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Strategies & Market Trends : Mish's Global Economic Trend Analysis -- Ignore unavailable to you. Want to Upgrade?

To: redfish who wrote (12291)	9/27/2004 10:47:40 AM
From: mishedlo	Respond to of 116555

Global: Collision Course Stephen Roach (from Melbourne) The world economy is on a collision course. The United States -- long the main engine of global growth and finance -- has squandered its domestic saving and is now drawing freely on the rest of the world’s saving pool. East Asian central banks -- especially those in Japan and China -- have become America’s financiers of last resort. But in doing so, they are subjecting their own economies to mounting strains and increasingly serious risk. Breaking points are always tough to pinpoint with any precision. Most serious students of international finance know that these trends are unsustainable. But like any trend that has gone to excess, a group of “new paradigmers” has emerged with a compelling argument as to why these imbalances can persist in perpetuity. That is usually the sign that the denial is about to crack -- possibly sooner rather than later. Unfortunately, the case for mounting US imbalances is easy to document. Reflecting an unprecedented shortfall of domestic saving -- a net national saving rate that fell to 0.4% in early 2003 and since has rebounded to just 1.9% in mid-2004 -- the US has turned to imported saving in order to finance economic growth. And since it must run external deficits to attract that capital, it should not be surprising that the US current account deficit hit a record 5.7% of GDP in 2Q04. Yes, America has had a current-account problem for quite some time. But there has been an ominous change in the character of these external deficits. For starters, the US current-account deficit is no longer the means by which America funds investment-led growth that drives increases in productive capacity. In 2003, net investment in the business sector -- the portion of capital spending left over after allowing for the replacement of worn-out capacity -- remained an astonishing 60% below levels prevailing in 2000. Meanwhile, the government’s overall saving rate -- federal and state and local units, combined -- went from a surplus of 2.4% in late 2000 to a deficit of 3.1% in mid-2004. Over the same period, overly-extended US consumers have wiped out any vestiges of saving -- taking the personal saving rate down to a rock-bottom 0.6% in July 2004. In short, America is no longer using surplus foreign saving to support “good” growth. Instead, it is currently absorbing about 80% of the world’s surplus saving in order to finance open-ended government budget deficits and the excess spending of American consumers (see my 23 August dispatch, “The Funding of America”). The international financial implications of America’s mounting imbalances are equally astonishing. It wasn’t all that long ago that the United States was the world’s largest creditor. In 1980, America’s net international investment position -- the broadest measure of the accumulated claims that the US has on the rest of the world less those that the rest of the world has on the US -- stood at a surplus of $360 billion. By the end of 2003, that surplus had morphed into a deficit of -$2.4 trillion, or 24% of US GDP. This transformation from the world’s largest creditor to the world’s largest debtor is, of course, a direct outgrowth of year after year of ever widening current-account deficits. Moreover, reflecting the particularly sharp widening of America’s current-account deficit in the past year -- an external shortfall of 5.7% at mid-2004 that is already running 1.2 percentage points above the 4.5% gap prevailing at year-end 2003 -- America’s net international indebtedness could easily hit 28% of GDP by the end of this year. Unless the US quickly addresses its current-account deficit problem, foreign debt is set to rise for as far as the eye can see. The best forecasts I have seen of this possibility are presented in a recent paper by Nouriel Roubini of NYU and Brad Setser of Oxford (see “The US as a Net Debtor: The Sustainability of the US External Imbalances,” September 2004). Under three alternative saving and current-account scenarios, Roubini-Setser bracket America’s net indebtedness in a range of 40-50% of GDP by 2008. This is hardly a result to take lightly. As scaled by exports -- a good way to measure the ability of any economy to service its external debt -- Roubini and Setser point out that US international indebtedness could be closing in on 300% of exports by the end of 2004. By way of comparison, pre-crisis debt-to-export ratios hit about 400% in Argentina and Brazil. Of course, America is far from a “banana republic” -- or is it? But this is only half the story. For every debtor there is always a creditor. Popular folklore speaks of a return-starved world that has an insatiable demand for dollar-denominated assets as a claim on America’s productivity-led miracles. But in fact, private demand for most major classes of dollar-based assets has been on the wane. Foreign direct investment into the US has fallen off sharply; outward FDI exceeded inward FDI by $134 billion in 2003 -- a dramatic reversal from 2000, when inward FDI flows exceeded outward flows to the tune of $160 billion. Moreover, foreign buying of US equities has also dried up. During the first seven months of 2004, foreigners bought an average of just $0.6 billion of US equities -- well short of the bubble-driven peak of $14.6 billion but also a significant shortfall from the post-bubble period 2001-2003, when foreign equity inflows averaged $5.7 billion per month. In addition, there is even a case that can now be made for a slowing of US productivity growth in the years ahead (see my 17 September dispatch, “Productivity Endgame?”). By default, that leaves foreign demand for US fixed income securities as the principal conduit of external financing. Contrary to widespread belief, it is not an open-ended “buy America” campaign by enthusiastic private investors from abroad. Instead, it is increasingly a policy decision by foreign officials with very different motives. Over the 11 months ending in July 2004, foreign official buying of US securities accounted for 35% of net inflows into dollars -- more than double the longer-term norm and 4.5 times the 7.6% share of 2000-02. In this case, there’s no deep secret as to the identity of the Great Enabler -- Asian central banks. The rationale is clear: Lacking in domestic demand, Asia needs cheap currencies in order to subsidize its export-led economies. Given the massive overhang of excess dollars that have arisen from America’s ever-widening current account deficits, Asian central banks must recycle their equally massive accumulation of foreign exchange reserves back into dollar-denominated assets. If they don’t do that, the dollar will fall and their currencies will appreciate. It’s as simple as that. Asian central banks currently hold about $2.2 trillion, or 80% of the world’s official foreign exchange reserves. As of year-end 2003, BIS data reveal that dollar-denominated assets made up about 70% of these reserves -- an astonishing overweight considering America’s 30% share in the world economy. Moreover, given the likelihood of persistent US current-account deficits, there is every reason to believe that Asian currency reserves -- as well as the dollar exposure of such holdings -- will have to rise sharply further in the years ahead. Nor should it be surprising as to who is driving Asia’s demands for dollars. Japan’s currency reserves are now in excess of $825 billion, whereas those of China have now exceeded $480 billion; collectively, these two nations account for more than half of Asia’s total foreign exchange reserves. Needless to say, should the dollar ever fall in the face of such a massive overhang of dollar holdings, portfolio losses -- the functional equivalent of an enormous welfare decline of foreign creditors -- would be staggering. America’s role as the world’s reserve currency offers no special dispensation from dollar depreciation or the staggering portfolio losses that Asian central banks would face in the event of such an outcome. That was the case in the latter half of the 1980s and is likely to be the case in the not-so-distant future, as well. A new-paradigm crowd now argues that these trends are a manifestation of a new world order. They refer to it as a new de facto Bretton Woods II Agreement -- or a new “dollar bloc” zone that includes the dollar-pegged countries of China, Hong Kong, and Malaysia, along with “soft-pegged” economies such as Japan, Korea, and Taiwan. The argument is based on the premise that it is in Asia’s best interest to keep funding America’s current account imbalance. To do otherwise would run the risk of Asian currency appreciation -- tantamount to economic suicide for these export-led economies. And, of course, there is an added twist in an increasingly China-centric Asia. As long as the RMB peg remains unchanged, other Asian economies -- including Japan -- have no desire to lose competitiveness with China. That puts China in the role as being the linchpin of the broader pan-Asian approach toward funding global imbalances. Lacking in domestic demand, export-led Asia simply can’t afford to go it alone. Like most things in the world today, dollar buying is made in China, and the rest of Asia is going along for the ride. This approach has the added advantage of also providing a subsidy to US interest rates that would undoubtedly rise sharply in the absence of this Asian dollar-support program. And, of course, those low interest rates provide valuation support for US asset markets -- first equities and now property -- that US consumers lever to reckless abandon (with cut-rate refinancing deals) in order to fund current consumption that then gets directed at buying cheap goods from Asia. In my view, this is an insane way to run the world. But the new paradigmers believe that this is the true “miracle” of international finance -- binding an unbalanced global economy together in a fashion we have never seen before. There is a huge flaw in this so-called miracle, in my view. Just as America is putting itself in grave danger by squandering its national saving, America’s Asian financiers are running equally reckless policies in providing open-ended funding for these imbalances. China is a leading case in point. I have been a diehard optimist on China for over seven years. But now I am worried that China is at risk of making a series of major policy blunders that are tied directly to its role in leading the new Asian way. It was one thing to maintain the RMB peg in the face of mounting world pressures to do otherwise in recent years. I still feel this was the right thing to do on a stop-gap basis -- in effect, providing China’s undeveloped financial system with an anchor during a critical phase of its integration into the global economy and world financial markets. But now China is digging in its heels on interest rate policy -- refusing to deploy the conventional policy instrument that is widely accepted as the principal means to restrain an overheated economy. China, instead, prefers to use the administrative edicts of its central planning heritage -- controlling the quantity of credit and project finance rather than its price. The combination of these two policy rigidities is especially worrisome. China’s central bank must keep creating RMB in order to recycle its foreign exchange reserves back into dollars; this runs the grave risk of undermining China’s ability to control its domestic money supply. But now, by holding its interest rates down, China is encouraging the very excesses that are driving its overheated economy -- a massive investment overhang and mounting property bubbles in several important coastal markets, especially Shanghai. By freezing the currency and its interest rates, China is, in effect, forcing its own imbalances to be vented in increasingly dangerous ways. This is not sustainable. In the end, sustainability will probably be challenged by the unintended consequences of this new arrangement. Several potential implications of this new world order worry me the most: First, there is the growing risk of politically-inspired protectionism in the US. A saving short economy will continue to suffer from large current-account and trade deficits -- putting unrelenting pressure on job creation. Washington -- even though it is creating these problems with a penchant for deficit spending -- will look to scapegoats in the arena of foreign trade. US Treasury Secretary John Snow’s recent broadside aimed at Chinese currency policy is especially worrisome in that regard. Second, China is hurtling down an increasingly unstable path by mismanaging its domestic and international finances. Inflation is now on the rise in this overheated economy and could well continue to accelerate until China shifts its macro policy settings (monetary, fiscal, and currency) into restraint. A failure to do that is a recipe for the dreaded hard landing. Third, Europe is being squeezed harder and harder. Asia’s dollar pegs means that the euro has to bear a disproportionate share of any dollar depreciation -- a depreciation that is a perfectly normal outgrowth of any US current-account adjustment. Europe’s economic malaise is a source of considerable political angst in that region. As a consequence, continued Asian currency pegging and dollar-buying could raise the likelihood of European protectionism -- especially toward Asia. In contrast with the claims of the new paradigmers, the stresses and strains of an unbalanced world are growing worse by the moment. These imbalances can be sustained only if the major nations of the world all march to the same beat. With the world’s growth dynamic now being effectively driven by just one consumer -- America -- and just one producer -- China -- the odds are growing short that such an increasingly tenuous arrangement can be sustained. China is probably the weakest link in this chain. That’s where I would look first as the potential trigger of the coming global rebalancing. I now suspect that China will flinch sooner rather than later. morganstanley.com

To: redfish who wrote (12291)	9/27/2004 11:48:26 AM
From: mishedlo	Respond to of 116555

Euroland: Inflation to Surprise on the Downside Elga Bartsch & Annemarieke Christian (London) While our colleague Dick Berner warns against false complacency about inflation in the United States (see his dispatch elsewhere on these pages), Euroland inflation seems poised to surprise markets and economists on the downside. In an otherwise eventless data week, a string of lower than expected regional state CPIs out of Germany, which showed a monthly drop of 0.3%M, caused the year-over-year inflation rate in Germany to ease from 2.0%Y to 1.8%Y. If a similar move would be repeated at the euro area level, HICP inflation could even decline from 2.3%Y in August to 2.1%Y in September. Assuming that the surprise drop in the price level would not be reversed in the coming months, Euroland inflation therefore could be back to the ECB?s upper ceiling of 2.0% already in January. So far, we had expected this to happen in the spring 2005 only. Against conventional market wisdom, we don?t view this potential downside surprise in Euroland inflation as a reason for the ECB not to hike rates before year-end. This is because the reasoning behind our call primarily rests on the low level of interest rates (see ECB Watch: The Door for a Rate Hike is Open, September 2, 2004). Lower than we and the consensus had expected, Pan-German consumer prices fell by 0.3%M in September. The Pan-German inflation rate fell by two tenths to 1.8%Y in September on the national CPI definition. On the harmonised measure, a similar fall on the month takes the annual rate down by only one tenth to 2.0%Y. The downward pressure was broad-based, according to the reports from six different regional states, with marked reductions in components such as food, services, gasoline and communication. Food prices fell by an around 0.5%M, taking the annual rate down by an average 0.9 percentage points. Developments within the energy component were mixed. While heating oil prices rose on the month, gasoline prices fell sharply, likely accounting for one tenth of the drop in consumer prices. In addition, marked declines in prices for package holidays likely pushed down the recreation component by a larger than usual 2.0%M. This could potentially be related to a shift in the holiday pattern across regional states compared to last year as we already observed some quirks in this particular component in August. The communication component was affected by a base effect which pushed down the annual rate markedly in September. Prices in the clothing component also seem to have risen by less than last year, pushing down the annual rate. Downward pressure in the clothing and recreation components likely pushed down core inflation (which strips out food and energy prices but not tobacco prices) by three tenths to 1.5%Y in September, on our estimates. Going forward, higher oil, gas and electricity prices together with the announced hike in railway ticket prices of 3.1% in early December might partly unwind the drop in September inflation. Elsewhere, French retailers have promised to cut prices by 2% this month and by another 1% in January. According to our colleagues Eric Chaney and Annamaria Grimaldi, the deal between the big retailers, their suppliers and the French Finance Minister to lower prices of various consumer staples will likely shave almost two tenths off September CPI and another tenth in January. More recently, the Italian government has reached an agreement with several large Italian retailers and supermarkets for a price freeze for selected products and a 2% reduction for some others. According to various press reports the agreement affects about 15% of the products sold at large retail groups and supermarkets in Italy. The price freeze will initially last until the end of this year. But the government seems keen to extend it into next year and also mulls a liberalization of the rigid rules on sales and opening hours in Italy. Yet, compared to France, where the agreement is to lower prices noticeably, the Italian deal concentrates on price freezes. That said, government projections of an impact of 0.7% look stretched compared to estimates from various Italian research institutes and consumer groups. Our own Vincenzo Guzzo estimates the impact to be between one and two tenths. In conclusion, if the German September CPI data are anything to go by, Euroland consumer price inflation data could potentially surprise on the downside in the near term. Yet such a downside surprise, especially if it to some extent comes from government-sponsored prices freezes or cuts, would not affect our call for a first ECB rate hike before year-end. When you think about it, it is somewhat ironic that European Finance Ministers, who likely add more than half a point to overall inflation this year through indirect taxes and administrative prices, now put on their hats as regulators (and thus guardians of price stability) and pressure retailers into lowering prices. morganstanley.com

To: redfish who wrote (12291)	9/27/2004 12:01:57 PM
From: mishedlo	Read Replies (1) \| Respond to of 116555

Time to Sell Bonds? Richard Berner (New York) Bonds are expensive in my view, and I think investors should lighten up to wait for better buying opportunities. Real yields are unsustainably low, complacency about inflation abounds, and many market participants believe — incorrectly in my opinion — that the Fed is nearly finished tightening monetary policy. However, there is some near-term risk that yields could dip slightly farther, reflecting so-called mortgage “convexity hedging.” And on both fundamental and technical grounds, the rebound in yields that I see coming from today’s too-low levels may not be immediate: Investors can still carry securities profitably, corporate borrowing is still muted, Asian official institutions are still accumulating dollar-denominated securities, and core inflation has recently declined. But I think that most of the “technical factors” keeping yields low are in the price and that they will fade. More important, I believe that a coming change in perceptions about inflation and growth fundamentals will be catalysts to sell bonds. Given the ongoing nature of the rate debate, and the new conviction among many investors that yields won’t rise, it’s worth reviewing both sets of factors, the risks to being short, and where value in US debt might reemerge. The first part of the debate revolves around the level of real yields. Real 10-year Treasury yields are 1½–2%, and the real federal funds rate is essentially zero; both are well below historical norms. Yet many investors suspect that the market is sending a message: We’re in a low-return world, and low real yields are just one aspect of that brave new paradigm. I’ve championed the idea that we are living in a world of single-digit returns for the past few years. But as I see it, even in that context, real interest rates are too low by any measure, given current economic and financial conditions. In my view, real yields should be significantly higher than they are for two reasons. First, faster trend productivity growth is associated with higher returns on invested capital (ROIC) and higher profitability. Higher ROICs will tend to increased investment, boosting credit demand relative to supply, and thus real yields. And because I think trend productivity is 2½% or higher, real yields in my opinion should rise to 3% or more. Second, our chronic imbalance between investment and domestic saving also argues for higher real rates. That imbalance is most obvious in two bleak elements of the saving picture: Absent policy changes, I think cyclically-adjusted federal budget deficits are more likely to rise than fall from today’s 3.2% of GDP, and while I think personal saving rates will ultimately rise, they have persistently edged lower to today’s 1%. But four factors are temporarily depressing real yields: A view that short-term rates won’t rise much, the return of the carry trade, low external financing needs, and Asian official institutions’ ongoing accumulation of dollar-denominated securities. In my view, at least the first three of those factors are poised to fade (see “Paradigm Shift?” Investment Perspectives, September 23, 2004). And if my colleague Steve Roach is correct, heavy Asian central bank buying of US securities may fade as they flinch from capping any increase in their currencies (see his accompanying dispatch, “Collision Course.”) Inflation and inflation expectations are the second key part of the rate debate. Rising inflation fears contributed to the 110 basis-point jump in 10-year Treasury yields that began in late March. Now, in my view, investors are overly complacent about inflation risks. TIPS spreads and our fixed-income strategy team’s curve-embedded inflation indicator both suggest that markets are discounting roughly stable-to-lower core inflation. I still think inflation threats are mild, but whereas the market is now priced for slightly declining inflation, I see upside risks (see “Inflation: From Fear to Complacency,” Global Economic Forum, September 24, 2004). Specifically, I think core inflation likely will rise to 2% or more, reflecting the three factors I’ve stressed for the last eighteen months. First, continued improvement in the balance between aggregate supply and demand, manifest in a narrower output gap and in rising operating rates, implies firmer pricing. The “output gap” has narrowed by more than a percentage point over the past year, to roughly 1½%, and factory operating rates excluding high-tech industries have jumped by more than 400 bp over the past 14 months. Second, monetary policy is still accommodative, evident in elevated inflation expectations and the lagged impact of the dollar’s decline on import prices. One-year-ahead median inflation expectations as measured in the University of Michigan’s monthly canvass are 30 bp higher than earlier this year. And the lagged impact of the dollar’s steep slide over the past 2½ years is now showing up in a reversal of earlier declines in import prices. Finally, unit labor likely rose at a 1.3% rate from a year ago in the third quarter — not high, but the fastest pace in three years. To be sure, there are risks to being short for the immediate future, because the rebound in yields may not come quickly. Indeed, there is some risk that yields could decline even farther; so-called mortgage “convexity hedging” could accelerate as mortgage refinancing rebounds at levels slightly below today’s yields. According to Morgan Stanley mortgage expert Laurent Gauthier, up to 3/4 of securitized mortgages are refinanceable at 10-year yields below 3.85%. A temporary further dip might also occur as the Fed slows its pace of tightening, the carry trade is still in vogue, and investors stretch for yield. The fact that corporate borrowing is still muted, Asian official institutions are still accumulating dollar-denominated securities, and core inflation is still tame for the moment all could continue to cap the upside in yields for now. Nonetheless, I think most of these factors are likely to change, and thus better bond-buying opportunities will emerge as Treasury yields rise towards 5%. Faster US economic growth and an upcreep in inflation will probably jolt the current consensus about monetary policy. Indeed, at the August FOMC meeting, officials pointedly reminded market participants 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 coming acceleration in business credit demand that I see will likely herald a changed balance between US investment and saving and push up real yields. The unwinding of some carry trades likely will accelerate the process. And even at such yield levels, we’ll still be living in a world of single-digit returns. morganstanley.com

To: redfish who wrote (12291)	9/27/2004 12:11:39 PM
From: mishedlo	Respond to of 116555

Currencies: Pondering the Fate of the Chinese RMB Stephen L Jen (Shanghai) A move toward greater RMB flexibility is a matter of time. I attach a 0% probability to RMB revaluation, but a close to 100% probability that the next RMB regime will NOT be another peg but a more flexible framework. In my view, the most likely new RMB regime is a ?crawling band?. In terms of likely timing, China will move when it is ready. In my view, it is possible that China dismantles the peg some time in 2005. Third, as regards the likely USD/RMB trajectory, my own guess is that, beyond an initial knee-jerk response, a downtrend in USD/RMB is far from certain. The next regime to replace the current de facto USD peg. As early as 2001, the PBOC declared its intention to eventually move toward a more flexible currency regime. Eventually, China will need to assert monetary independence, which necessarily implies dismantling the peg, at any parity. ? In contrast to the widely and deeply held view outside China, Beijing is not likely to revalue the RMB. Moving USD/RMB to a different parity does not enhance RMB flexibility. We draw a key distinction between what some investors and non-Chinese policymakers prefer versus what Chinese policymakers have in mind: Foreigners believe the RMB is grossly undervalued, and an appreciation would be justified. However, China does not necessarily believe that the RMB is overvalued, but wants greater flexibility. Chinese policymakers and foreigners have different objectives in mind when they espouse what to do on the RMB. ? Second, China is likely to maintain a dominant currency market presence to contain USD/RMB volatility. I believe China will not simply widen the trading band, while keeping the central parity unchanged because this would increase volatility with no gains in flexibility. More likely, in my view, is a Singapore-like ?crawling band?, whereby the central parity will be guided along an index tracking a trade-weighted basket of currencies, and a trading band will be defended. In the initial stages of the float, I expect to see a relatively narrow trading band to muffle the market?s knee-jerk response and to allow Chinese market participants to get used to increased volatility. ? Third, if I am right on a ?crawling band? regime, we should think harder about likely trade weights. If we use China?s trade weights, the USD and the explicit USD pegs (Hong Kong and Malaysia) account for some 38% of China?s total trade, while the other Asian currencies (JPY, TWD, KRW, etc.) account for about 45%, with Euroland and the UK accounting for only 12%. This means that, even if China moves to a ?crawling band?, the index is likely to be very ?docile,? as 80-85% of the index will either not move at all or move very modestly against the USD. Further, to the extent that the rest of Asia also runs, explicitly or implicitly, similar ?NEER-like? models in the background to help guide their exchange rate policies, the whole Asian region will move very slowly against the USD. The likely timing. The question of timing is a function of key factors that matter to Chinese policymakers. First, political considerations may be just as important as economic considerations. Second, my colleague Andy Xie has been a leading voice underscoring the downside risks to the Chinese economy. If the economy hard-lands, there would be virtually a 0% probability that the de facto peg would be altered. Third, adequate progress must be made in financial sector reforms before it is exposed to such a big shock. Finally, there will necessarily be an element of surprise. Although China will, in principle, change its RMB regime when it is ready, it will have to make the move a bit earlier than people think, before everyone is ready for the float, before speculative positions pile up in the market. For this reason, I suspect we could see the peg dismantled before most of the financial reforms are complete. The likely USD/RMB trajectory. The markets? knee-jerk reaction may initially push USD/RMB toward the lower barrier of the band, but where USD/RMB trades thereafter is far from clear: First, if China adopts a ?crawling band?, the evolution of USD/RMB will reflect movements in the trade weighted average of China?s trading partner currencies, not China?s own fundamentals. In the event that USD/JPY and USD/Asia drift higher, the whole USD/RMB trading band would drift higher, despite the fact that the actual spot rate may hover in the lower part of the band. Second, Beijing is likely to widen the trading band only very gradually. This should limit the scope for USD/RMB to collapse initially. Third, China?s private sector still has significant scope to raise its foreign currency (read, USD) holdings, if only controls on capital outflows are liberalised. Implications for other currencies. Movements in USD/RMB would have implications for other currencies, especially the USD. Asia accounts for 40.1% of the Fed?s broad USD index. If USD/RMB moves, it is likely that all of the Asian currencies not explicitly pegged to the USD will also move. Further, if the PBOC steps back on intervention to allow USD/RMB to fall, the psychological impact on the USD and indirect impact on US term structure could be severe and abrupt.

To: redfish who wrote (12291)	9/27/2004 12:13:21 PM
From: mishedlo	Read Replies (1) \| Respond to of 116555

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.