U.S.: Review and Preview
Ted Wieseman/David Greenlaw (New York)
The Treasury yield curve flattened sharply over the past week, as the Federal Reserve hiked rates another 25 basis points and, in the statement announcing the move and minutes from the August FOMC meeting, suggested that it remains optimistic about the economic outlook and on track for continued measured rate hikes. The Fed?s ?steady as she goes? rhetoric forced the futures market to price in the possibility of more near-term rate hikes, but investors? pessimistic views on growth and complacency on Fed policy led the expectations of more near-term rate hiking action to be largely mirrored in lowered expectations for next year. The economic data calendar in the past week was very quiet, but better than expected capital goods shipments in the durables report led us to raise our Q3 GDP estimate to +4.1% from +3.9%. With little economic data, aside from post-Fed adjustments, investors focused on activity in other markets and more technical considerations. In particular, the curve-flattening move was significantly boosted by the larger than expected drop in crude oil inventories reported Wednesday ? although the Energy Department predicted that it would prove to be a temporary result of hurricane disruptions and reversed in coming weeks ? and an associated spike in energy prices and decline in equities. The resulting strength at the long end of the market took the 10-year yield below 4% Wednesday afternoon, leading to increased focus on the possibility of heavy mortgage duration-related buying, but there was a lack of follow-through, and the 4% level didn?t hold. Still, with our mortgage research team estimating that a move to 3.8% would leave 70% of the mortgage market fully refinanceable (see the September 17 edition of MBS Perspectives entitled ?Cliffhanger?), the market remains in the convexity danger zone and susceptible to self-reinforcing moves on surprises in the data or swings in other markets ? based on both actual mortgage flows and other investors trying to front-run such flows. There is a very busy economic calendar in the coming week, which we expect to have a positive tone overall from expected improvements in ISM and car sales and an upward revision to Q2 GDP. But focus remains on the October 8 employment report for a verdict on whether the economy is gaining ?traction? or stuck in the ?soft patch.? The Treasury yield curve flattened dramatically in the past week, with 2?s-30?s moving 20 bp lower on a 12 bp drop in the long bond yield to 4.80% and an 8 bp rise in the 2-year yield to 2.58%. The week?s end 222 bp 2?s-30?s spread was the lowest since April 2002. The 10-year yield ended at 4.03%, down 10 bp on the week, after trading as low as 3.96% Thursday before the release of the FOMC minutes. The break below 4% was clearly accompanied by significant mortgage-related receiving in swaps, with the 10-year swap spread moving to just above 40 bp at the 10-year yield bottom before rebounding to near 42 bp at Friday?s close, 1.5 bp narrower on the week. The 18 bp flattening in 2?s-10?s on the week to 145 bp was the lowest spread since before 9/11/01. The 5-year yield ended 2 bp lower at 3.325%, and the 3-year 4 bp higher at 2.84%. The big curve-flattening move began after the Fed?s mostly unchanged policy statement disappointed investors who were looking for some signal of a near-term pause in the rate-hiking cycle, pressuring the front end and pushing buying out the curve. With little room for gains at the front end, a spike in oil prices Wednesday that followed the announcement by the Energy Department of a larger than expected 9.1 million drop in crude oil inventories in the latest week continued to support the longer end and significantly heighten mortgage convexity fears as the 10-year yield cracked the 4% barrier. When the market fell from the highs Thursday and Friday in response to more hawkish than expected FOMC minutes and the durable goods report, the prior bullish curve-flattening move continued in a bearish manner into week?s end. Despite the $3 a barrel rise in benchmark oil in the past week, TIPS continued to underperform. An 8 bp drop in the real 10-year yield, to 1.77%, trailed the nominal benchmark and left the 10-year breakeven inflation spread 2 bp lower at 2.26%. The outcome of the past week?s FOMC meeting was as expected ? a unanimous vote for a 25 bp rate hike to 1.75% and no change in the formal risk assessment. The official statement accompanying the action contained minimal changes that did not appear to have been aimed at altering expectations for further rate hikes. Indeed, we believe that the FOMC remains solidly on track for another tightening at the November 10 meeting. Meanwhile, the minutes from the August FOMC meeting showed the Fed optimistic about the prospects for the economy gaining traction after the prior soft patch and continuing to plan a gradual return of policy to a more neutral setting going forward. There was not anything particularly surprising in this assessment from our perspective or anything out of line with Fed comments since August, but there was also no confirmation of the market?s increasing view that the end of the rate-hiking campaign may be imminent. Although members ?noted that the pace of expansion had moderated,? they believed that the ?softness would prove short-lived and that the economy was poised to resume a stronger rate of expansion going forward.? Looking ahead, they recognized that policy normalization had a long way to go to get to neutral ? ?members noted that significant cumulative policy tightening likely would be needed to foster conditions consistent with the Committee?s objectives for price stability and sustainable economic growth.? The neutral long-term real fed funds rate is probably around 3%, implying a 4% to 5% neutral nominal level, so the Fed has a lot of work ahead of it. The lack of any signals from the Fed that a near-term pause in rate hiking is being considered forced the futures market to price in more near-term Fed action. The rate on the November fed funds contract rose 3 bp to 1.895%, consistent with an 80% to 85% probability of a 25 bp rate hike on November 10, while the rate on the January contract rose 9.5 bp to 2.095%, a seven-week high, as investors raised the likelihood to 40% that there will be 25 bp rate hikes in both November and December. The near-term upside, however, was taken out of medium-term expectations, as red/white eurodollar spreads continued to compress sharply. Although rising off the midweek lows following the minutes and durable goods report, the spread between the December 2004 and December 2005 eurodollar contracts still ended the week 6.5 bp flatter at 96 bp, as the rate on the former rose 8.5 bp to 2.30% while the rate on the latter rose only 2 bp to 3.26%. The economic data calendar was very quiet in the past week. The most noteworthy release was the August durable goods report. Although the orders numbers were mixed, strength in capital goods shipments led us to raise our Q3 investment spending estimate. Overall durable goods orders fell 0.5% in August, with the drop more than accounted for by a 43% plunge in civilian aircraft that partly reversed a 104% spike in July. The weakness in aircraft offset a 5.7% jump in motor vehicle orders to leave overall transportation orders down 6.8%. Excluding transportation, orders rose 2.3%, with upside in fabricated metals (+4.2%), high tech (+4.1%), and electrical equipment and appliances (+1.8%). The key core orders measure ? nondefense capital goods ex aircraft ? was down 0.5%, however, restrained by flat machinery orders. Nondefense capital goods shipments gained 1.4% in August on top of an upwardly revised 1.8% gain in July, pointing to about an 18% jump in Q3 real equipment and software investment. The other noteworthy releases were housing-related, with August housing starts (+0.6%) hitting the highest level of the year, but existing home sales (-2.7%) posting a second straight decline to a level about 6% below the record June pace. Although homebuilding is holding up relatively well at this point, a pullback in sales from the record spring levels is likely to lead to some softness in residential investment in Q3. With both new and existing home sales hitting record highs in Q2, real brokerage commissions surged at a record 99% annual rate, contributing more than two-thirds of the 15% gain in overall residential investment. With sales moderating in Q3, brokerage commissions are likely to reverse some of the Q2 surge, contributing most of an expected 4% decline in residential investment. Netting the upside in business investment implied by the durables report and downside in residential implied by the existing home sales data, we upped our Q3 GDP estimate to +4.1% from +3.9%. On Wednesday we expect Q2 growth to be revised up to +3.3% from +2.8%. If these estimates are right, then annualized growth in Q2 and Q3 would have been +3.7%, not exactly the sort of disastrous relapse that would seem to be implied by the recent plunge in long-term yields and aggressive scaling back of expectations for Fed actions over the next year. The economic data calendar is busy in the coming week, but investors will likely continue to focus on the forthcoming employment report ? delayed to October 8 by the calendar quirk of the September survey week being as late as possible and the October first Friday as early as possible ? as the overwhelmingly most important near-term data release. There are also a number of Fed officials speaking in the coming week and the potential FX important comments from the G7 meeting on Friday. On the supply calendar, Treasury will announce a 2-year on Monday for auction Wednesday. We expect an unchanged $24 billion size. Key data releases in the coming week include new home sales Monday, Conference Board consumer confidence Tuesday, revised GDP Wednesday, personal income and Chicago PMI Thursday, and Michigan consumer sentiment, ISM, construction spending, and motor vehicle sales Friday: * We expect August new home sales to edge down by about 1% to a 1.12 million unit annual rate. Hurricane Charley may have delayed some contract signings, but we suspect that the impact was relatively minor. Weather-related factors may be more of an issue in September. Note that our August sales estimate is quite high from a long-run standpoint but is about 13% below the record peak seen in May. * The various consumer sentiment gauges showed little change in early September, so we look for the Conference Board index to rise slightly to 99.0 from the 98.2 reading seen in August. * Upward adjustments to net exports, inventories, and construction should lead to about a +0.5 percentage point revision to Q2 GDP to +3.3%. Final sales are expected to be pushed up to +2.5% (from +2.1%), while final domestic demand should be little changed at +3.5%. * We look for a 0.4% rise in August personal income and a 0.1% increase in spending. The employment report pointed to a decent gain in August wages and salaries and an upward revision to prior months. The major uncertainty on the income side will be the accounting for hurricane-related property damage, although this is a larger potential wild card in September. Meanwhile, a dip in vehicle sales and only a slight rise in retail control point to little change in consumer spending. Still, factoring in the expected 0.1% rise in both the core and headline PCE deflators, it appears that real consumption will show about a 4% gain for Q3 as a whole. * We expect the September ISM index to rise slightly to 59.5. The headline results of the regional surveys released so far have been mixed. However, on an ISM-weighted basis, these measures showed some improvement. Therefore, we look for a slight gain in the ISM relative to the 59.0 seen in August. The price component is expected to tick down a bit from the elevated level seen in August. Finally, note that even though the ISM diffusion index has slipped a bit in recent months, a reading of 59 is still about 1 point higher than the peak readings seen during the so-called ?boom? period of 1995-2000. * We look for a 0.2% rise in August construction spending. Housing starts posted a surprising uptick in August, but we believe that there will be some slight negative impact on overall construction spending associated with Hurricane Charley. A more pronounced fall-off might be seen in September, when the weather-related distortions were even greater. However, rebuilding in the wake of the numerous recent storms should actually help to bolster construction outlays in the months ahead. * We expect September motor vehicle sales to rise to 17.7 million from the 16.6 million unit reading seen in August, matching the best sales pace of the year. Anecdotal reports suggested that hurricane disruptions depressed sales early in the month, but activity appears to have subsequently rebounded significantly, with a sizable boost expected from the introduction of heavily promoted incentive offerings at month end. Current assembly schedules point to stable production levels in Q3 and Q4 on a seasonally adjusted basis. However, sales will probably need to average a bit better than 17 million over the next few months in order to avoid cuts to Q4 production. |
