United States
Review and Preview
Mar 20, 2006

Ted Wieseman (New York) and David Greenlaw (New York)

After a nearly uninterrupted sell-off since mid-January, Treasury prices rallied strongly over the past week, with the gains coming in two big bouts of short covering on Tuesday and Thursday. The week’s data were mixed but provided on balance some modest support for the rally. Retail sales were a bit weaker than expected on an underlying basis, core CPI inflation was marginally better than expected, underlying manufacturing output slightly weaker than anticipated, and initial jobless were up.

But on the other side, housing starts held up far better than expected after a huge surge the prior month, regional manufacturing surveys were robust on an underlying basis, suggesting the manufacturing output pause in the IP report will prove temporary, and continuing jobless claims plunged to another new cycle low. The main driver for the week’s gains, however, appeared much more technically than fundamentally based, with a market that had apparently become quite short and bearish during the past couple months’ plunge caught offsides and forced to scale back short positions on some rethinking of the Fed outlook and a boost from even just modestly supportive economic data, with the reversal focused in red (June 2007 to March 2008) eurodollar futures. However, on a fundamental basis from our perspective (even after upping our Fed forecast a bit in our monthly forecast update released Monday), coming into the week the market had moved to price in an excessively hawkish near-term Fed path that contrasted markedly with recent Fed rhetoric and official statements suggesting that a near-term pause in the rate hiking cycle is likely. Coming out of the week, the Fed profile in the futures market looks more reasonable to us in the near term, but the reflattening in the eurodollar curve, with the Sep 06 to Sep 07 spread back to not far from its maximum inversion on the big gains in the reds on the week, was certainly a strange complement to a scaling back of near-term Fed expectations and seemed to have little basis in any fundamental news. In the upcoming week’s key event, Fed Chairman Bernanke will have a final chance to shape policy expectations pre-FOMC meeting when he speaks Monday night before the Fed enters its traditional quiet period ahead of the March 27-28 FOMC meeting.

Benchmark Treasury yields fell 3 to 16 bp on the week, and, tracking big gains in the red eurodollar futures — which were the star performers in the two big short covering rallies on Tuesday and Thursday that defined the week’s trading — the 3-year led, with its yield down 16 bp to 4.635%. The 5-year yield fell 15 bp to 4.62%, the 10-year 8 bp to 4.67% (recoiling Friday off what had been seen by some investors as a key technical level near 4.63% to 4.64%), and the long bond yield 3 bp to 4.72%. The 2-year yield completed the wild repo driven ride it has been on the past two weeks, breaking fully out of its squeeze on Thursday, and therefore underperformed badly on the week, with its yield down 9 bp to 4.65%. On March 3, the current 2-year and the 3% February 2008 issue both closed with 2.75% yields. Over the next six trading sessions, a dealer driven repo squeeze led to a considerable 7 bp outperformance by the on-the-run. But the squeeze fell apart late the past week in a hurry, and at Friday’s close these two issues were again back at identical 4.65% yields (with the 14 bp decline in the yield on 3% Feb 08 issue on the week certainly more indicative of the underlying performance of the front end). At Friday’s close, all the benchmark coupons were of course trading through the 4.75% level where we think the overnight rate will almost certainly be on March 28, so we’ll see in the days ahead if this is sustainable.

The strong rally in short and short-intermediate Treasuries was accompanied by a sizable repricing of the Fed in the futures market. The May fed funds contract rallied 3 bp to 4.88%, and is now pricing in about a 70% to 75% chance of a 25 bp rate hike at the May FOMC meeting to 5.00%, down from a nearly 90% chance a week prior. And after having started previously to move in the direction of pricing in a decent risk of yet another move to 5.25% in June, the market moved back to pricing a 5% peak, with the July contract rallying 9 bp to 4.96% and the September contract 12 bp to 4.99%.

You’d think that with the market moving to price in a lower terminal funds rate, it would price in less of a subsequent reversal (either in magnitude or timeliness), but just the opposite happened, with the Sep 06 to Sep 07 eurodollar futures spread flattening 4.5 bp to -17.5 bp, with the former contract gaining 13.5 bp to 5.085% and the latter 18 bp to 4.91%.

This compares with a maximum inversion of -21 bp hit February 28 and a recent peak of -12 bp on March 8. It would probably be a bad idea to try to draw too much fundamental message from this latest move, however, as the violence of the rally in the red (June 07 to March 08) eurodollar futures during Tuesday and Thursday’s big market moves, with gains of roughly 12 bp each day, appeared to have a lot more to do with short covering and lopsided market positioning than any reasoned reconsideration of the likely Fed path in the year after September. Our Fed expectations are now essentially in line with the market pricing in the near term, but we think the market is off base beyond that. We expect the Fed to hike the funds target to 5% in May and then pause with a tightening bias before a final hike to 5.25% around September, as growth accelerates a bit in the second half and underlying inflation picks up. We then expect policy to be on hold for an extended period before an expected soft landing to a slightly below trend growth rate in 2007, and attendant moderation in inflation pressures might allow some slight easing late in 2007. Our interest rate strategy team has recommended steepeners between the June 06 and September 2006 eurodollar contracts and flatteners between the June 2007 and December 2007 contracts, and our economic and Fed forecasts are in full agreement with these trade ideas.

Key economic data released the past week were mixed — on the market positive side, somewhat weaker-than-expected retail sales that led us to trim our 1Q consumption estimate a bit, marginally better than expected core inflation, and a slightly softer-than-expected IP report; and on the market negative side, significantly more resilient housing starts than expected and underlying strength in the key early regional manufacturing surveys. Retail sales fell 1.3% in February, dragged down by a 4.6% plunge in auto dealers’ receipts. Excluding autos, sales dipped 0.4% after surging an upwardly revised 2.6% in January. Weather related distortions clearly appeared to play a role in this volatility, with key categories such as clothing (-3.3%), restaurants (-1.9%), and general merchandise (-0.3%) correcting after very strong January results. The strange outlier to this trend was building material stores, which saw sales jump another 1.5% in February on top of a 7.3% spike in January. Since this category is not included in the key ‘retail control’ grouping that feeds into GDP-based consumption estimates, however, it was largely irrelevant. Retail control fell 0.7% after surging 2.0% in January. This was weaker than we had assumed in our first quarter GDP estimates, so we trimmed our 1Q consumption estimate to +4.8% from +5.1%. However, following some offsetting upside in ex auto retail inventories (+0.5%) in January and tweaks to some other assumptions, our 1Q GDP forecast remained unchanged at +4.6%.

The consumer price index rose 0.1% in February, both overall and excluding food and energy, though the core just barely rounded down to +0.1%, leaving the year/year rate unchanged at +2.1%, as expected. The slight downside in the core was attributable to a 1.0% drop in apparel prices, causing a 0.1% dip in core goods prices. This offset a 0.3% rise in core services, which were boosted by a 0.4% rise in the shelter category. This reflected some continued catch-up in hotel prices (+0.6%) and a bit of upside in rent and owners’ equivalent rent (both +0.3%).

Meanwhile, the headline CPI was a bit higher than expected as energy fell a smaller than anticipated 1.2%. The surprise there was a further 0.4% gain in electric utility rates after a record 5.5% surge last month.

We continue to look for core CPI inflation to accelerate a half point to +2.6% by the end of the year and the market-based core PCE price index three-quarters of a point to +2.2%, as we expect rising industrial operating rates, a sinking jobless rate, and a narrowing gap between actual and potential GDP have slowly helped many U.S. firms recapture pricing power, and will allow them increasingly to pass along higher costs. In addition to this fundamental argument, we think some more technical factors in the shelter components will also provide a boost to the core CPI in the months ahead. Hotel prices in the CPI, after a bizarre collapse last year, have started to close the previously yawning gap with much higher pricing reported by industry sources, but the CPI measure still seems to have a ways to go on the upside. Improving fundamentals in rental markets don’t seem to have been fully picked up yet in the CPI, which by its design of rolling samples (six separate rental ‘panels’ are each sampled twice a year, every six months, to construct the rent component) may lag turning points a bit, and as this filters through it should boost both rent and the key owners’ equivalent rent category. And if utility rates flatten out going forward, for technical reasons related to the way the rental sample is re-estimated as an ex-utilities ‘pure rent’ before being used to figure OER, the current gap between rent (+3.1% year/year) and OER (+2.5% year/year) that has been driven in part by previously surging utility costs should start to close, with OER moving up towards rent.

Housing starts fell 7.9% in February to a 2.120 million unit annual rate after having surged 15.8% in January to 2.303 million, a 23-year high.

The national average temperature in January was the warmest in the 112 years the government has collected data, but February was only slightly warmer than average, so the fact that starts only reversed half the January surge was quite impressive. In addition, underlying details of the report were stronger than the headline result. In particular, most of the decline in overall starts in February was attributable to a 30.4% plunge in the volatile multi-family category. More stable single-family starts only fell 2.3% to a very strong 1.80 million units annualized after having hit a record high in January. Obviously, this strength points to upside to residential construction in 1Q, but looking at the inventory and starts numbers together does start to raise some potentially worrisome questions about the possibility of homebuilder overconfidence.

The number of unsold new homes for sale was up 20.8% year/year in January to a record high, and relative to the (still strong) sales pace was at 5.2 months, the high since 1996. We look for a continued gradual decline in home sales and building and a flattening out in home price appreciation to about zero growth in real terms this year. If the incipient signs of possible overbuilding seen in the combination of the starts and inventory figures continue, however, there could be more abrupt adjustments down the road.

Weather volatility showed up yet again in the IP report. Industrial production jumped 0.7% in February, but all of the upside was attributable to a 7.9% surge in utility output, which partially reversed a record 11.5% plunge the prior month, the warmest January on record.

Manufacturing output was flat, pausing after a 12.0% annualized surge in the prior four months, the strongest gain over such a period since 1997.

Results by sector were mixed, with gains in fabricated metals, aircraft, printing, and paper offset by weakness in machinery, chemicals, petroleum, and food. The overall capacity utilization rate rose four tenths to 81.2%, returning to the cycle high previously hit in February, while the manufacturing rate dipped a tenth to 80.4% after hitting a multi-year high last month. The Fed estimates that manufacturing capacity is only growing 0.2% per month, so if output resumes its previous solid expansion after this February pause, the capacity utilization rate will likely resume a rapid rise.

Based on the results of the past week’s regional manufacturing surveys, a reacceleration in factory sector growth does indeed seem likely. The key early regional manufacturing surveys for March had mixed results in the volatile headline sentiment measures, but both were robust on an underlying basis, pointing to stronger factory sector growth in March and a solid national ISM result. For the Empire State survey, an ISM-comparable weighted average composite rebased to a 50-breakeven level jumped to 62.7 from 58.8 on gains in all the key components, including orders (29.15 v. 27.14), shipments (38.70 v. 32.22), and especially employment (21.75 v. 5.99). This was the second highest ISM-comparable Empire state reading in the four and half year history of the survey, trailing only a 63.6 reading recorded in May 2004.

Meanwhile, on the same basis the Philly Fed rose to 57.5 from 56.9, an eleven-month high. Upside was led by a sharp gain in the key orders index (+20.8 v. +12.5). Based on these results, partially tempered by a slight dip in the Morgan Stanley Business Conditions Index survey of our equity analysts (see the report Business Conditions: Forward-Looking Signs Point to Improvement by Shital Patel and Richard Berner for details), our preliminary forecast is for a rise in the national ISM to 57.0 in March from 56.7 in February.

There are a number of economic reports due out in the coming week, but none that seems likely to significantly alter market thinking ahead of the March 27-28 FOMC meeting. Instead, the most closely watched event of the week will likely be a speech by Fed Chairman Bernanke Monday night to the Economic Club of New York on “Reflections on the Yield Curve and Monetary Policy.” This will be the last public appearance by a Fed official before the traditional ‘quiet period’ ahead of the FOMC meeting begins, and investors will certainly be looking for any hints that the Fed might be preparing to signal a near-term pause in the rate hiking cycle. In supply news, the timing of the Fed meeting will result in the monthly 2-year and 5-year notes being announced early, on Thursday, for auction the following Monday and Wednesday. We look for unchanged sizes of $22 billion and $14 billion, respectively. Economic data releases due out include leading indicators Monday, PPI Tuesday, existing home sales Thursday, and durable goods and new home sales Friday:

* The index of leading economic indicators should fall 0.3% in February, the first outright decline since September, with negative contributions from vendor deliveries, consumer confidence, and building permits more than offsetting increases in the money supply and the factory work week.

* We forecast a 0.5% decline in the February producer price index but a 0.2% increase excluding food and energy. A sharp pullback in energy prices should help restrain the headline PPI this month. Meanwhile, we expect the core to post a more modest gain than seen in January as prices for motor vehicles are expected to have flattened out. Ongoing increases in quotes for drugs, metals and some paper products should be the main upside contributors this month.

* We look for a slight 1% dip in February existing home sales to a 6.50 million unit annual rate, as the pending home sales index suggests that activity is flattening out somewhat following significant deterioration at the end of 2005. In particular, the condo category may show some further slippage. However, this sector accounts for only about 10% of overall sales volume.

* We forecast a 1.5% gain in February durable goods orders. The main source of the expected elevation is a quirk in the defense component. A cut in budget appropriations for the Pentagon apparently resulted in the cancellation of a large tank order during January. Since the durable goods orders data are net of cancellations, this led to a negative dollar value for a component of military orders. This category should rebound in February, as the cancellation is a one-time event. Also, company data suggest that bookings for civilian aircraft stabilized in February following a sharp plunge from extremely elevated levels in the prior month. Finally, survey results point to some recent underlying improvement in order volumes. So, we look for an uptick in the key core category — non-defense capital goods excluding aircraft.

* After posting significant declines in November and December, the homebuilder sentiment survey has stabilized over the past couple of months. So, we look for a modest 1% dip in February new home sales to a 1.20 million unit annual rate.

 

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Italy
Soft Platforms
Mar 20, 2006

Vincenzo Guzzo (London)

In a previous dispatch recently (March 10, 2006, The Risk of Political Instability), we said that Italy’s return to an electoral system of full proportional representation would exacerbate the risk of political fragmentation within each of the two coalitions and, in the worst-case scenario of a split Parliament, it could even result in political paralysis.  In this note, we argue that the new voting system is also behind the dilution of the two electoral platforms.

International investors ask two recurrent questions.

The first question is whether any of the two coalitions, be it the incumbent government or the opposition, are delivering proposals that will be able to lift Italy’s trend GDP growth rate, now probably fallen close to 1%.  The second question is regardless of how convincing the two programs are, whether the prevailing coalition, whichever it is, will be able to implement material changes.  I find it hard to come up with a firm ‘yes’ on either of these two questions.  These soft electoral platforms are by-products of the proportional voting system.  They are the minimum denominator under which widespread coalitions managed to reach a broad agreement, and thus not particularly aggressive in tackling the country’s structural issues.  As far as their feasibility is concerned, the real game will kick off after April 10, in other words only once the actual balance of power within the winning coalition will have emerged.

At least five key issues are still pending and policymakers will find them on their desks.

1) How to put the debt ratio back on a declining trend?

A stock of public debt regularly above 100% of GDP is a serious drag on the economy.  Even at current favorable market rates, Italy pays €65 billion or 4.6% of GDP in debt services costs.  If only a fraction of these resources became available, it would allow a significantly lower tax intake, higher public investment in infrastructure, human capital, and innovation or a good mix of the two types of measures.  We often said that the 2006 budget was a more ‘responsible’ document than one might have expected.  Yet, in our view, it will still not prevent the deficit from rising further this year.  Sales of public assets may help reduce the stock of outstanding obligations, but the key variable is the primary balance, now at 0.5% of GDP from a peak of nearly 7% in 1997.  The new government, whoever chairs it, will have to scale back current spending and it will have to do it quickly.  We do not perceive a sufficient sense of urgency from both platforms.

2) How to cope with a shrinking manufacturing sector?

There will be no stability without growth.  Not only has the economy concentrated with time a large share of its manufacturing output in traditional low-growth, low-tech sectors, but also the weight of these sectors has become comparatively bigger.  Relatively cheap labor cost has long offered the country a competitive edge.  Globalization has now sentenced the end of that growth model.  True, average unit values of Italian exports have been on a rising trend lately, a sign of growing pricing power for some good players, but beyond these areas of excellence, the painful fall in manufacturing output volumes will likely continue and the country will have to cope with that.  The center-left proposal of cutting social security contributions by five percentage points certainly deserves attention, but the platform does not provide convincing arguments on how to fund these tax cuts.  The idea of a flat tax rate for all savings products at around 20% (currently deposits and postal savings are taxed at 27%, everything else at 12.5%) might not generate sufficient revenue, we think.

3) How to deregulate the services sector?

Against a shrinking manufacturing sector, there is an urgent need for a deregulated services sector.  Instead, businesses and professions sheltered from global competition keep enjoying fat margins at the expense of consumers and other sectors that have to confront that same competition.  In a monetary union, where competitive devaluations are not on the menu any longer, the only way to regain competitiveness is through relative price adjustments.  Germany has made progress through wage deflation.  In Italy, where wage levels are comparatively low, competitive disinflation will only be able to come from smaller increases in the prices of services.  Supporters of widespread deregulation in services sit in both coalition, but unfortunately, they are not the majority in any of them.  That is why both platforms take too soft a stance on this issue.

4) How to pursue first-tier labour market flexibility?

One should not underestimate the progress made in the labour market over the last two parliamentary terms.  More than two million jobs in seven years and an unemployment rate now standing at 7.7%, well below the euro-area average, are tangible signs of important transformations.  The result, however, came through a large use of temporary contracts, what we call second-tier flexibility, rather than lower firing barriers.  Such a widespread use of temporary workers might have weighed adversely on productivity and exacerbated Italy’s loss of competitiveness in the medium term.  The reform will have to strike a fine balance between reducing the use of temporary contracts and lowering firing costs.  There is no sign of this trade-off in either platform.

5) How to leverage on migration?

Migration is as an opportunity rather than a threat, we think.  On the back of one of the lowest fertility rates among the industrial countries, Italy’s population growth came to a standstill during the nineties.  That discrepancy alone would explain the growth differential observed during those years.  Migration will play an incrementally important role and the ability to put foreigners to work will be a critical factor of success for any European country looking forward.  On this front, Italy’s national labour contract does not offer sufficient flexibility to deal with the issue of migration, in our view.  Yet, for several politicians in both coalitions, let alone union members, this is still a taboo.  Electoral platforms offer only slim chances of seeing a shift towards a more decentralized wage bargaining system, where productivity and local conditions are appropriately accounted for.

Bottom line: there is a lot of work to be done to take Italy out of the doldrums.  Financial markets, rating agencies, European partners, and globalization will all press for changes.  I fear that politics will be reactive rather than proactive, a perfect recipe for volatility.

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