United States Review and Preview By Ted Wieseman

May 19, 2009 By Ted Wieseman New York Even after a small bout of profit-taking Friday, Treasuries had their best week since the mid-March surge that followed the FOMC's announcement that it would be buying Treasuries and sharply boosting its MBS and agency buying. The temporary shift in supply dynamics - three rounds of Fed Treasury buying during the week and no new coupon supply - was a key positive backdrop for the week's partial recovery from a rough few weeks when the market had to take down an absolute flood of coupon supply. A general, and obviously not surprising, trend seems to have emerged since the Fed starting buying Treasuries in the past couple of months of the market struggling during the supply weeks and then doing better, holding steadier if not necessarily seeing the sort of upside of the past week in the non-supply weeks, of which there are usually two each during a month. However, the net of this has been one step forward, two steps back, as the losses during supply periods have been bigger than any recoveries in non-supply, Fed buying-only weeks. On top of this temporarily positive background shift before the next wave of supply after Memorial Day, interest rate markets also benefited from negative turns in both risk markets and the tone of the economic data. After having surged to recent highs at the end of the prior week, both equity and credit markets saw partial negative reversals - relatively modest reversals certainly compared to the upside of the past couple months, but still about the only meaningful break in the powerful rallies that had been ongoing since early March for stocks and more so early April for credit. And on the data front, a second-straight weak retail sales report that reinforced expectations for a renewed contraction in consumer spending in 2Q after the small recovery in 1Q along with an ugly jobless claims report that pointed to another painful employment report in May marked a break in what had been a fairly consistent recent trend of economic news that was still bad by any absolute standard but in most cases notably less so than during the 4Q/1Q period when the economy was in near freefall. To be sure, though, this general underlying trend does still appear to be on track. A number of data releases directly impacting our 2Q GDP forecast ultimately netted to us slightly reducing our estimate to -2.8% from -2.5%, which would certainly be a lot less bad than the 6% annualized plunge in 4Q and 1Q. On the other hand, such a contraction would hardly be good news in any absolute sense. The worst single quarter in the 2001 recession saw GDP fall just 1.4% and the 1990-91 recession 3.0%. Coming into the past week, though, it had appeared that many investors were thinking that as negative as 2Q could still end up being in an absolute sense, we might have entered a quickly improving path of something like -6% to -3% to +3% or even stronger in short order. Indeed, we've noticed increasing chatter drawing comparisons to the nearly 8% surge in real GDP in 1983 that followed what was previously the deepest post-war recession in 1981-82, without taking proper account of the much different causes and characteristics of the early 1980s downturn. The more negative tone of some of the past week's key data appears to have thrown some, in our view certainly appropriate, caution back into the outlook about how soon and how robust the ultimate move back towards actual recovery instead of just slower contraction will be. On the week, benchmark Treasury yields plunged 14-20bp and the curve flattened more than reversing the prior few weeks' losses at the short end to take yields to the low end of the ranges seen since the end of January, though only recouping a portion of the recent sell-off in the high yields for the year at the longer end hit at the end of the prior week. The 2-year yield fell 14bp to 0.85%, 3-year 17bp to 1.29%, 5-year 16bp to 1.98%, 7-year 16bp to 2.63%, 10-year 17bp to 3.13% and 30-year 20bp to 4.08%. Considering the magnitude of the rally in nominals, weakness in commodity prices, and the major outperformance they were coming off the prior week, TIPS performed very well even if they couldn't quite keep pace with nominals across most of the curve, and the long end even managed to do that. Big support for TIPS was seen after Friday's slight upside surprise in the headline CPI print. The 5-year TIPS yield fell 10bp to 0.99%, 10-year 10bp to 1.63% and 20-year 25bp to 2.20%. The benchmark 10-year inflation breakeven has been holding close to 1.5% for several weeks now after having seen a big move up from the recent low close of 0.84% on March 6 (certainly not coincidentally almost right at the same time stocks bottomed). The renewed upside in Treasuries helped mortgages get back on track as well after a rough end to the prior week when Treasuries were crushed by the weak 30-year auction that wrapped up the most recent supply deluge. Yields on 4% MBS rallied from about 4.05% to about 3.95%, right in the middle of what's been a narrow range since the rally that followed the Fed's March 18 upsized buying announcement. The good news in that clearly is that mortgage rates have been so stable as Treasuries have been under pressure, and spreads have thus come in. The bad news is that after a quick move to new record lows in late March, average 30-year fixed mortgage rates have also been tightly range-bound, not moving far from 4.80%, and to this point while refi applications and origination activity have definitely picked up notably; at this point, we're really just not seeing a refi wave of nearly the size we had been hoping for a couple of months ago. Mortgage rates having stalled out has not helped obviously, but the extent to which borrowers are too far underwater on their mortgages to refi even with the relaxed loan-to-value standards adopted by the agencies may also be more severe than was generally thought. The rebounds in Treasuries and mortgages in the past week were positive developments, but probably the most notable ongoing trend in the interest rate space was the continued collapse in interbank lending rates and spreads and the knock-on effect this has had on swap spreads the past two weeks. We have to acknowledge that the magnitude and rapidity of the improvement here indicate that pressures on bank balance sheets may be easing at a more substantial pace, and the credit crunch that has resulted from the bank balance sheet, capital and liquidity strains may thus be easing sooner and more rapidly than we had expected. 3-month Libor has now been lower at every fixing for seven straight weeks, extending last week's initial move to a record low by another 11bp the past week to 0.83%. The spot 3-month Libor/OIS (a measure of the expected average fed funds rate over the next three months) saw another similar-sized drop on the week to 63bp, a low since right around the time of the Bear Stearns collapse in March 2008. The improvement in forward spreads remained just as impressive, as the white (Jun 09 to Mar 10) eurodollar futures rallied 8-19bp on the week, with 3-month Libor expected to hit a low (at least on a eurodollar settlement date) of 0.75% on June 15. As a result of these gains, the forward Libor/OIS spread to June fell about 7bp to near 55bp, September 9bp to 50bp, December 13bp to 53bp and March 12bp to 43bp. Longer-dated forwards indicate that, in this new financial world, we'll never get to the just 10bp or so spreads seen before mid-2007, and the projected March 2010 spread is not too far from the expected long-run normal level. It was rather odd that, over the recent months of steady Libor improvement, for some reason it was really only when the new record low was originally hit on May 5 that swap spreads began to respond in kind, but the huge improvement that started then has kept running, with a major further narrowing in the latest week. The benchmark 2-year swap spread fell another 5bp on the week to 42bp and 5-year 4bp to 46bp, both two-year lows, while the 10-year spread fell 3bp to an all-time low of 9bp. It clearly won't take much of an additional supply-driven sell-off in 10-year Treasuries for the 10-year swap spread to join the 30-year in negative territory, a phenomenon that has not been so abnormal in many other countries but had never been seen in the US before last fall. After hitting their best recent levels following a powerful recent rebound, risk markets gave back some ground in the past week, supporting the bid in Treasuries on top of the improved supply balance and the less positive tone to the data. The S&P 500 fell 5% after the previous 37% recovery off the March 9 low. Financials, as usual, remained the high-beta sector, leading on the way down the past week after leading the prior rebound, with the BKX banks stock index down 16% the past week. To some extent, this appeared to reflect supply pressure and dilution concerns from stepped-up issuance, and so couldn't really be considered a particularly negative sign to the extent that it also indicated the renewed openness of equity markets to bank stock issuance. A similar phenomenon appeared to be a notable cause of a widening in corporate credit spreads on the week after the recent tights hit Friday, as corporate issuance ran at a robust pace through the week. In late trading Friday, the investment grade CDX index was 14bp wider at 157bp, still retaining the bulk of the rally from 202bp on April 1 to 143bp at the end of the prior week (the credit rally didn't really get going to the same extent as stocks until a bit later than the early March take-off point for equities). Similarly, the high yield CDX index was 119bp wider at 1,127bp through Thursday after hitting a recent tight at the end of the prior week and trading down a bit further Friday, while the leveraged loan LCDX index was showing a comparable pullback, widening 112bp through midday Friday to 1,175bp. In the commercial mortgage CMBX market, the AAA index pulled back 2 points on the week to just above 73, a comparable showing to other risk markets. The middle-rated indices in this market have been going a bit crazy recently, though. A huge short squeeze that began in the prior week extended into Monday in the AJ to BBB indices that resulted in eye-popping percentage gains in these indices in a very short time period (including 50% in the AJ in five trading sessions and 84% in the AA). A portion of these gains were reversed through Thursday, but it looked like a second upside wave might be kicking in Friday, with the AJ in particular posting a big gain. Netting all this volatility, it ended up being a very good week for the AJ through BBB- indices, but with market positioning and technicals seeming to have taken over market dynamics, the path forward in the near term is obviously subject to a lot of uncertainty. The subprime ABX market has had a much more stable recent trading pattern - steady upside off the early April lows for the AAA index, little movement at levels not much above zero for the lower-rated indices. What had been a series of almost daily gains for the AAA index since the April low, however, did seem to be petering out towards the end of the week, with the index falling a quarter point on the week to 26.58, its first down week since the rally off the April 8 low of 23.10 started. The past week's active economic data calendar had a number of releases that directly impacted our GDP forecasts. After swinging around a fair amount in response to the figures, we ultimately slightly reduced our 2Q GDP forecast to -2.8% from the -2.5% we had reset it to on Monday in our regular post-employment report reassessment of our estimates. The expected composition of the 2Q decline looks more notably different, however. In particular, a second-straight worse-than-expected retail sales report combined with an updated slightly higher assumption for PCE inflation led us to cut our 2Q consumption estimate to -1.4% from -0.5%. And a higher-than-expected outcome for retail inventories at the end of 1Q suggested that 1Q growth will be revised up a bit further than we previously estimated, but with an offsetting more negative inventory contribution now expected in 2Q. On the positive side, though, the trade deficit was substantially narrower than expected in March, providing a much more positive starting point for 2Q net exports, which we now expect to be a neutral influence on 2Q growth instead of a moderate drag. The trade results also pointed to a somewhat smaller drop in 1Q growth, and combined with the upside in March retail inventories, we now see 1Q GDP being adjusted up to -5.7% from -6.1%. Also a bit positive for 2Q, moderation in the rate of decline in computer production, part of a broader pattern of slower rates of deterioration across most key industries in the industrial production report, pointed to a slightly-less-severe further decline in 2Q business investment after the record plunge in 1Q. Retail sales fell 0.4% in April, a second-straight-renewed decline after a brief bounce early in the year followed the collapse seen in 2H08. Motor vehicle sales posted a surprising 0.2% gain despite the drop in unit sales, but ex-auto sales dropped 0.5% on top of a downwardly revised 1.2% decline last month. Softness in non-auto sales in April was broadly based. The heavily weighted grocery store component (-1.0%) saw unusually large weakness, and there was a price-related pullback at gas stations (-2.3%). And key discretionary categories including clothing (-0.5%), general merchandise (-0.1%) and electronics and appliances (-2.8%) came in weaker than expected after the somewhat better-than-expected chain store sales results. The key retail control grouping was down 0.5% in April on top of a downwardly revised 1.2% decline in March, a worse outcome than we expected. Translating the CPI results into an estimate for the PCE price index also gave us a slightly higher estimate for April than we had been building in, pointing to slightly weaker real spending on top of the downside in nominal outlays implied by the retail control contraction. As a result, we now see 2Q consumer spending heading down again at a 1.4% annual rate in 2Q after the small (and likely to be revised down a bit) 2.2% rebound in 1Q that followed the near-record 4% collapse in 2H08. Meanwhile, retail ex-auto inventories dipped 0.2% in March, a significantly smaller drop than BEA assumed in preparing the advance estimate of 1Q growth, pointing to a smaller (but still very large) inventory drag in 1Q, but with an offsetting more negative contribution in 2Q. On the positive side, the trade deficit only widened US$1.5 billion in March to US$27.6 billion after having plummeted US$10 billion in February to a ten-year low. On the face of it, the huge narrowing in the trade deficit since last summer is good news, but the extraordinary collapses in both imports and exports that have driven it are quite disturbing. In March, imports were down 1.0%, a ninth-straight decline at a record 40% annual rate over this period. March weakness was led by natural gas, autos and consumer goods. Meanwhile, exports resumed sinking in March after a small bounce in February, falling 2.4% for an eighth drop in the past nine months, plunging at an unprecedented 31% annual rate over this timeframe. Downside in March was concentrated in capital goods. BEA had assumed a larger widening in the March trade gap, and we had built in a bigger widening than BEA, so these results were positive for the 1Q GDP revision and provided a notably positive starting point for 2Q net exports than we had expected. We now see net exports being about neutral for 2Q GDP instead of subtracting a half point, though we see both exports (-18%) and imports (-15%) falling again. Although the trend turned a bit more mixed with the past week's retail sales downside and a terrible jobless claims report, the industrial production data extended the general recent trend of continuing negative data flow, but to a lesser extent than when the economy was in freefall in 4Q and 1Q. IP remained weak in April, but the latest month's 0.5% drop marked a notable deceleration in the pace of decline after a 17% annualized plunge over the prior eight months. The key manufacturing gauge declined another 0.3%, but this similarly represented a less bad result than the prior trend. Motor vehicle and parts output rose 1%, a smaller gain than we had expected based on industry data, but there has still been at least some rebound in assemblies after an astounding collapse in January. It appears likely that the motor vehicles sector will be a small positive for 2Q growth, but clearly this will swing sharply in the other direction over the summer into 3Q as GM implements its plans for extended and widespread plant shutdowns to try to get inventories under control (note also that the dealership closing announcements by GM and Chrysler could have a substantial negative impact on retail employment, probably starting with the June payrolls report). Manufacturing ex-autos output was down 0.4%, with most key sectors remaining weak, but less so than in prior months. This included computer production, which declined 2%, a slower pace of decline than seen in nearly a year and a bit less bad than we expected. Computer investment in GDP is mostly sourced to computer IP, so this slightly boosted our forecast for business investment in equipment in software to a slightly less disastrous -22% from -23% after non-residential investment collapsed at a record rate in 1Q. Meanwhile, capacity utilization dipped 0.3pp to 69.1%, another record low after a massive collapse from 78.7% in mid-2008. The economic calendar is very light in the upcoming week, with the data focus likely to be largely on leading indications for the upcoming employment and ISM reports, as initial jobless claims this week will cover the survey period for the May employment report, and the Philly Fed survey on Thursday will help set ISM expectations after the small improvement in the underlying details of the Empire State survey released Friday that lagged the larger gain in the headline sentiment measure. Unless claims swing back in a notably more positive direction after the terrible results of the past week's report - a big rise in initial claims that reversed much of recent improving trend and a near-record gain in continuing claims to yet another record high - initial expectations for employment will likely be for another grim report. Supply dynamics should remain positive for another week, with another week of no new coupon supply and three more rounds of Fed buying. On Thursday, however, the Treasury will announce the terms of the 2-year, 5-year and 7-year notes that will be auctioned after Memorial Day, which will likely start swinging the oscillating week-to-week supply dynamics back in a negative direction. Note that although SIFMA has partially acquiesced to the Treasury's request to eliminate early closes ahead of holiday weekends (though we'll see to what extent market participants actually follow SIFMA's official recommendations), the early close before Memorial Day remains, so Friday will be a short trading session. Other than claims and the Philly Fed survey on Thursday, the only data releases of particular note in the coming week are housing starts Tuesday and leading indicators Thursday: * Outside of a short-lived spurge in February - driven by the volatile multi-family category - starts appear to have settled in near a 500,000 annualized rate over the past several months, and we expect them to remain there in April. We suspect that this sluggish pace of homebuilding will be sustained for the foreseeable future, which should help to absorb much of the excess inventory of unsold new homes by late 2009. * Based on currently available components, the index of leading economic indicators is likely to jump 1.1% in April, which would be its first increase in nearly a year and the sharpest gain in four years. The recent surge in stock prices represents a huge positive contribution, with more modest but still sizeable adds also from the steep yield curve, an improvement in consumer confidence and some slippage in jobless claims. The only substantial negative offset at this point is from a significant decline in the money supply that is likely related to some tax season volatility.