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July 19, 2011

By Ted Wieseman | New York

Continued turmoil in Europe, soft domestic economic data that continued to portray an increasingly poor 1H, and a strong run of 3-year, 10-year and 30-year auctions in dramatic contrast to the very poor 2-year, 5-year and 7-year sales in the last week of June boosted Treasuries to solid gains over the past week, moving yields in the short and intermediate parts of the curve back down towards the lows for the year hit three weeks ago.  The debt ceiling/deficit reduction negotiations turning into what seems to be acrimonious partisan debate and Moody's and S&P both warning about the possibility of an imminent downgrade of the AAA US sovereign rating became an increasing focus of investors through the week - and along with developments in Europe, will likely continue to dominate market focus in the coming week - but market impact to this point has been limited.  While there were brief bouts of general Treasury market weakness in response to the announcements from Moody's and S&P, the key impact for the week overall was notable underperformance by the long end and a rise in long-term inflation expectations rather than, to this point, any general impact on the level of rates.  The Moody's warning focused on the very small, but in its view no longer ‘de minimis', risk of an actual short-term default caused by the debt ceiling.  S&P, on the other hand, indicated that it believes that a major breakthrough on reducing the long-term deficit outlook is needed within three months to preserve the AAA US sovereign rating.  Odds of such an agreement being reached in the short term seem to be falling.  There has been a major shift in Washington this year towards broad bipartisan agreement that the deficit must be reduced sharply over the next decade and the debt/GDP ratio stabilized.  How to get there remains subject to vigorous debate and strong partisan disagreement, but we view as quite encouraging on a medium-term view the fact that the debate is now over how, not whether, to cut the deficit enough to stabilize the debt/GDP ratio.  And while without action the long-term debt outlook starts to become deeply concerning over the next decade, at only about 65% of GDP currently, the federal government debt/GDP ratio is not now at a problematic level at all, in our view.  So, we think that S&P's insistence that a deal be reached in three months is very short-sighted, but if it sticks to the view that a major long-term deal must be reached that quickly, then odds of a downgrade, mistaken as it might be, in our view, would certainly seem to be on the rise.



The bulk of the week's Treasury market gains came Monday, driven by continued heavy pressure in Italian markets as the crisis in Greece seemed to be spreading into broader systemic worries about the EMU, causing a substantial flight-to-safety rally in Treasuries.  While US market attention shifted somewhat back to domestic concerns about the economy and the fiscal situation over the course of the week, there was little relief in Europe stresses, with only a small improvement after bank stress-test results were released Friday.  Italy remained the key focus, and in late trading Friday, its 5-year CDS was trading near a record 305bp after about a 50bp widening on the week.  The EMU peripheral also remained under heavy pressure, with Spain's 5-year CDS widening about 40bp to near 350bp, Ireland 230bp to 1,120bp, Portugal 240bp to 1,140bp, and Greece to a 50-point upfront charge, up 2.5 points.  Domestically, weak results from the international trade report for May and retail sales report for June pointed to even slower 1H growth, while another upside surprise extended the rapid acceleration in core inflation.  We now see 2Q GDP tracking at 1.9% instead of +2.6%, while there is a rising likelihood that core PCE inflation could move above the top of the FOMC's 1.7-2.0% target range at year-end.  Although Fed Chairman Bernanke's semi-annual monetary policy testimony was somewhat more dovish than expected, such a trajectory for core inflation would likely still raise a high bar for additional easing even if the soft patch were to persist into 2H.
In addition to the crisis in Europe and softer-than-expected US growth data, it seems that investors are finally starting to focus much more closely on the debt ceiling fight in the US.  After a couple of days of surprising signs of hope at the end of the prior week after reports that President Obama and House Speaker Boehner had agreed in principle to a 10-year $4 trillion deficit reduction plan to attach to a debt ceiling increase, partisan deadlock has quickly returned as the clock continues ticking towards the August deadline.  That $4 trillion number is an important benchmark, because we estimate (see US Economics: Is a Debt Ceiling Deal on the Horizon? July 7, 2011) that a reduction in the deficit relative to the CBO baseline of about that much over ten years would be needed to stabilize the total federal debt to GDP ratio near 70% in 2021 compared to near 60% at the end of fiscal 2010 (which is about 50% Treasuries and 10% non-market debt-like savings bonds and SLGS).  With no change to the baseline, the debt/GDP ratio would likely be over 100% of GDP - and rising - in ten years.
Early the past week, Republican Senate Minority Leader McConnell proposed a three-stage plan that would require the president to announce a series of planned budget cuts that would allow a series of shorter-term debt ceiling increases, maybe creating some sort of avenue for compromise.  And Friday's news that House Republicans plan to approve a debt ceiling increase/deficit reduction plan in the coming week briefly lifted market hopes that a debt ceiling agreement might be nearer. The ‘cut, cap and balance' plan that the House will vote on slashes F2012 spending by $111 billion, cuts federal spending as a share of GDP to below 20% over the next few years (near the long-term average) from almost 24% this year, and requires passage of a balanced budget amendment to the constitution by Congress that caps federal spending at 18% of GDP as a condition for raising the debt ceiling.  The House Republican plan will most likely receive no consideration in the Democratic-controlled Senate, so the vote seems to represent a hardening of the partisan divide more than any progress towards a compromise.  The McConnell plan also seems unlikely to gain much traction, in our view, since it seems to be designed to force President Obama to identify specific cuts in popular programs and subsequently take the blame for not following through on those cuts.  So, the President would wind up taking the political heat from both sides.  We continue to see very little risk of any actual missed interest payment or other short-term debt default.  But it appears we may be heading towards a deal built more on less substantive or unenforceable provisions than real, enforceable deficit reduction.  With S&P warning that a plan implementing the $4 trillion needed to stabilize the debt to GDP ratio must be reached (or be very close to being reached) within the next several months to maintain the US's AAA rating, and chances of such a comprehensive deal seemingly declining, risks of a downgrade - unjustified as it would be at this point, in our view - appear to be rising.

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On the week, benchmark Treasury yields fell 5-15bp, with strong performance in the belly of the curve, but notable lagging at the long end as debt ceiling fears rose.  The 2-year yield fell 3bp to 0.36%, 5-year 13bp to 1.47%, 7-year 15bp to 2.17%, 10-year 11bp to 2.91%, and 30-year 2bp to 4.25%.  The long-end underperformance was all in higher long-term inflation expectations, reflecting both the somewhat more dovish-than-expected tone from Fed Chairman Bernanke as well as some sense that failure so far to make progress on a credible deficit reduction plan increases tail risks that the US debt will eventually need to be inflated away.  The 5-year TIPS yield fell 11bp to -0.63%, 10-year 10bp to 0.54%, and 30-year 9bp to 1.59%.  So, the benchmark 10-year inflation breakeven dipped 1bp to 2.37% while the benchmark 30-year breakeven rose 6bp to 2.66%.  There has been a nearly 40bp rise in the implied 20-year inflation breakeven 10 years forward over the past month to near 2.8% now from 2.4% in mid-June.
The trade deficit jumped $7 billion in May to $50.2 billion, a high since October 2008, with imports up 2.6% and exports down 0.5%.  In real terms, the widening in the deficit was somewhat smaller but still sizeable.  As a result, we now see net exports adding 0.3pp to 2Q GDP growth instead of 0.7pp, with exports expected to be up 9% and imports 5%.  Meanwhile, retail sales ticked up 0.1% overall in June and were flat excluding autos, which showed an odd 0.8% gain in contrast to the decline in unit sales results.  While lower gasoline prices weighed on ex auto sales, with gas station sales down 1.3%, underlying results were also surprisingly soft.  The key retail control gauge - sales ex autos, gas stations and building materials - rose only 0.1%, and there were slight downward revisions to prior months.  Results at clothing (+0.7%), general merchandise (+0.4%), and drug (-0.2%) stores were much softer than implied by the robust company-level sales reports for June, and the electronics and appliances (-0.2%), sports, books and music (-0.7%), and restaurants (-0.4%) categories posted unexpected declines.  Incorporating these results, we now see real consumer spending rising only 0.5% in 2Q.  While much of this weakness reflects the supply-driven pullback in auto sales, there was also some significant underlying softening as gas prices surged into the spring and soft employment reports in May and June led to sluggish income growth.
Combining the worse outlooks for net exports and consumption, we now see 2Q GDP growth tracking at +1.9% instead of +2.6%, a second straight sub-2% reading, adding to what has clearly been a very disappointing first half of the year.  We still believe that fading of some unusual and temporary drags point to a pick-up in GDP growth during 2H.  Four factors in particular should help deliver a 2H rebound.  First, recent assembly schedules point to a near-term spike in vehicle production.  Second, consumer spending should be supported over the next few months by a pullback in gas prices.  Also, we expect a further acceleration in capital spending tied to the tax benefits that expire at year-end and a significant boost from net exports (especially in 4Q as a result of persistent seasonal adjustment problem with oil imports).  A significant improvement in our MSBCI survey was an encouraging sign of some near-term improvement, with the index surging to 56% in July, from 33% in June, reversing last month's sharp contraction (see US Economics: Business Conditions: Sentiment Turns Up, July 13, 2011).  Still, the extent of the improvement in 2H activity seems likely to be less than we thought a month ago before the weak June employment report, given the fading support for income and production evident in the jobs figures, and the weak underlying June retail sales results provides a weaker starting point than we expected for the +2.9% gain in consumption built into our +3.3% 3Q GDP forecast.
Fed Chairman Bernanke provided some hope to investors that a continued soft patch into 2H could possibly draw a Fed response, but the substantial acceleration in core inflation likely leaves a high bar for renewed easing.  The consumer price index fell 0.2% in June, leaving the year-on-year pace steady at +3.6%, as a 7% plunge in gasoline led to a 4.4% drop in energy prices.  The core continued to accelerate, however, rising 0.25% on top of a 0.29% gain in May, the largest two-month increase since 2006.  This lifted the year-on-year rate another tenth to +1.6% (and it nearly rounded up to +1.7%), up a full percentage point in the past eight months, the fastest acceleration over such a period in over 20 years.  Notable core upside in June was seen in owners' equivalent rent (+0.2%), apparel (+1.4%), new motor vehicles (0.6%), used vehicles (+1.6%), and personal care goods (+0.4%).  While the acceleration has been broadly based, given that it makes up over 40% of the core, the turn higher in shelter costs from -0.7%Y last August to +1.2% in June continues to be the most important development.  Industry reports indicate that rental market conditions have continued to tighten substantially in recent months, with vacancy rates falling rapidly after years of minimal new construction and effective rent growth continuing to accelerate.  We look for overall CPI shelter inflation to accelerate to over +2% by year-end from +1.2% in June, providing a substantial further boost to overall core inflation.
Based on the CPI and PPI results, we forecast a 0.20% gain in the core PCE price index in June, which would lift the year-on-year rate to +1.4% from +1.2% in May and the +0.7% December low.  Core PCE inflation only rose 0.20% cumulatively in 2H10, so even with a significant deceleration in sequential gains through the rest of this year, we now see core PCE inflation as likely to end this year slightly above the Fed's 1.7-2.0% target range.  Fed Chairman Bernanke's semi-annual monetary policy this week was somewhat more dovish than expected, as he spelled out for the first time the criteria for additional easing and again discussed the explicit measures that could be used to ease further.  For the Fed to move towards QE3 or other forms of renewed easing, Chairman Bernanke said that the recent economic weakness will have to prove to be more persistent than expected and deflationary risks will have to reemerge.  It was notable that he did not specifically say again that the bar to renewed easing is high.  But with core PCE inflation on pace to accelerate significantly further through the rest of the year, potentially breaking above the top of the Fed's preferred range by year-end, we believe that it will be very difficult for the FOMC to consider renewed easing even if the 1H economic soft patch continues into 2H.
The economic calendar is very light in the coming week, and investor focus will likely remain on developments in Europe and on the fight over the debt ceiling in the US.  Data releases due out include housing starts Tuesday, existing home sales Wednesday and leading indicators Thursday:
* We expect housing starts to rise 1% in June to a 560,000 unit annual rate.  By sector, we look for a very slight dip in the key single-family category to be more than offset by some upside in multi-family.
* We forecast a gain in June existing home sales to a 5.00 million unit annual rate.  The pending home sales index registered a solid rebound in May, and some regional realtor groups have reported improved results in June.  So, we look for about a 4% rise in June resales.  We will update our estimates if any of the other regional organizations release their results ahead of the national figures.
* The components that are available at this moment point to a decent 0.4% gain in the index of leading economic indicators in June, with significant positive contributions from money supply and the yield curve partly offset by negative contributions from stock prices, consumer confidence and the manufacturing workweek.