Need To Know News

In its initial revision to Q2 real GDP, the U.S. Commerce Department reported that the economy grew at a 4.0% q/q seasonally adjusted annual rate. This compared to an initial estimate of 3.4% growth and was in line with market expectations. The overall GDP chain-type price index was reported to have advanced at a 2.7% seasonally adjusted annual rate, which was identical to that originally released and also in line with market expectations.

As expected, the upward revision to growth in Q2 was due to a combination of factors, with the most important being 0.29pp more upside impetus from capital spending, 0.24pp more from net exports (a combination of higher exports and lower imports), and 0.14pp more from consumer spending. A partial offset was provided by a bigger decline in housing than first estimated. Real final sales growth (GDP less inventory change) was revised to 3.7% from an initial estimate of 3.2%, and domestic final sales growth (which also excludes the net export sector) was revised to a 2.2% pace from an initially reported 1.9%.

The big swings in inventories (-0.65pp contribution in Q1, +0.21pp contribution in Q2) and net exports (-0.51pp in Q1, +1.42pp in Q2), which proved so important to the improvement in overall growth in Q2, will not be replicated in Q3. Moreover, housing activity is going to weaken significantly further, and consumer spending is soggy. Real GDP growth in Q2 is thus likely to be well below that of Q3, with something on the order of 2.5% now looking to be a reasonable bet. A further slowdown is likely in Q4 as housing continues to bite and output growth slows in line with final demand. Our September U.S. Economic Chartbook and Forecast Update will be distributed next week, and, while we have not yet finalized our figures, it will definitely contain a significantly downgraded growth forecast and a revision in our Fed call to encompass near-term easing.

The overall GDP chain-type price index was unrevised, continuing to show a 2.7% q/q annualized rise in Q2, which followed gains of 4.2% in Q1 and 1.7% in Q4. The price index for core gross domestic purchases (GDP excluding food, energy, and the influence of net exports) was revised to show a 1.6% rate of increase, down from an initial estimate of 1.7%, and this followed increases of 3.1% in Q1 and 2.3% in Q4. The core personal consumption price index was also revised slightly lower, now showing a 1.3% rate of gain in Q2 versus an initial estimate of 1.4%, and this followed increases of 2.4% in Q1 and 1.9% in Q4.

The Conference Board U.S. consumer confidence index sank to 105.0 in August from a downward revised 111.9 in July (originally reported as 112.6). The August compared to a median market forecast of 104.0, and the move essentially retraced a July jump that was not expected at the time. With that said, we believe that further declines are likely given recent events in financial markets and the housing arena.

The expectations sub-index of the overall confidence index fell to 88.2 in August from 94.4 in July (June was 88.8).

The present situation sub-index declined to 130.3 in August from 138.3 in July (June was 129.9).

According to the Conference Board, “A softening in business conditions and labor market conditions has curbed consumers’ confidence this month. In addition, the volatility in financial markets and continued sub-prime housing woes may have played a role in dampening consumers’ spirits. But, despite less favorable conditions and in spite of all the recent turmoil, consumers still remain confident. And, current Index levels suggest further economic growth in the months ahead.”

The proportion of those reporting jobs as “plentiful” fell to 27.5% in August from a revised 30.0% in July (originally reported as 30.5%). Earlier results for this key measure were 27.6% in June, 29.1% in May and 29.0% in April. The August result suggests that the payroll gain for the month will be a moderate one.

The S&P/Case-Shiller home price index showed an accelerating rate of decline in June, which dragged prices down in Q2 by a substantial amount. The composite 20 city index, which only has a history dating back to 2001, fell by a record 3.50% in June measured on a 3-month annualized basis and by 3.49% measured on a y/y basis. The composite 10-city index, which has a longer history, fell by a y/y 4.1% in June and by a 3-month annualized 4.63%.

This index tracks individual properties, and therefore is not affected by a changing mix of housing. While not a perfect measure of home prices, it (and the OFHEO index which is similarly constructed) are the best indicators currently available.

As the chart at the bottom of this note illustrates, we are fast approaching the rate of price decline seen at the end of the 1990-91 recession, and the odds strongly favor blowing past this mark in coming months. With supply overhang growing and mortgage financing tougher to obtain, home prices are going to soften considerably further in the quarters ahead.

With that said, there is still a considerable dichotomy between geographical markets, as illustrated by the city detail in the table below. The weakest markets saw m/m declines of over 1% in June, while stronger markets were still posting increases of roughly 1%. Given conditions relating to mortgage financing, and the number of unsold homes that is piling up, areas posting price increases are likely to dwindle in the months ahead and weaker markets are going to erode further.

Existing home sales edged down by a m/m 0.2% in July to a 5.75M unit seasonally adjusted annual rate. The June sales pace was revised up to 5.76M from an originally-reported 5.75M, so the July sales pace matched what had originally been reported for the previous month. The median forecast for July called for a decline to a 5.70M unit pace (and our own estimate was even lower at 5.50M), so the result was better than generally expected.

The price data are mixed; we have been thinking that with the increased number of homes that were likely to come onto the market now, prices would soften in a significant manner. According to these data, this has not yet been the case.

The median price was $228,900 after $229,200 in June and $222,700 in May. The year over year change was -0.6% in July after no change in June and -2.5% in May.

Homes available for sale leaped by a m/m 5.1% to 4.592M units, representing a huge 9.6 month supply (a new cycle high) at the current sales pace. This followed 4.368M units in June, which represented a 9.1 month supply. Homes for sale are now +18.9% y/y from 3.861M units in July 2006, which represented a 7.3 months supply at the time. The trend here continues to show burgeoning new inventory, as potential sellers who had been keeping their home off the market, perhaps in hopes of seeing better prices, are now coming back into the market. This supply deluge is likely to depress prices (and probably has in real life), although the reported numbers do not yet show it. A 6.0 month supply used to be an average, but it fell to the very low level of 3.7 months as recently as January 2005, and that it is back well above a 6.0 month level, now reaching over 9.0 months, is a very good indication of the continuing slowdown in sales.

The July sales rate was well above the median forecast of 820K.

On an underlying trend basis, we have been looking for a floor near a 1.000 mln SAAR by year-end. Recent turmoil in the credit market, however, could put this forecast in jeopardy, and we would not be surprised to see sales rates in the high 800K’s to the low 900K’s persist for some time.

Our longer-term forecast for demand to level out near a 900K to 1 mln SAAR remains in place and that remains our forecast for 2008.

Interestingly, the relation between mortgage applications for purchases and actual purchases of new homes seems to have broken down in the past year or so, with applications well above actual sales. This could be due to multiple applications being filed by potential homebuyers in order to ensure a mortgage approval from someone.

In today’s report, the July new home sales rise was driven by a rebound in the West (213K after 174K in June and 203K in May). The Northeast was weak (53K after 70K and 88K), while the Midwest (112K after 113K and 144K) and the South (492K following 489K and 446K) were little changed in July.

The median home price rose to $239,500 in July from $230,600 in June, with the y/y change +0.6% after -5.2% in June. However, regional mix undoubtedly played a role here, as homes in the West are relatively expensive, and sales jumped in that region in July.

Homes for sale were edged down to 533,000 in July from 538,000 in June, and these followed 5341000 in May, 547,000 in April, 548,000 in March, 544,000 in Feb, and 536,000 in Jan.

The SA month’s supply is now at a 7.5, which follows 7.7 months in June, 7.5 months in May, 7.4 months in April, 8.3 months in March, 8.1 months in Feb, and 7.2 months in Jan. In the past, a 5.5 to 6 months supply was normal, but it had been near 4 months for several years before the current move up as inventories surge. The move up to over 6 months is a sign of increasing slowness as inventories rise.

Overall U.S. durable goods orders increased by a m/m 5.9% in July after an upward revised 1.9% gain in June (last reported as +1.3%). The reported headline result for July was well above the 1.0% gain expected by the market, but as usual interest lies in the details rather than the often volatile overall result. This month, the message from the details was strong, which follows weakness in June and May, strength in April and March, and weakness in February and January. While choppy on a m/m basis, the underlying trend of key series is improving, which is consistent with the path of the ISM new orders index. However, with these data for July, before credit market turmoil began in earnest, they are viewed as old news and not necessarily representative of current economic conditions.

In terms of capital spending, nondefense capital goods orders excluding aircraft rose by a m/m 2.2% in July after a 0.1% decline in June, a 1.5% drop in May, a 2.0% gain in April, and a 4.6% jump in March. Results for January and February (-4.4% and -2.4%) were suppressed by declines in orders for heavy trucks and heavy truck engines. These items were affected by new EPA emission regulations that took effect on January 1st and which caused demand to be pulled forward into 2006 so that purchasers avoided the new regulations. March and April orders seemed to be much less affected by this issue, and hence the strong rebound in capital goods orders. Subsequent softness in May and June was probably mostly due to payback from the outsized strength in the prior two months. Today’s strong result for July is heartening, but as stated above, not necessarily of current economic conditions given recent credit market events.

Shipments of nondefense capital goods excluding aircraft increased by a m/m 0.5% in July after a 0.8% drop in June and gains of 0.7% in May and 0.9% in April. The level of these shipments in July was only a smidgen above the average for Q2 as a whole, so there is little momentum entering Q3.

Orders for core durable goods (which exclude the volatile categories of civilian aircraft and defense capital goods) leaped by a m/m 4.1% in July after a 0.1% decline in June, a 0.9% drop in May, a 2.4% increase in April, a 1.9% rise in March, and declines of 1.6% in February and 3.7% in January. This category also encompasses the heavy truck and truck engine data discussed above, and the same reasoning holds for recent patterns as does the caveat concerning July strength.

Elsewhere in this report, inventories of durable goods rose by a m/m 0.1% in July after no change in June and gains of 0.1% in May and 0.4% in April. We are not assuming any great contribution (positive or negative) from inventories in terms of Q3 real GDP growth, and this report is broadly consistent with than notion.

The Bank of Japan voted 8-1 to leave rates on hold, but Fukui maintained his hawkish stance and the economic assessment was left unchanged.

The appetite for bottom fishing risky assets has taken hold this morning, reversing some of the asset price shifts of the past two weeks. This is still a risky market, vulnerable to a late announcement of financial problems as foreclosures rise (it is still almost impossible to roll mortgage backed commercial paper), hedge funds face calls to withdraw funds, and private equity deals struggle to get done. Central banks are still inclined to remain on hold rather than cut rates to give markets a boost. And for now that stance seems to be paying off. Bank of America bought $2 billion of Countrywide, while the concerted discount window borrowing by four big US banks, not for need but to reduce the stigma for others of going to the discount window, was joined by a German bank, who presumably was grateful for the cover.

Equities are up, with gains in Asia particularly impressive. The NIKKEI rose 2.6% (to remain down by over 5% for the year), the Hang Seng up almost 2.8% (to be up just over 15% for the year) and the Aussie ASX 200 up about 2.6%, to be up 8.6% for the year. Hong Kong is getting an extra boost from the policy shift to allow Chinese to buy HK shares. European markets are also showing solid gains, rising by just over 1% in the UK and across most of the Eurozone (Spain is up by about half that). The DAX has risen by almost as much as the Hang Seng this year, up 14.8% to date this morning.

The yen is down sharply, even against a fading dollar, as carry trades resume. As would be expected the AUD and NZD hare stronger. The yen was down by about ¥2.4 against the euro at just after 7:00 am New York time. As we noted, there was a pile into short-term US government assets which had a counterpart in a strong dollar. That had nothing to do with dollar fundamentals, so the dollar is very vulnerable to spreading good news on the liquidity front.

Bond prices are down, with the short end underperforming as might be expected. Yields in 10’s are up about 2bp across Europe and in Japan, while they are up 7bp in Australia and 16bp in New Zealand. Yields on two’s have registered more of the price action, rising about 5bp in Europe, 3 in Japan, 11 in Australia and 29 in New Zealand.

Oil prices rose this morning, with the US light crude contract up 44 cents at $69.70/bbl at about 7:30 est; Brent was up 63 cents, at $69.33/bbl. It is not yet clear when Mexico will reopen wells shut by the passage of Hurricane Dean. In addition, some of the sell off in oil contracts was the result of the need to sell liquid assets rather that a shift in sentiment about oil prices. Gasoline and diesel prices at the pump have edged off the lows they reached on August 19th.

On the data front, German real GDP details were firm. German GDP growth slowed to 0.3% in Q2, about a 1.0% annualized growth rate, from a rise of 0.5% in Q1. Declining inventories subtracted 0.6 percentage points from growth. Construction was also weak, falling 4.8% for the quarter, almost 20% at an annual rate, as truly dreadful weather put projects on hold. In combination those two points of weakness suggest that Q3 real GDP growth will show a solid gain. Private consumption contributed 0.4 percentage points to GDP growth, while investment in machinery and equipment added another 0.2 points, rising almost 10% at an annual rate. The largest contributor was net exports, adding 0.8 points to growth; that is not likely to repeated going forward.

UK Q2 investment spending was somewhat disappointing, as it was up just 0.8% after falling 0.6% in Q1. Manufacturing investment fell by almost 6% in the quarter. Investment intentions remained firm even as the data on spending has been quite weak in the first half of the year. The Bank of England has been down the big revision road before and is not likely to by moved much by these data.

Markets are calmer again this morning, with the predictable result that the yen is weaker and the euro and high yielders firmer. There are still calls for an immediate rate cut to ease pain in financial markets, but Bernanke seems rather determined to restore discipline in lending standards and risk management buy forcing lenders and investors to sort this out and take their losses. Over the long haul restoring market discipline is a good move; but it is also a good bet that any sign of emerging underlying economic weakness will lead to easier policy. In the meantime the Fed is taking administrative steps to make liquidity flow, such as the move yesterday to cut the fee for System Open Market operations.

The dollar has a somewhat weaker undertone this time, suggesting that we may be starting to see a bit of calm entering the markets — no guaranty yet of course. Hedge funds will undoubtedly face notice of planned withdrawals and will have to sell assets to prepare to meet those calls in coming weeks. Private equity deals still struggle to find financing and overly leveraged deals will not meet the return test once higher risk premia are penciled in, so this could be a slow unwind, possibly punctuated by another big chunk of bad news.

The Reserve Bank of Australia added liquidity to the system this morning. Tonight the Bank of Japan meets but no rate move is expected. The economic view will be important. So, it is still day-to-day.

Most global equity markets are up this morning, with the MSCI Asia Pacific up 0.3% despite flat to softer markets in Japan. The Hang Seng continues to outperform, probably on expectations of more Chinese money flowing in. European markets are solidly firmer, with the DAX up 0.9% and the CAC40 up 1.3% around 7:00am, est. A French bank said that it hoped to release funds frozen earlier this month, if market conditions allow, and that has given French markets a boost.

Bond prices are down this morning, with yields up 1bp in 10’s in Japan and 2bp in 2’s, outperforming European markets just as the NIKKEI underperformed. Yields in Europe are up about 3bp in 10’s and 7-8bp in 2’s; in the UK they are up about 5bp across the curve. Corporates are doing a bit better. The Itraxx Crossover index fell to 228bp; it soared to over 500bp at one point in this meltdown.

Oil prices firmed ahead of today’s US inventory data, with the US light crude contract up 22 cents at $69.79/bbl and Brent up 20 cents to $68.89/bbl. US crude stocks are projected to have fallen by 2.8 million barrels last week, with a drop of 900,000 barrels in gasoline. Hurricane Dean did not seriously damage oil facilities in the Bay of Campeche but rigs and platforms have been evacuated, temporarily disrupting Mexican production.

On the data front, Japanese exports and imports rose in value terms in July; both were up 0.5% M/M. The seasonally adjusted surplus edged up to ¥823 billion from ¥822 billion in June. In real terms exports rose 1.1% in July with imports up 1.4%, leaving the real balance almost unchanged from June and from Q2 as well.

In the Eurozone, new orders were up 4.4% in June, beating expectations; this followed a rise of 1.5% in May. Transport orders jumped 15.7%, a lumpy component of the orders data. Orders in Germany and France were particularly strong. The Eurozone current account surplus rose to E5.9 billion sa in June from a deficit of E7.8 billion in May.

UK CBI industrial trends data were firm in August. Total orders jumped from -6 in July to +9 in August, with expected output up to 13 from 10. Export orders improved, with that index at -3, up from -8.

Australian leading indicators jumped in June, rising 1.0% after a 0.2% increase in May. DEWR skilled vacancies rose 0.7% in August after a 0.1% drop in July. The economy remains strong but the upcoming election and financial jitters will keep the RBA on hold for now.

The jitters are back, although markets have come back fairly sharply off their morning lows in Europe. Rumors are circulating that the Fed might cut rates today, as Bernanke, Paulson and Dodd are meeting to discuss market turmoil. The Bank of England lent £314 million at the penalty rate overnight among reports of tight liquidity. The ECB injected E46 billion above estimated needs this morning. German banks in particular are complaining of funding problems. WestLB indicated it has some E1.2 billion in sub-prime paper and there are stories circulating that a German state-owned bank received E3 billion in emergency funding.

Government bond prices are higher, with yields in the Eurozone down 2-4bp in 10’s and 7-9bp in 2’s. Ten-year bunds are yielding 4.233% with 2-year Schatz yielded 3.848% (at 7:50 am New York time).

China raised interest rates by 27bp overnight, in its ongoing effort to curb rapid growth and mounting inflationary pressures — although for the most part those are from rising food prices about which monetary policy can do little. This is the fourth rate hike this year, bringing the one-year deposit rate to 3.6%; lending rates were raised 18bp to 7.02%. Low deposit rates have encouraged funds to be shifted into equities. This does not appear likely to impact that at all.

Equities rose in Asia, with the MSCI Asia pacific up 1.2% overnight. Equities slipped in early trading in Europe but reversed in mid-day European trading to be up in most markets. The DAX was up 0.38% at just after 7:30am NY time; it was off 0.56% at 6:40am.

The yen and euro strengthened slightly against the dollar this morning, while the high yielders and emerging market currencies were softer as risk aversion returned to markets.

Oil prices slipped this morning as the worst fears about storm damage from Hurricane Dean abated. The US light crude contract was trading off 9 cents, at $71.03/bbl with Brent up 14 cents at $69.99/bbl.

On the data front, the Japanese All-industry index rose 0.2% in June after falling 0.3% in May. That was a bit weaker than expected. Machine tool orders were revised up slightly for July, to 18.8% Y/Y.

The Eurozone trade surplus was higher than expected, at E7.8 billion in June, up from E1.7 billion in May; the seasonally adjusted surplus rose to E5.2 billion from E3.9 billion. ZEW investor confidence fell sharply in August, which is not surprising. Expectations in Germany slipped from +10.4 to -6.9. At the same time current conditions held up fairly well, falling to 80.2 from 88.2.

Canadian consumer prices rose in line with expectations, with headline and core prices up 0.1% in July for a headline Y/Y gain of 2.2% and a core increase of 2.3%. The core rate was down from 2.5% Y/Y in June.

Compared to the immediate past, today was a comparative yawn. Markets were orderly, and the Federal Reserve did not need to inject large amounts of liquidity into the system (and indeed announced that it would redeem $5B of T-bill holdings on Thursday). With that said, fear continues to be the sentiment du jour, best evidenced by a sharp drop in Treasury bill yields, propelled by money market funds jettisoning more risky paper in favor of bills. The current one-month bill fell about 70bp in yield to close at 2.25% (and actually hit a low yield of 1.27% near mid-day), while the current three-month bill also fell by about 70bp, closing at 3.04% (and hitting a mid-day low of 2.50%). A late-day bounce by stocks helped to limit gains elsewhere in the curve. Twos closed at 4.10% after opening at 4.18% and hitting a low of 4.05% early in the afternoon, threes closed at 4.17% after opening at 4.24% and reaching a low of 4.12%, tens closed at 4.64% after opening at 4.68% and reaching a low of 4.61%, and the bond closed at 4.98% after opening at 4.99% and hitting a low of 4.95%. With flight-to-quality still occurring, the curve steepened as twos outperformed tens, bringing the 2-10 slope to 54bp from closes of 50bp on Friday, 44bp on Thursday, 35bp on Friday, August 10, and 26bp on Friday, August 3.
With the spread of twos to the Fed funds target a whopping 115bp, and Fed funds futures pricing in 75bp of Fed ease by year-end, markets clearly believe that turmoil in the credit markets will have a significant impact on real economic activity and that the Federal Reserve will be forced to act in a decisive manner. With the Fed saying on Friday that it was prepared to “act as needed” to aid the economy, this is not an unreasonable bet given the uncertainty surrounding markets and economic activity. However, being not unreasonable is not the same as being a sure thing. Mr. Bernanke et al are surely anxious to avoid continuing the infamous “Greenspan put”, and therefore are unlikely to ease policy by as much as the markets are currently pricing in unless the economy truly careens into a ditch.