining under the current debt ceiling over the course of the coming months. Absent any special action by the Treasury, we believe that the debt ceiling would first begin to pose problems in late March. However, the initial step to address the problem is relatively straightforward. Beginning in early March, we believe that the Treasury will start to wind down the Supplementary Financing Program (SFP). This will free up $200 billion in borrowing capacity. But, it could also have a meaningful impact on the bill sector, with spillover to the rest of the money markets, since the SFP represents about 10% of the outstanding supply of bills at present. Around the same time, the Treasury is also likely to suspend SLGS issuance. Once these steps are taken, and with the benefit of April tax inflows, the Treasury will likely remain under the limit until late May. At that point, more drastic action would be necessary.
The most powerful tool that the Treasury has to maneuver around the debt ceiling is to suspend reinvestment of certain government trust funds (note: this is often referred to as "disinvesting" the trust funds). Such action must be preceded by announcement of a "debt issuance suspension period". This is an accounting gimmick that has been used in the past to free up some borrowing authority (for more details, see the GAO reports, Debt Ceiling: Analysis of Actions Taken During the 2003 Debt Suspension Period and Debt Ceiling: Analysis of Actions During the 1995-1996 Crisis).
Based on the current asset values of the relevant trust funds, we estimate that the Treasury could generate about $250 billion of additional borrowing capacity, broken down as follows: disinvest G-fund ($125 billion), disinvest a portion of civil service retirement fund based on a debt suspension period declaration of 12 months ($90 billion), disinvest Exchange Stabilization Fund ($20 billion), and transfer some civil service fund debt to the Federal Financing Bank ($15 billion). This means that the debt ceiling might not be reached until late July or early August. The borrowing need steadily rises over the course of the rest of the summer, so it seems to us that action to raise the debt ceiling will be imperative by Labor Day.
In past episodes, Congress has sometimes approved short-term increases in the debt ceiling that expire within a few days or weeks as it continues to struggle to reach a compromise agreement on a longer-term extension. In these situations, the Treasury Department will typically postpone coupon auctions and issue very short-term cash management bills that coincide with the timeframe of the temporary extension. After a permanent hike is enacted, all of the delayed coupon auctions are rescheduled. We summarize the actions that the Treasury Security is likely to employ in order to avoid default.
If Congress refuses to enact even a temporary extension, then the Treasury will eventually run out of accounting gimmicks and will be unable to legally meet the government's obligations. Obviously, this scenario has an extremely low probability, but it is non-zero. In fact, during the 1995-96 episode, a number of key players even argued that it would be less damaging to the economy and the financial system for the Treasury to default than it would be for the Republicans to back away from the pledge to achieve a balanced budget. In addition to the aforementioned speech by House Speaker Gingrich, commentator James Glassman authored an op-ed in the Washington that said default was not as bad as "Wall Streeters" say it is. And, two well-known money managers took out a full-page ad in the Washington Post that said: "Let's not allow fears of temporary market instability serve as an excuse for equivocating on spending cuts".
Continuing Resolution expiration versus debt ceiling. Each year, Congress is supposed to pass and the president signs 13 separate appropriations bills by the start of the new fiscal year (October 1) to fund all of the federal government's discretionary spending programs. If the Congress and president fail to pass all of the appropriations bills - as has been the norm for many years - then Congress and the president will typically agree to a Continuing Resolution (CR) which provides temporary funding authority. Although the debt ceiling situation is unlikely to come to a head until summer, it's important to recognize that there is a risk of a federal government shutdown well before that point. That's because the federal government is currently operating under a CR that expires on March 4, and the new Congress may try to block an extension unless demands for spending cuts are met.
In fact, there have been a number of federal government shutdowns in recent years, and all of them have been attributable to a lapse in funding authority - not a debt ceiling constraint. There is some confusion about this matter because, during the most serious episode (in 1995-96), a debt ceiling crisis played out simultaneously with a CR expiration (note: Wikipedia has a nice summary of the events surrounding the 1995-96 government shutdown). A debt ceiling crisis is far more serious because it affects all government obligations - interest payments, social security, Medicare, etc. A lapse in a CR only impacts discretionary spending programs and even has a waiver for personnel and services deemed to be "essential".
Market implications. In addition to the direct impact on the Treasury bill market associated with a winding down of the SFP, a debt ceiling showdown could rattle investor confidence. It's always a bit difficult to isolate the market impact of factors such as this that tend to play out over a lengthy period of time, because so much else is going on at the same time. But there is some evidence to suggest that there was a noticeable spillover effect on bond and currency markets during the 1995-96 experience. For example, in the lead-up to the 1995-96 episode, House Speaker Gingrich delivered a speech in which he warned that he was prepared to default on the debt unless the president agreed to Republican demands. "I don't care what the price is", Gingrich said. Here is a Washington Post report from September 21, 1995 that (partially) attributed a significant move in the dollar and a rise in Treasury bond yields to that threat:
"House Speaker Newt Gingrich threatened today to send the United States into default on its debt for the first time in the nation's history, to force the Clinton Administration to balance the budget on Republican terms. His comments, a more extreme version of the hardball stance frequently used in past budget showdowns, raised the specter that the looming stand-off may begin to rattle financial markets around the world. Mr. Gingrich's remarks came in the middle of a day in which the dollar plunged as much as 5 percent against major currencies before recovering slightly, sending interest rates up sharply. The Speaker's statement appeared to be one of several factors that added to the markets' unsettled condition. More broadly, Mr. Gingrich's speech to the Public Securities Association, which represents traders in government debt, underscored the growing agitation and sense of imminent collision in official Washington as both Democrats and Republicans move toward a confrontation that could shut the government down this fall."
Will Congressional opposition to a debt ceiling hike lead to meaningful fiscal reform? Of course, anything's possible, but it seems unlikely that a major shift in the direction of fiscal policy will occur any time soon. A return to FY 2008 levels of appropriations for non-defense discretionary spending probably amounts to no more than $50 billion of cuts relative to the Continuing Resolution baseline. And, as Treasury Secretary Geithner indicates in his recent letter to Congress formally requesting a debt ceiling hike, even if these spending cuts were adopted, "the need to increase the debt limit would be delayed by no more than two weeks".
What's really needed from the standpoint of fiscal reform are long-term measures to rein in the deficit. The Bowles-Simpson deficit commission offered some bold initiatives that, from our standpoint, would move fiscal policy in the right direction over the long run. However, although the overall Commission voted 11 to 7 in favor of the final package of recommendations, the vote among those members who are returning to Congress was 6 to 4 against. While some components of the Commission's recommendations may come up for a vote in Congress, support appears lukewarm at best. In other words, it's very hard for elected representatives to agree on the tough choices that are needed to achieve significant fiscal reform. At the end of the day, we're likely to experience a tough political battle that will disrupt markets somewhat but achieve little in terms of meaningful policy change.
Treasuries ended the past week sharply mixed - little change at the front end, modest further gains in the intermediate part of the curve on top of the prior week's outperformance, and substantial losses at the long end - after a big rally Friday in response to the disappointing employment report reversed significant losses across the curve seen through Thursday on better economic news through the first part of the week and pressures from record corporate issuance. The December employment report wasn't terrible, but after the surge in the ADP employment report added to widespread signs of accelerating labor market improvement, including claims, the Challenger and Manpower surveys, and strong recent individual tax receipt growth, seeing payrolls at +103,000 come in below the October/November average and other details of the establishment survey (flat average workweek, only minor gains in aggregate hours worked and average earnings, small rise in aggregate earnings that will be negative in real terms) show little improvement was certainly a letdown. And the much more positive 0.4pp drop in the unemployment rate to 9.4% was discounted since it came to a significant extent from a sharp decrease in the labor force that is unlikely to be sustained. On top of the boost from the softer-than-expected employment results, a significant renewed deterioration in sentiment towards peripheral EMU sovereign credit and increasing signs of contagion into core Euroland, which flowed through into significant worsening in US muni bond CDS, and associated pressure on European bank debt, provided a flight-to-safety boost to Treasuries late in the week. Prior to the employment report, economic data released during the week were more positive but, setting aside the misleading ADP report, also mixed. Both ISM surveys posted strong results, with the non-manufacturing index exceeding the manufacturing index for the first time in the recovery, a positive indication of a broadening expansion. Motor vehicle sales rose more than expected to extend the best three-month run since 2008, but chain store sales growth significantly decelerated in December after a very strong start to holiday shopping in November, pointing to a slowing in underlying retail sales. As a result, we trimmed our 4Q consumption forecast to +3.8% from +4.1% and GDP to +4.3% from +4.5%.
After seeing a 7-19bp long end-led sell-off through Thursday, Friday's strong 5-year-led post-payrolls rally left yields at the short end unchanged on the week, belly of the curve moderately lower, and long end significantly higher. The 2-year yield rose 1bp to 0.60%, 3-year was unchanged at 0.98%, 5-year fell 6bp to 1.95%, 7-year fell 3bp to 2.68%, 10-year rose 3bp to 3.33%, and 30-year rose 15bp to 4.49%. TIPS solidly outperformed, especially at the shorter end. An expected big gain in Friday's CPI report and a general move by investors into inflation hedges at the start of the year more than offset any drag from a pullback in commodity prices, with the CRB index falling 2.7% on the week after hitting a multi-year high Monday. The 5-year TIPS yield fell 18bp to -0.22%, 10-year fell 4bp to 0.94% and 30-year rose 5bp to 1.91%. This lifted the benchmark 10-year inflation breakeven 7bp to 2.39%, down from the one-year high of 2.46% hit at Wednesday's close. With shorter-end inflation expectations rising more, the 5-year/5-year forward inflation breakeven ultimately ended only slightly higher near 2.80% (based on constant maturity yields), down from a cycle (and near historical) high 2.90% hit Wednesday. The further outperformance by the intermediate part of the Treasury curve tracked another week of solid outperformance by mortgages, which extended their recovery from a horrific run seen from early November to mid-December. Fannie 4s outperformed Treasuries by about 12 ticks on the week after a 9-tick outperformance the prior week, helped by very light origination, bank buying, and a decline in interest rate volatility, lowering current coupon yields to near 4% from 4.1% at the end of the prior week and the mid-December highs near 4.4%. After a run-up from record lows near 4% in early November to highs around 5% in mid-December, this rebound has helped stabilize 30-year mortgage rates recently near 4.75%. The impact of that prior big run-up will take a while to work its way through the monthly economic data, however. The immediate impact is likely to be a rise in home sales as prospective buyers were spurred into action by the rise in rates, which has been flagged by recent strength in mortgage purchase applications and the pending home sales index. Clearly, though, such a dynamic would tend to lead to a front-loading of home sales followed by a correction.
While the MBS market outperformed Treasuries, shorter-end swap spreads saw significant widening over the past week, as interbank rates were pressured by the rising worries about the European fiscal situation and apparently rising momentum to implement bank debt haircuts as a formal part of a future sovereign debt resolution mechanism. Eurodollar futures through 2012 posted losses on the week, led by 6-6.5bp losses in the Sep 11 to Mar 12 contracts. Renewed European-led pressure on dollar interbank rates is being priced much more as a tail risk going forward this year at this point than an immediate threat, since 3-month Libor didn't move and the spot 3-month Libor/OIS spread held at a very calm 12bp. The forward Libor/OIS spread to March, however, rose 3.5bp to 21.5bp, June 6bp to 29bp, and September 5bp to 32bp. These adjustments pressured shorter-dated swap spreads, with the benchmark 2-year spread up 4.5bp to 26bp.
Risk markets diverged significantly over the past week, with stocks focusing on the improving economic outlook (with a bit of softening after the disappointing employment report) while credit was hurt by weakness in Europe. The S&P 500 gained 1.1% for the start of 2011 on a strong pace after last year's 13% rally. The more cyclical technology, financial, and industrial sectors outperformed, but the generally defensive healthcare sector also performed quite well. In contrast to the solid stock market gain, the investment grade CDX index widened 4bp to 89bp, hurt by a 7bp widening in the iTraxx Europe index to 112bp, with significant pressure on European financials. The muni bond market also came under significant renewed pressure as the sovereign credit worries in Europe intensified. 5-year CDS spreads for Ireland (+35bp on the week to 650bp) and Portugal (+45bp to 545bp) ended the week at new closing highs, though Spain (+8bp to 358bp) held steadier. Peripheral worries continued to spread into the softer Euroland core, with Belgium (+35bp to 252bp) hitting a new wide as its political crisis showed no signs of resolution and Italy (+17bp to 255bp) weakening notably. Contagion is even starting to become more evident in the harder core, with France (+9bp to 110bp) also moving to a new wide. Spillover from European sovereign credit concerns drove the 5-year muni bond MCDX index 20bp wider to 237bp, its worst level since July.
Non-farm payrolls rose a sluggish 103,000 in December on top of upward revisions of 70,000 to November (+71,000 versus +39,000) and October (+210,000 versus +172,000), but the unemployment rate plunged 0.4pp to a 20-month low of 9.4%. The main negative payrolls surprise was an only 12,000 gain in retail jobs for a small decline in November and December holiday hiring, sharply contrasting with industry surveys showing intentions to sharply boost temporary holiday payrolls. On the positive side, this means that there will be fewer post-Christmas firings of temporary holiday retail workers, so there could be upside in seasonally adjusted retail payrolls in coming months. Other details of the establishment report were also muted. The average workweek was flat at 34.3 hours, which left total hours worked up 0.1%. With average hourly earnings ticking up 0.1%, aggregate earnings gained 0.3%, which will be negative in real terms after the expected surge in December inflation.
Within the much stronger household survey results, the plunge in the unemployment rate reflected both a big gain in employment (+297,000) and a plunge in the labor force (-260,000). The labor force drop lowered with the labor force participation rate to a new 27-year low. This will probably start moving in the other direction this year, and the return of discouraged workers to an improving job market will likely slow further improvement in the unemployment rate. We see unemployment falling to 8.5% at the end of this year. Widespread indications point to an acceleration in payroll job growth in the coming months, however. Jobless claims have been steadily improving since mid-August after the mid-year soft patch ended, with a further 3,500 decline in the four-week average of initial claims in the latest week to 410,500, a low since July 2008 after a 77,250 drop from the mid-August high. Job cutting plans continue to plunge, with the Challenger survey showing a 29% decline in December that brought the total for 2010 to a ten-year low, and hiring plans have been picking up, with the Manpower survey showing a good gain in 1Q hiring plans to the best level since 2008. Job openings in the BLS's JOLTS survey have similarly been trending higher recently to the highest levels since 2008. And individual tax receipt growth has sharply accelerated in recently, suggesting the possibility that the payroll numbers are underestimating job growth, with withheld income and payroll tax receipts up 8%Y in 4Q and 10% in December.
The other key early data were also somewhat mixed, with very strong results from both ISM surveys and upside in motor vehicle sales but a significant slowdown in chain store sales after the big start to the Christmas shopping season in November. The composite manufacturing ISM index rose to a seven-month high of 57.0 in December from 56.6. Underlying details showed a larger improvement, with the key orders (60.9 versus 56.6) and production (60.7 versus 55.0) indices posting big gains that were partly offset by a sharp drop in the inventories gauge (51.8 versus 56.7). The employment index (55.7 versus 57.5) also pulled back but remained at a high level. The manufacturing sector recovery broadened a bit in December, with 11 of 18 industries reporting growth, up from 10 in November. The composite non-manufacturing ISM index gained 2 points in December to 57.1, a high since mid-2006. This was the first time the non-manufacturing gauge has exceeded the manufacturing index since the recession ended in mid-2009, as the initially manufacturing-led recovery continues to broaden. Upside in December was led by big gains in the business activity (63.5 versus 57.0) and orders (63.0 versus 57.7) gauges to their best levels since 2005. This was partly offset by a pullback in the employment index (50.5 versus 52.7) from a three-year high hit in November to an only slightly positive level. Growth was much more broadly based, with 14 of 18 industry groups reporting expansion in December, high since June and up from 10 in November.
Early indications for December retail sales were negative overall, though the gains through November still point to a big acceleration in consumption for 4Q as a whole. Motor vehicle sales rose to a better-than-expected 12.5 million unit annual rate in December from 12.2 million in both November and October, the best three months aside from the peak month of cash for clunkers since September 2008. Retail auto sales likely showed a bigger pick-up, as both GM and Ford reported a significant decline in the share of their sales going to businesses. Offsetting this, however, was a deceleration in chain store sales after the very strong November results. Bad weather in December was likely a bit of a drag, but it also appears that the momentum in sales on the weekend after Thanksgiving didn't fully carry through the rest of the holiday shopping period. Based on these results, we look for the retail control component of the retail sales report to dip 0.1% in December after surging 0.9% in November. With a partial offset from the upside in auto sales, we lowered our 4Q consumption forecast to (a still quite strong) +3.8% from +4.1%. Building in some small adjustments from other data released through the week and tweaking various assumptions, we lowered our 4Q GDP forecast slightly to +4.3% from +4.5%.
There is another busy economic calendar in the coming week, with focus on retail sales and CPI on Friday. The main issue for rates markets this week, however, could be very heavy supply. There is $66 billon in gross Treasury coupon supply Tuesday to Thursday ($32 billion 3-year Tuesday, $21 billion 10-year reopening Wednesday, and $13 billion 30-year reopening) along with a lot of government bond issuance in Europe through the week across core and peripheral countries (see European Auction Pipeline: The Month Ahead, Elaine Lin, January 6, 2011). Corporate supply is also likely to remain heavy after record issuance the past week. Data releases due out include the Treasury budget Wednesday, trade balance and PPI Thursday, and retail sales, CPI, and industrial production Friday:
* We expect the federal government's budget deficit to narrow $12 billion from a year ago in December to $78 billion. The improvement would be more significant were it not for an important special factor. Specifically, commercial banks were required to prepay about $45 billion of deposit insurance premiums in December 2009, which held down the reported deficit for that month. This effect was partially offset by calendar quirk which resulted in lower outlays for regular monthly benefit obligations compared to the previous year. The underlying improvement in the budget picture is being driven by a pick-up in tax collections. Receipts appear to have risen about 9% in the first quarter of the new fiscal year relative to the same period a year ago.
* We look for the trade deficit to widen $3 billion in November to $41.5 billion, reversing half of the sharp $6 billion narrowing seen in October, with exports expected to be up 0.9% and imports 2.2%. Another surge in agricultural export prices and further gains in other commodity prices should provide a solid boost to exports. On the import side, a surge in petroleum products on higher prices and a rebound in volumes after last month's steep decline should account for the majority of the upside. Port data also point to a decent further rise in non-energy goods imports.
* We forecast a 1.0% surge in the headline producer price index in December and a 0.2% rise in the core. Another month of sharp gains in the food and energy categories is expected to lead to some significant elevation in the headline PPI. In particular, an estimated 7.5% run-up in quotes for wholesale gasoline is a key contributor to the upside. Meanwhile, the core PPI is expected to register another modest rise, with some of the recent elevation in raw materials prices beginning to show up in finished goods. However, the motor vehicle sector continues to represent an import wildcard that drives most of the month-to-month volatility in the core PPI measure.
* We forecast a 0.6% gain in overall retail sales in December and a 0.3% rise ex autos. Following impressive results in November, the chain store results for December were much weaker than anticipated. In fact, we look for a slight outright decline in the key retail control measure that feeds directly into the calculation of personal consumption spending. However, auto company reports showed stronger-than-expected unit sales, so we look for a solid rise in the auto dealer component of retail sales. Also, we should see another sharp jump in gas station sales tied to higher prices. For the quarter as a whole, we see consumption at +3.8%.
* We look for a 0.6% gain in the overall consumer price index in December and a 0.2% gain in the core. The headline CPI is expected to show a sharp jump in December, mainly driven by a spike in gasoline prices. Prices at the pump rose nearly 5% during the month, and this is a time of the year when prices typically decline, so the seasonal factor adds on a few more percentage points. Meanwhile, the food category should edge higher, with sizeable increases in some important categories partially offset by a drop in milk prices. Most importantly, we look for the core CPI to post its biggest increase since April 2009. The 0.1% rise in the core in November was restrained by an unusually small seasonal boost, with the seasonal factor adding 0.1 percentage point less than in November of past years. There should be some catch-up in December. In addition, both used cars and hotels saw further significant weakness in November, continuing a recent major divergence from industry data. We expect the CPI results in these categories to begin to move toward the industry reports. Finally, the core is expected to be very close to +0.85% on a year/year basis and thus could round up or down.
* We forecast a 0.8% gain in December industrial production. The employment report pointed to a modest gain in non-auto factory output during December, with the sharpest increases likely to come in sectors such as computers, food, machinery, and electrical equipment. Meanwhile, industry data show that motor vehicle assemblies edged up slightly in December. Overall manufacturing output is expected to be +0.5%. The remainder of the anticipated rise in IP is attributable to a weather-related spike in utility output, as temperatures across much of the nation turned much colder than normal during the month.
Chile welcomed the New Year with the announcement of an intervention program involving the purchase of US$12 billion over the course of 2011. The central bank justified the move through the desire to boost international reserves - which ended 2010 at US$27.9 billion or 15% of GDP - as well as to help "smooth out the effects" on the economy of the ongoing exchange rate adjustment.
Unlike many central banks in the region which have been quite active in currency markets, Chile's intervention has been the exception rather than the rule: since the peso began to float freely in 1999, the central bank has only stepped in under "exceptional circumstances" for a total of four times (including last week's move). By the end of last week, the central bank had succeeded in weakening the peso by near 7% versus the dollar, sparking fears among some Chile watchers of a repeat of 2008, when the peso experienced a period of persistent depreciation in the aftermath of the April 10 unveiling of a plan to purchase US$8 billion. After all, intervention in both years came after a prolonged bout of peso appreciation - which pushed the real effective exchange rate to similar levels - and involved equivalent dollar amounts.
Though the New Year's intervention program shares many characteristics with the 2008 episode, today's supportive fundamental backdrop suggests that persistent peso weakness is unlikely, in our view. In 2008, after hitting 434 per dollar in early April, the currency experienced a prolonged bout of depreciation, weakening by some 15% two months after the start of intervention. Though the initial spike in the currency following news of central bank action has been sharper this time around, strong fundamentals - ranging from solid growth prospects, record-high terms of trade and prospects for further central bank tightening - suggest that once the dust settles, the exchange rate is likely to be well supported (see "Latin America: 2011 Currency Outlook", This Week in Latin America, December 13, 2010).
Shades of 2008...
For the most part, the dollar purchase program announced on January 3 is equal in form to the actions from April 2008. Though the current program involves US$12 billion over the course of 2011 - or a 50% increase versus the 2008 plan (US$8 billion) - in 2008 the intervention span was just eight months (April 14-December 12). Indeed, the central bank began both programs with daily US$50 million auctions while retaining the ability to revise the daily amounts based on market conditions. And as has been customary in Chile, the central bank's actions were not open-ended; instead, the authorities informed the amounts and tools involved, as well as the timeframe for the intervention. Though in 2008 the global financial crisis led to a premature end of intervention on September 29 - international reserves rose by US$5.8 billion from mid-April of that year - absent major global dislocations we see a high probability that the central bank will complete its entire 2011 plan. Unlike 2008, importantly, last week the central bank stressed that that intervention involves "relevant financial costs" (the difference between the central bank's funding cost and what it earns on its reserves) and that there is "limited slack" on this front, suggesting that increasing the purchases beyond US$12 billion is unlikely, in our view, particularly when the fully sterilized nature of the program is already adding pressure to local interest rates.
The objective of increasing the level of international reserves was prominent in both cases, even though today Chile's reserves to GDP (15%) are comparable to those of Brazil (14%) and Argentina (13%) and ahead of Mexico's (11%). Importantly, the government is sitting on ample international assets held mainly in the Economic and Social Stabilization Fund (US$12.6 billion), which combined amount to just over 9% of GDP. Last, after a prolonged period of appreciation, the authorities choose to act in both years when the real effective exchange rate was at levels within 1% of each other, according to our calculations.
...but a Different Fundamental Backdrop
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